Savvy investors appreciate Roth IRAs for their tax benefits: you can grow contributions and earnings tax-free, withdraw money from the account tax-free and there is no required minimum distribution (RMD) rule, meaning you can keep growing the money for as long as you want.
However, according to IRS rules, those with income exceeding $153,000 as single filers and $228,000 as joint filers cannot contribute to a Roth IRA.
Individuals with high net worth and others who are eager to enjoy the benefits of a Roth IRA have found a way to do this despite the income limits above — enter the backdoor Roth IRA.
Backdoor IRAs are not an official account type. But with this process, individuals can contribute to a traditional IRA on an after-tax basis and then convert it to a Roth IRA with no concern about the Roth income limits or contribution limits since any amount can be converted from a traditional IRA to a Roth IRA. This way, the investor can enjoy the benefits of Roth IRA through the “backdoor” strategy.
I am a longstanding proponent of saving money in both tax-deferred and tax-exempt retirement accounts – for the sake of maintaining flexibility. Early in my career, I was able to freely accumulate tax-deferred savings via an employer-sponsored traditional 401(k) and tax-exempt savings via a Roth IRA.
Then, I hit the Roth IRA income contribution limit and was prohibited from making deposits to the account. Fortunately, I discovered the backdoor Roth IRA process and opened a traditional IRA, which merely serves as a pass-through account.
Now, each year, I contribute after-tax dollars into the traditional IRA and immediately transfer the money to my Roth IRA. This gets me the desired result; I just need to take an extra step to achieve it
What Is a Backdoor Roth IRA and How Does It Work?
Basically, a backdoor Roth IRA is a process that allows individuals who are excluded from opening a Roth IRA due to income limits to enjoy its benefits by converting their traditional IRAs to Roth IRAs.
This process is a backdoor because those who use it can have a Roth IRA not directly but indirectly by first opening a traditional IRA, which does not have income limits.
The conversion from a traditional IRA can be partial or total. With the former, the account holder only rolls over a part of the funds from the traditional IRA into a Roth IRA.
A total conversion, on the other hand, involves the liquidation of the traditional IRA, and a complete transfer of the funds to the Roth IRA.
Many high net worth individuals enjoy Roth IRAs because they can contribute after-tax dollars to the account. Since the funds are already taxed, the funds — and the interest they earn — are not taxed further while they grow in the account or when they are withdrawn in retirement. This can have a powerful compounding effect over the long term.
Unlike traditional IRAs, Roth IRA holders are not required to make compulsory deductions at 72 (or any other age). This means their money can grow for as long as they want. In fact, they can leave it intact for their children.
The dollars contributed to a traditional IRA are usually pre-tax, meaning the funds contributed to a traditional IRA are not taxed at the time of contribution. The taxation takes place at the point of withdrawal, unlike a Roth IRA where taxation takes place before contribution.
In order to complete a Roth IRA conversion, the account holder must pay taxes on the funds converted from a traditional IRA to a Roth IRA. By doing this, the integrity of the traditional IRA, taxes paid at withdrawal, and the Roth IRA, contributions funded with after-tax dollars, are maintained.
Note, however, that holders of the backdoor Roth IRA only pay taxes on the portion of the converted funds that are pre-tax. So, if any contribution to the traditional IRA has already been taxed, a backdoor Roth IRA will not require any taxation again.
The IRS stipulates that conversions will be done proportionally when an account holds both after-tax and pre-tax funds. In other words, an investor cannot choose to convert only after-tax funds. This is known as the pro rata rule.
For example, suppose Morgan has $100,000 in a traditional IRA of which $90,000 (90%) was contributed pre-tax and $10,000 (10%) after tax.
In this scenario, Morgan will only pay tax on 90% of the money rolling over to a Roth IRA. If Morgan is transferring $50,000, Morgan will only pay tax on $45,000 (90% x $50,000); suppose Morgan is transferring $90,000. Here, Morgan will only pay tax on $89,000 (90% x $90,000).
Mega Backdoor Roth IRAs
Mega backdoor Roth IRAs are a special form of backdoor Roth IRAs that only apply to employees with a 401(k) plan.
If an employee has a 401(k), the employer allows after-tax contributions once the pre-tax portion of the 401(k) has been maxed and the employer allows in-service distributions, the employee can convert these after-tax contributions to a Roth IRA or a Roth 401(k).
For 2023, a 401(k) with after-tax contributions has a maximum contribution limit of $66,000 for those younger than 50 and $63,500 for those 50 or older. However, only $22,500 and $30,000 of these, respectively, are pre-tax contributions. And it’s these pre-tax contributions that employers who opt for 401(k) are mandated to offer.
However, some employers allow employees to go beyond these pre-tax contributions (after they have been maxed out) and add after-tax contributions of $66,000. If the employer matches the employee’s pre-tax contributions, that limit will be reduced.
So, for example, if Jordan has a salary of $100,000 (yearly) and the employer match is 3%, that means the employer will also contribute $3,000 to Jordan’s 401(k). In this case, the limit of after-tax contributions that Jordan can make is now $63,000 ($66,000 – $3,000).
For mega backdoor Roth IRAs to become possible, employers must also allow employees to take out money from the after-tax contributions while they are still working for the company.
Once these two conditions are met, after-tax contributions are permissible and in-service withdrawals can be made. Employees can roll over the after-tax contributions of their 401(k) to a Roth IRA (called mega backdoor Roth IRA in this situation) or a Roth 401(k) (if the company allows them).
Since the contributions were already after-tax when held in the 401(k), there is no additional tax when an account holder converts to a mega backdoor Roth IRA.
What is the advantage of this conversion to a Roth IRA?
If the employee leaves the money in the after-tax portion of the 401(k), earnings from those after-tax contributions will be subject to tax at the time of withdrawal. However, with a mega backdoor Roth IRA, both the converted contribution and all earnings from them grow tax-free. They are not taxed at withdrawal.
How Do You Set Up a Backdoor Roth IRA?
- A holder of a traditional IRA account can receive (by liquidating) the money accumulated in a traditional IRA and then deposit that money in a new or old Roth IRA account. Again, taxes will be paid on the portion of the converted funds that are pre-tax, according to the pro rata rule identified above.
A mega backdoor Roth IRA can also be set up by regularly rolling over the after-tax portion of the 401(k) to a Roth IRA. In this case, there is no tax liability since the funds have already been taxed.
- Alternatively, the trustee of the traditional IRA can directly transfer the funds to a Roth IRA (managed by them or another trustee). With this option, the account holder does not have to receive and then deposit the money. Everything is done directly by the trustee.
There are two ways to convert a traditional IRA to a backdoor Roth IRA:
Pros and Cons of Backdoor Roth IRAs
So, why do people who don’t qualify for a Roth IRA bother about getting one through the backdoor?
- Tax-free growth and withdrawal:
- The funds in a Roth IRA (and the interests they earn) grow tax-free and are not subject to tax at the point of withdrawal.
This is especially useful for people who believe that they will incur higher taxes in the future by joining a higher income bracket. By paying taxes now, they can enjoy the current lower rate. In a traditional IRA, they would instead pay nothing while the tax rate is lower and then pay taxes when the tax rate is higher.
- No RMDs
- Roth IRAs do not have required minimum distributions. Funds can grow in the account for as long as the account holder wants.
This is beneficial for those who want to leave the money in their Roth IRAs for their descendants or to sponsor some causes after they are dead.
Pros of Backdoor IRAs
Nevertheless, converting a traditional IRA to a Roth IRA comes with certain disadvantages.
- No Withdrawal for Five Years
- After the conversion has been done, the Roth IRA holder cannot withdraw funds from the account until after five years. Refusal to abide by this rule can lead to penalties and taxes.
- Tax Payment
- The money the account holder pays for taxes is money that could have continued to grow in a traditional IRA account, earning compound returns until withdrawal.
- Higher Taxes
- The conversion of a traditional IRA to a Roth IRA will increase your taxable income, as the pre-tax portion of the converted funds is now part of your taxable income. This can push you into a higher income tax bracket, which means higher taxes for that specific tax year.
Cons of Backdoor IRAs
Only the first disadvantage highlighted here applies to the mega backdoor Roth IRA.
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Who Is a Backdoor Roth IRA Best For?
A backdoor Roth IRA is best for those who believe they will move ahead in the income bracket and will be subject to higher taxes in the future. These individuals can take advantage of current lower rates by paying taxes now and making tax-free contributions to their retirement accounts.
A backdoor Roth IRA (and a mega backdoor Roth IRA) is also best for those who want the opportunity to grow their IRA as long as they want without being required to make minimum distributions once they are 72. This is especially desirable for those who want to leave their Roth IRA as an estate for their family instead of liquidating it during retirement.
A mega backdoor Roth IRA is also good for those employees who don’t want to pay taxes on the interests earned from their after-tax contributions in a 401(k). They can allow these earnings to grow tax-free in a Roth IRA.
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Is the Backdoor Roth IRA Going Away?
Though a backdoor Roth IRA is legal, the Build Back Better Act has plans to limit Roth IRA conversions. Some of these limitations include:
- The prohibition of conversion of all employee after-tax contributions in qualified plans and after-tax IRA contributions to a Roth IRA regardless of income level. This is effective for distributions, transfers and contributions made after Dec. 31, 2021.
- The prohibition of conversion of IRAs and employer-sponsored plans into Roth IRA for single taxpayers (or taxpayers married filing separately) with taxable income over $400,000, married taxpayers filing jointly with taxable income over $450,000 and heads of household with taxable income over $425,000 (all indexed for inflation). This provision applies to distributions, transfers and contributions made in tax years beginning after Dec. 31, 2031.
However, while the bill passed in the House of Representatives in November 2021, the Senate has sat on it since then.
Consequently, both backdoor Roth IRAs and mega backdoor Roth IRAs are still legal at the time of writing. However, how this bill will fare in the days ahead is anyone’s guess.
For this reason, it’s important you speak to your financial advisor before adopting either a backdoor Roth IRA or a mega backdoor Roth IRA. Your financial advisor will help you understand the legal, tax and other financial implications and whether the conversion is appropriate for your situation.
Frequently Asked Questions About Backdoor IRAs
Backdoor Roth IRAs are not an official type of IRA, but rather a loophole process that allows individuals to contribute to a traditional IRA and then convert it to a Roth IRA with no concern about income or contribution limits.
Though a backdoor Roth IRA is perfectly legal as of the time of publishing, the Build Back Better Act has plans to limit Roth IRA conversions.
The pro rata rule determines how withdrawals are taxed. It stipulates that conversions must be done proportionally when an IRA holds both after-tax and pre-tax funds. In other words, the rule prohibits an investor from converting only after-tax funds.
In 2023, the annual contribution limit to IRAs is $6,500 for people under age 50 and $7,500 for people ages 50 and over.