Backdoor Roth IRA tax benefits

If your career is going well, you may be earning a good — or very good — salary. But there is a possible drawback to your success: You might not be able to contribute to a Roth IRA. However, you may still be able to reap the benefits of this powerful retirement savings vehicle.

When you contribute after-tax dollars to a Roth IRA, any earnings grow tax free, and withdrawals are also tax free, provided you follow the IRS rules for a tax- and penalty-free withdrawal. A Roth IRA is one of very few investment vehicles that offers this type of tax treatment.           

But not everyone can take advantage of a Roth IRA. You can contribute the full amount ($7,000 per year for 2024, or $8,000 if you’re 50 or older) only if your modified adjusted gross income (MAGI) is less than $146,000 if you’re single or $230,000 if you’re married and filing jointly. Above these limits, you can contribute lesser amounts until your MAGI reaches $161,000 (single) or $240,000 (married, filing jointly), at which point your ability to contribute to a Roth IRA is phased out.

If your income exceeds these limits, you might want to consider what’s known as a backdoor Roth IRA. This isn’t a separate type of IRA but rather a strategy to gain the tax advantages offered by a Roth IRA.

How does a backdoor Roth IRA work?

First, you make a nondeductible, or after-tax, contribution to a traditional IRA. You may already have a traditional IRA, but if not, you’ll need to open one and fund it.

Next, you convert these contributions to a Roth IRA. Again, you can either open a Roth IRA or use one you already have. Even if you are above the income limits for contributing to a Roth IRA, you can still open one.

Finally, if necessary, pay taxes on the conversion.

Backdoor Roth IRA taxes

The backdoor Roth IRA strategy generally works best for individuals who have few to no existing pretax assets in any IRA. This is because of the pro rata rule, which requires any distribution from a traditional IRA to include a proportionate mix of pretax and after-tax assets. Additionally, it’s important to note that the IRS looks at all your traditional IRAs (SEP and SIMPLE included) when determining your allocation of pretax and after-tax dollars, not just the traditional IRA you're taking the distribution from. For example, if your aggregate traditional IRA balance consists of 80% pretax money and 20% after-tax money, 80% of the amount you convert to a Roth IRA will be considered pretax and subject to taxes when converted.

However, if you have few to no existing pretax assets in any traditional IRA and immediately convert the nondeductible contribution, taxes with a backdoor Roth IRA strategy can be small or nonexistent. And, once the money is in the Roth IRA, you'll get its tax benefits if you follow the rules to make a qualified withdrawal.

Backdoor Roth considerations

When considering whether a backdoor Roth IRA is right for you, ask yourself these questions:

Will I pay taxes on a backdoor Roth IRA?

To minimize taxes on the transaction, the backdoor Roth IRA strategy generally works best for individuals who have few to no existing pretax assets in any IRA. Even if you don't have existing pretax assets, it's possible you could owe some taxes, because any earnings on your nondeductible contribution will be considered pretax. If you owe taxes, it’s generally better to pay them from another source rather than having them withheld from the conversion. Otherwise, you’ll end up with a smaller amount of the contribution converted, and you’d essentially be giving up any potential future investment gains from this money. You could also owe a penalty on the amount withheld for taxes.

When do I need the money?

One of the conditions for taking tax-free withdrawals from a Roth IRA is that you must meet the IRS’ five-year holding period requirement. If you withdraw earnings before meeting this requirement, you'll generally owe taxes on the earnings and a possible 10% penalty. You’re also required to adhere to a five-year holding period for each taxable conversion contribution you make; otherwise, you may owe a 10% penalty on a withdrawal of these amounts as well. Before you start the Roth conversion, make sure you won’t need the funds for at least five years.

Will the backdoor Roth IRA strategy always be available? 

There’s no guarantee the backdoor Roth IRA strategy will always be available. Congress recently considered legislation that would have eliminated the backdoor option. As of now, the backdoor Roth IRA is still around, but no one can predict its future.

Before making any moves related to a backdoor Roth IRA, you’ll want to talk to your tax advisor to help ensure this strategy is appropriate for your situation. You also will want to consult with your financial advisor on the investment-related aspects involved.