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What is a Backdoor Roth IRA?

An old wooden lake house in Lago di Braies, Italy.

In a previous post of the Personal Finance Basics series we covered the Roth IRA.

We learned then that your Modified Adjusted Gross Income (MAGI) must fall below the IRS-imposed limit for you to be able to contribute to a Roth IRA.

We also learned that contributing to a 401k lowers your MAGI, effectively increasing the income limit for the Roth IRA.

As a quick review, if you make $149,500 and contribute the max to your 401k[1], your MAGI will be $129,000.[2]

This would make you eligible to make the maximum annual contribution[3] to a Roth IRA as your income would fall below the $129,000 income limit.

But what if you make over $129,000 even after deductions?

This is where the backdoor Roth comes in.

Backdoor Roth IRA

The backdoor Roth IRA[4] is a maneuver you can use to sidestep the income limits of a Roth IRA.

A “backdoor Roth IRA” isn’t an official type of retirement account, like the traditional IRA and the Roth IRA, but rather an informal name for the maneuver.

Here’s how the backdoor Roth IRA works:

  1. You put money into a traditional IRA.
  2. Wait a few days.
  3. Convert your IRA into a Roth IRA.

That’s it.

Breaking down the backdoor Roth IRA

Let’s cover some questions you might have at this point.

I thought my income was too high to contribute to a traditional IRA

I was slightly inaccurate when talking about the income limit for the traditional IRA for the sake of keeping things simple.

There’s actually no income limit to contribute to a traditional IRA.

There is an income limit to get the tax deduction for your contribution.

Thus, your contribution to a traditional IRA in step 1 gets you no tax benefits but is perfectly legal.

I can convert my traditional IRA to a Roth IRA just like that?

Yes, you can convert a traditional IRA to a Roth IRA any time you want, though you might have to pay taxes.

Remember that you didn’t pay any taxes on your contribution to your traditional IRA.

So if you want to convert these pre-tax dollars in your traditional IRA to post-tax dollars in your Roth IRA[5], you’ll have to pay income tax.

You can avoid paying taxes when converting a traditional IRA to a Roth IRA if:

  1. You didn’t get any tax deduction from the traditional IRA contribution
  2. You’re doing the conversion in a short timeframe

If either of these were not true, you’d pay income taxes on the conversion.[6]

To explore the “short timeframe” part, let’s say you do step 1 and contribute $6,000 to a traditional IRA and then forget about it until 3 years later.

Let’s pretend this money grows to $6,500 in those 3 years.

When you go convert your traditional IRA to a Roth IRA, you’ll have to pay taxes on the $500 gain.[7]

Any other gotchas?

One more: the pro-rata rule.

Let’s say you contributed to a traditional IRA for a few years and took the tax deduction as your income fell below the limit.

Your traditional IRA accumulated $30,000 worth of untaxed money and investment gains.

Your income then increases above the traditional IRA limit so you start contributing to a Roth IRA.

Your Roth IRA accumulates another $14,000. This money has all been taxed before.

All good so far.

Then your income goes up again, putting you over the Roth IRA limit, so you decide to make use of the backdoor Roth maneuver.

You’re now in a bit of a pickle because of the pro-rata rule.

The pro-rata rule says that all of your IRA money (traditional and Roth) forms one big pot and that you can’t selectively convert the post-tax portion of the traditional IRA to a Roth IRA.

🗒️ Sidenote

An analogy for the pro-rata rule is putting cream into coffee ☕: once you add cream to your coffee, they can no longer be separated; each sip is part coffee, part cream.

Let’s walk through how the pro-rata rule would play out in this scenario:

  1. You make your $6,000 non-deductible contribution to your traditional IRA
  2. Your IRA pot—as a whole—now has $50,000[8]
    • $30,000 is pre-tax and $20,000[9] is post-tax.
    • Put another way, 60%[10] of your IRA pot is pre-tax and 40%[11] is post-tax.
  3. When you go do the conversion, 60% of the $6,000 contribution will be taxable as the IRS says you can’t selectively convert! It’s all one big pot.
    • These $3,600[12] will be taxed as ordinary income.

So what can you do if you find yourself in this scenario?

  • Pay the taxes. Not ideal, but if the taxes are low, this might still be worth it.
  • Roll over the money in your traditional IRA into your 401k. You’d have to check with your employer to see if they allowed this (they should.) Your traditional IRA balance would go to zero and you’d pay no taxes on the backdoor Roth conversion.

To avoid getting into this scenario in the first place, make sure the balance in your traditional IRA account is at zero before doing the backdoor Roth.

Summary

There you have it. You’re now well-versed in the backdoor Roth maneuver.

If you have a high income, become comfortable with the backdoor Roth because it’s a valuable tool in your personal finance toolbelt.

🗒️ Sidenote

If you're looking for a step-by-step how-to for executing the backdoor Roth, check out this great post by Physician On FIRE.

I hope this was helpful. Shoot me an email if you have any questions.

And if you’re looking to learn more, you can find the whole Personal Finance Basics Series here.

Video for this post

If you prefer watching to reading, here’s an easy-to-follow video I made with all this info:

Slides for this post

And here are the slides I used for the video.

Footnotes

  1. In 2022, the maximum contribution limit for the 401K is $20,500 ↩︎

  2. $149,500 - $20,500 = $129,000 ↩︎

  3. In 2022, the maximum contribution limit for the Roth IRA is $6,000. ↩︎

  4. The backdoor Roth IRA was made possible by the Tax Increase Prevention and Reconciliation Act of 2005 which removed the income limit restrictions on conversions of a traditional IRA to a Roth IRA. ↩︎

  5. A Roth IRA is made up of post-tax dollars since you don’t get any tax benefit for your Roth IRA contribution.

    The Roth IRA’s advantage is not paying taxes on withdrawals while the traditional IRA’s advantage is not paying taxes on contributions. ↩︎

  6. So if your annual income falls under the IRS-defined limit and you take a deduction for your contribution to your traditional IRA, you’ll have to pay income tax to convert this contribution into a Roth IRA.

    Otherwise you’d be able to contribute pre-tax dollars to a traditional IRA, convert them into post-tax dollars in a Roth IRA, and then withdraw this money tax-free in retirement.

    This is the holy grail—tax-free income.

    Uncle Sam does his best to prevent this but there’s actually a way it can be done that we’ll cover in a future post. ↩︎

  7. But you’ll pay no taxes on the $6,000 contribution. ↩︎

  8. $30,000 in your traditional IRA + $14,000 in your Roth IRA + $6,000 you just added to your traditional IRA = $50,000 ↩︎

  9. The $14,000 in your Roth IRA plus this latest $6,000 non-deductible contribution into your traditional IRA = $20,000 ↩︎

  10. $30,000 ÷ $50,000 = 60% ↩︎

  11. $20,000 ÷ $50,000 = 40% ↩︎

  12. 60% × $6,000 = $3,600 ↩︎