A Backdoor Roth IRA: What It Is and How to Use It

If you earn too much to contribute directly to a Roth IRA, you may think that you are out of luck when it comes to this tax-advantaged retirement account. However, there is a loophole that could allow you to contribute to a Roth IRA, regardless of your income. This loophole is known as the backdoor Roth IRA.

What is a Backdoor Roth IRA?

A backdoor Roth IRA is a way for high earners to get money into a Roth IRA, even if their income exceeds the IRS limits for direct contributions. For tax year 2022, individuals earning more than $144,000 (or couples earning more than $214,000) are not eligible to contribute directly to a Roth IRA. For tax year 2023, the income limits are $153,000 and $228,000 respectively. However, by using the backdoor Roth IRA strategy, these individuals can still take advantage of the tax benefits of a Roth IRA.

How Does a Backdoor Roth IRA Work?

The backdoor Roth IRA strategy involves two steps:

Step 1: Make a nondeductible contribution to a traditional IRA. This is essentially the same as making a contribution to a Roth IRA, except that you do not receive a tax deduction for the contribution. This means that the money you contribute has already been taxed.

Step 2: Convert the traditional IRA to a Roth IRA. After you make the nondeductible contribution to your traditional IRA, you can then convert the money to a Roth IRA. Because the contribution was already taxed, you will not owe any taxes on the conversion. 

Important Note: You will have to pay taxes on any gain that is accumulated in the Traditional IRA prior to converting it. To avoid this, it is recommended that you convert the funds soon after making the nondeductible contribution so that there are no gains to be taxed. 

If you have other traditional IRA funds, the conversion will be taxed pro rata based on the total balance of all your traditional IRA funds, including the nondeductible contribution, so the conversion could trigger a large tax bill. Be sure to consult with your financial advisor and tax advisor if you have money in a Traditional IRA.

Benefits of a Backdoor Roth IRA

The main benefit of a backdoor Roth IRA is the ability to contribute to a Roth IRA, even if your income exceeds the limits for direct contributions. Roth IRAs offer several advantages over traditional IRAs, including tax-free growth and tax-free withdrawals in retirement. Additionally, Roth IRAs do not require you to take mandatory distributions in retirement, which can be a benefit for those who want to leave their money to heirs.

A backdoor Roth IRA can be a great way for high earners to take advantage of the tax benefits of a Roth IRA. However, it's important to weigh the potential benefits and potential tax implications before deciding whether this strategy is right for you. It's also worth noting that this is a strategy that has been threatened in the past, meaning the IRS has attempted to not allow this loophole and there is a possibility that this strategy is taken off the table in the future. 

If you have questions about the backdoor Roth IRA or other retirement planning and investing strategies, give us a call or schedule a consultation.