Backdoor Roth IRA: What It Is, Tax Implications and How To Set One Up

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A backdoor Roth IRA isn’t a specific type of individual retirement account. Rather, it’s a description of a strategy to help wealthier taxpayers avoid certain Roth IRA restrictions. Financial advisors are quick to note that despite being called “backdoor” Roths, there’s nothing shady about this strategy. In fact, IRS rules specifically allow it, although the IRS refers to it as a rollover or conversion.

What Is a Backdoor Roth IRA?

As the name would suggest, a backdoor Roth IRA is a way to get money into a Roth IRA that wouldn’t normally be authorized. Since a Roth IRA provides great tax advantages in retirement, particularly for wealthy individuals, it’s perhaps not surprising that investors have exploited a loophole in the law that allows backdoor contributions. 

How Does a Backdoor Roth IRA Work?

The “backdoor” in a backdoor Roth IRA is a traditional IRA. 

Currently, wealthier taxpayers can work around the Roth IRA income limits by instead making contributions to a traditional IRA. Since there are no income limits on contributions to a traditional IRA, higher-income taxpayers are free to contribute to an IRA up to the annual limit. Then, they can convert their traditional IRAs into Roth IRAs, thus providing “backdoor” access to a Roth.

For example, let’s say you earn $300,000 in modified adjusted gross income (MAGI). The IRS won’t allow you to contribute to a Roth IRA, but you can put up to $7,000 into a traditional IRA for tax year 2024.  Later, you can convert that $7,000 to a Roth IRA. This essentially makes the traditional IRA a funnel into your Roth IRA, allowing you to backdoor the Roth income contribution limit.

Backdoor Roth IRA Contribution Limits for 2024 

The backdoor Roth IRA contribution limits for 2024 is $7,000. For individuals, 50 and older, the limit is $8,000. 

Is a Backdoor Roth Allowed for Tax Year 2024?

Yes. As of November 2024, backdoor Roths are still allowed for tax year 2024. However, investment brokerages warn that Congress has considered doing away with them. Schwab noted in a 2023 blog post that if the IRS closes the loophole without grandfathering in taxpayers who already made the conversation, the result could be a 6% excise tax, and perhaps a penalty, for overfunding the Roth account.

Who Is Eligible for a Backdoor Roth IRA?

Here is the eligibility requirements for a backdoor Roth IRA in 2024: 

Married Filing Jointly

• Full Roth IRA contribution allowed for MAGI under $230,000.
• Partial contributions allowed for MAGI between $230,000 and $240,000.
• No contributions allowed if MAGI exceeds $240,000.

Single, Head of Household, or Married Filing Separately (did not live with spouse during the year) 

• Full Roth IRA contribution allowed for MAGI under $161,000.
• Partial contributions allowed for MAGI between $146,000 and $161,000.
• No contributions allowed if MAGI exceeds $161,000.

Married Filing Separately (lived with spouse during the year)

• Partial contributions allowed for MAGI between $0 and $10,000.
• No contributions allowed if MAGI exceeds $10,000.

What Are the Tax Implications of Using a Backdoor Roth IRA?

While the ultimate goal of a backdoor Roth IRA is to generate tax-free income in retirement, the consequence usually is that you’ll have to pay taxes on the traditional IRA funds you convert, in the year you do the conversion. Let’s take a look at an example of tax implications with a backdoor Roth IRA. 

Example of Taxation

If you have $15,000 in a Traditional IRA (with $12,000 in contributions and $3,000 in earnings), you’ll pay taxes on the full $15,000 when converting.

• The taxes paid compensate for the $12,000 deduction on original contributions and the $3,000 in deferred earnings.
• After paying the taxes, the funds are treated as after-tax funds, similar to directly contributing to a Roth IRA.

Complications with Multiple IRAs

• If you have more than one traditional IRA or have made after-tax contributions, the conversion process becomes more complex.
• During tax filing, you must report the total balances of all your IRAs, both deductible and nondeductible contributions.
• You then calculate the percentage of your total IRA assets that are part of the conversion and determine how much is taxable and how much is tax-free.

IRA Aggregation Rule

• The IRS treats all your IRAs as a single account for tax purposes, which is known as the IRA aggregation rule.

Example of Aggregation:

If you have two IRAs: one with $10,000 in deductible contributions and one with $40,000, and you want to convert the $10,000 account:

• Step 1: Calculate the percentage being converted:

$10,000 /$50,000 = 0.20 (or 20%)

• Step 2: Calculate the tax-free portion of the $10,000 conversion

$10,000 x .20 so $2,000 is tax-free

• Step 3: Subtract the tax-free portion from the total conversion amount

$10,000??’$2,000 = $8,000 so $8,000 is taxable

Consistency of Aggregation

• Aggregation allows for consistent calculation whether you’re converting part of a traditional IRA or multiple IRAs with both deductible and nondeductible contributions.
• Always start with the total of all IRA balances and calculate the percentage that comes from deductible contributions.

Step-by-Step Guide: How to Set Up a Backdoor Roth IRA 

Setting up a backdoor Roth IRA is fairly simple. If it’s the right choice for your financial situation, here’s a quick guide to help you get started:

Step 1. Make a determination on whether you’re eligible for a Roth IRA. If your income falls above a certain limit, you cannot set up a Roth IRA. 

Step 2. If you’re eligible, place money in a traditional IRA. You may already have an existing IRA account or may need to open one. You can do so at a financial institution. 

Step 3. Convert your traditional IRA into a backdoor Roth IRA. You will need to contact your IRA administrator at your financial institution to do this step. If you don’t have a Roth IRA already then you need to set one up. If you’re uncomfortable doing this step, you can check to see if a financial advisor can handle it for you. 

Step 4. Be aware of the tax implications. Roth-IRAs are funded with after-tax dollars. If you’ve taken a tax deduction on contributions to your traditional IRA and then converted it to a Backdoor Roth, you’ll need to give up that tax deduction. When it’s time to file your taxes, be prepared to pay income tax on the amount you converted. 

Pros and Cons of a Backdoor Roth IRA

How To Convert a Traditional IRA to a Backdoor Roth IRA

If you already have a traditional IRA, converting the funds to a backdoor Roth IRA is easy. However, it’s a good idea to consult with a tax accountant or financial planning professional before you move the money. That way, you’ll understand the tax consequences and can prepare for the tax bill.

• Open a Roth IRA at the brokerage where you have the traditional IRA.
• Contact the brokerage to let it know you want to roll your traditional IRA into the new Roth IRA.

If you don’t already have a traditional IRA, you’ll have to take an extra couple of steps, but you can avoid the tax consequences. Again, consult with a financial professional to make sure this strategy is a good fit for you.

• Open a traditional IRA with an investment brokerage.
• Fund the IRA with one or more nondeductible contributions. The contributions become non-deductible when you file IRS Form 8606 with your tax return, according to Vanguard.
• Open a Roth IRA with the same brokerage.
• Contact the brokerage to let it know you want to roll your traditional IRA into the Roth IRA.

How To Convert a 401(k) to a Backdoor Roth IRA

Some 401(k) plans allow participants to convert 401(k) contributions to a backdoor Roth. However, the plan must allow you to make after-tax contributions, according to Fidelity. In addition, the plan must have a Roth 401(k) that allows in-plan Roth conversions and/or allow in-service withdrawals of after-tax contributions. In-service withdrawals are withdrawals you make while still employed at the company offering the plan. 

Alternatively, you might be able to roll your 401(k) into a Roth IRA, or roll your 401(k) into a traditional IRA, and then convert the traditional IRA to a Roth.

Contact your plan’s administrator to find out if your plan allows these so-called “mega” backdoor Roth conversions. 

What’s the Difference Between a Roth IRA and a Backdoor Roth IRA?

There’s no difference between a Roth IRA and a backdoor Roth IRA. It’s the same account. The difference is in how you make contributions to the account.

Roth IRA contributions come from after-tax income. Backdoor Roth IRA contributions often come from a pretax traditional IRA or 401(k) account — the funds are converted to a Roth IRA.

Traditional IRA vs. Backdoor Roth IRA

A backdoor Roth IRA and a traditional IRA are both retirement accounts. However, there are some key differences.

A traditional IRA focuses on individuals who want to save for retirement with tax-deferred growth. A backdoor Roth IRA is targeted toward high income earners who want to convert after-tax contributions from a traditional IRA to a Roth IRA.

Both a traditional IRA and a backdoor Roth IRA have the same contribution limits. Contributions cannot be more than $7,000 or $8,000 if you’re 50 or older.

In terms of differences, with a traditional IRA you must take required minimum distributions at age 73. A backdoor Roth IRA doesn’t require you take required minimum distributions. 

Withdrawals are taxed as ordinary income in a traditional IRA. Keep in mind withdrawals before age 59½ are subject to income tax and a 10% penalty, unless an exception applies. All withdrawals in retirement are taxed as ordinary income.

In a backdoor Roth IRA Withdrawals of contributions are tax-free and penalty-free at any time. Withdrawals of earnings are tax-free in retirement, as long as you are 59½ or older and meet the 5-year rule.

Backdoor Roth IRA vs. Mega Backdoor Roth IRA

Both the backdoor Roth IRA and the Mega backdoor Roth IRA are both retirement accounts, but there are a few key differences.

The backdoor Roth IRA has a contribution limit of $7,000 (or $8,000 if your are 50 and older). With a Mega backdoor Roth IRA, there is an opportunity for much larger contributions. It is up to the 401(k) total contribution limit of $69,000 ($76,500 if you are 50 and older).

A backdoor Roth IRA is funded from contributions that come from personal savings, while a mega backdoor Roth IRA are through a 401(k) plan.

The key component of a mega backdoor Roth IRA plan is dependent on two factors: 1) You are in 401(k) plan that allows after-tax contributions and in-service distributions or rollovers to either a Roth IRA or Roth 401(k). This feature isn’t available on all 401(k) plans.

In terms of tax treatment, you pay taxes on any pre-tax contributions and earnings when you convert a traditional IRA to a Roth IRA. Once conversion occurs, those funds grow tax free. For a mega backdoor Roth IRA no taxes are owed on the after-tax contributions when they are converted to a Mega backdoor Roth IRA.

Backdoor Roth IRA vs. 401(k) 

There are key differences between a backdoor Roth IRA and a 401(k) plan. This chart highlights the differences, 

Is a Backdoor Roth IRA the Right Choice for You?

A backdoor Roth IRA could be the right choice for you if you’d like to take advantage of the tax benefits of a Roth IRA, but high income disqualifies you from contributing to one directly. This strategy can also factor into your estate planning because heirs can inherit the account tax-free.

It’s important to remember the consequences before you convert funds, however. You’ll have to pay tax on deductible traditional IRA contributions you convert. As taxable income, the converted funds could even bump you up into a higher tax bracket. In addition, you’ll have to wait at least five years to withdraw the money from the Roth account or else incur a penalty.

If any of these situations outweigh the long-term benefits of a conversion, you’re probably best off exploring other options.

Takeaway

Finding and working with a financial advisor is a great idea. A financial advisor will help keep track of your finances and assist you in attaining your financial goals. While finding the right one can be overwhelming, you can decide to work with a financial advisor in your community or a virtual one.

Get to know your financial advisor options today for free!

Rudri Patel and John Csiszar contributed to the reporting for this article.

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