A “backdoor” Roth IRA is not a special type of Roth IRA but is instead a special way to FUND a Roth IRA that allows high-income earners the ability to get tax-free growth instead of tax-deferred growth. It takes a traditional IRA contribution and converts it into a Roth.
What Is a Backdoor Roth?
Those who don’t qualify for a Roth IRA based on income limitations can contribute to a deductible or nondeductible traditional IRA instead and convert the contribution into a Roth after the contribution is complete. This is called a “backdoor Roth IRA” because investors are using a loophole that allows for conversions regardless of income limitations.
All investors who withdraw money from a deductible IRA are subject to taxes on the converted amount and those who withdraw from a non-deductible IRA are subject to taxes on any gains or earnings. But once transferred into a Roth, their money can grow, and subsequently be withdrawn, tax-free.
While the conversion process is relatively simple, the rules about taxes owed, age and income requirements, forms to file, withholding requirements, and Roth withdrawal waiting periods can be complicated and can result in unwanted taxes and penalties if not implemented correctly, even on money that has already been taxed.
Takeaway: Investors who earn too much to qualify for a Roth IRA can take advantage of a "backdoor" process for contributing to a traditional IRA and then converting to a Roth. Possible taxes and penalties make it advisable to seek professional advice when considering a Roth conversion.
Mega Backdoor Roth IRA
The ”Mega Backdoor Roth IRA” is similar to the backdoor Roth IRA, except that it uses 401-K assets to fund the Roth. This means that as of 2022, investors over the age of 50 can contribute up to $27,000 into a 401k, compared with the $7,000 annual limit in an IRA, and then convert to a Roth.
Tip: Keep in mind that investors are responsible for taxes on IRA and 401k plan withdrawals and may be subject to penalties if they are under age 59 1/2. Make sure to check with a tax advisor before starting the process.
Backdoor Roth IRA Contribution Limits
The IRS limits for contributions to traditional IRAs exist when contributing to a backdoor Roth IRA because investors are opening a traditional IRA to begin with.
2024 Roth IRA contributions limits:
- $7,000 for everyone under 50
- $8,000 as catch-up contributions for those over the age of 50
2024 401-K contributions limits:
- $23,000 for employee contributions.
- $69,000 for the combined employee and employer contributions.
There is no limit to the amount that can be converted, which means investors can convert older IRAs or 401ks with higher balances if desired.
Tip: There is no limit to how much can be converted. Investors just have to consider the tax implications of implementing a large conversion in a single year.
Backdoor Roth IRA Rules
There are some key rules to keep in mind about opening a backdoor Roth IRA.
- Annual contribution limits for IRAs and 401ks.
- Age and income rules for both contributions and withdrawals from qualified retirement plans
- Rules for deductible and non-deductible contributions made to the same or multiple retirement plans. For example, IRS form 8606 is required to be filed for non-deductible IRA contributions.
- IRA and 401k withdrawal rules: age, minimum requirements, penalties
- Roth IRA waiting periods for withdrawals
- IRS withholding rules on taxable withdrawals
- State tax requirements for taxable withdrawals
How To Do a Backdoor Roth IRA Conversion
Step 1: Check your Roth Eligibility
It’s easier to just contribute straight to a Roth if you are eligible. The IRS's 2024 income guidelines allow single taxpayers and heads of household who earn less than $146,000 to contribute the full amount to a Roth. Married couples can contribute the full amount if they earn less than $230,000.
Step 2: Fund a Traditional IRA
Next, open a traditional IRA account or fund an existing one in accordance with standard limitations. For 2024, you can put up to $7,000 in an IRA ($8,000 if you are older than 50). You can fully fund it or make a partial contribution depending on your financial situation.
Remember: When a deductible IRA converts to a Roth, taxes will be owed on the full amount. When a non-deductible IRA converts, taxes will be owed only on gains.
Step 3: Open a Roth IRA
Open a Roth IRA account and request a Roth conversion. This will entail completing rollover paperwork from the existing traditional IRA. Conversions handled through the same IRA custodian will be the simplest to implement.
Step 4: Pay the Taxes on the Conversion
If you owe taxes, they will be due when you file your annual income tax return.
Note: IRA custodians are required to withhold a minimum of 10% on taxable withdrawals, unless instructed otherwise. You can pay some or all of your taxes due in this manner, but then the part of your withdrawal going to the IRS will not be part of the Roth conversion. If your traditional IRA was non-deductible and had no earnings, there should be no tax owed.
Bottom Line
The backdoor Roth IRA is a widely used procedure that allows those who don't qualify for a Roth IRA to contribute to a traditional IRA or 401k and then convert those funds into a tax-free Roth. Investors should be well aware of the tax implications of implementing a Roth conversion and check all relevant rules and requirements to avoid any unwanted taxes or IRS penalties in the process.
- Spencer South, Tower 68 Financial Advisors, Newport Beach
Important Information:
Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.
Contributions to a traditional IRA may be tax deductible in the contribution year, with current income tax due at withdrawal. Withdrawals prior to age 59 ½ may result in a 10% IRS penalty tax in addition to current income tax.
A Roth IRA offers tax deferral on any earnings in the account. Qualified withdrawals of earnings from the account are tax-free. Withdrawals of earnings prior to age 59 ½ or prior to the account being opened for 5 years, whichever is later, may result in a 10% IRS penalty tax. Limitations and restrictions may apply.