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Is a Backdoor Roth IRA right for you?

Is a Backdoor Roth IRA right for you?

June 27, 2023

We often receive questions from clients with regard to what the best strategies are for maximizing retirement plan savings. This especially applies to high-income individuals and households who are limited by annual contribution and income limits. 

If you are maxing out your 401(k) and want to learn more about how to add additional contributions to your retirement, or if you are interested in Roth IRAs and are curious about backdoor Roth conversions, please take a few minutes to read the following article by Fidelity on "Backdoor Roth IRAs." - Lee Peters


What is a backdoor Roth IRA?

A backdoor Roth IRA isn't a different kind of IRA. It's a "backdoor" way of moving money into a Roth IRA by making nondeductible contributions (or contributions on which you do not take a tax deduction) to a traditional IRA and then converting those funds into a Roth IRA. A traditional Roth conversion transfers tax-deductible contributions from a traditional IRA to a Roth IRA. While this option for conversion would be fully taxable, a backdoor Roth conversion could have some important tax differences. 

A backdoor Roth IRA strategy could be helpful to high earners as they may not be able to fully deduct IRA contributions or contribute directly to a Roth IRA due to income limits on contributing. If you earn $153,000 or more as a single taxpayer or $228,000 or more as a married-filing-jointly taxpayer, then you can't contribute anything directly to a Roth IRA for the 2023 tax year. 

How does it work?

The process behind a backdoor Roth strategy can be pretty simple. Set up a new traditional IRA and make nondeductible contributions to it, then convert the contribution to a Roth IRA. You can also contribute nondeductible funds to an existing traditional IRA and convert the funds to a Roth IRA. In either case, converting the funds to a Roth IRA could trigger IRA aggregation rules described below. 

If you're evaluating the strategy, it's always a good idea to consult with a tax professional to discuss the timing, the potential tax impact, and the individual steps involved in a backdoor conversion. 

Tax Considerations

Where the process can get complicated is in figuring out the taxes you may owe on a conversion. Taxes resulting from a backdoor Roth IRA conversion can be significant and complex. That's especially true if you have more than a traditional IRA. 

If you have anything other than nondeductible contributions in your IRA(s), it's essential not only to understand what the tax consequences will be but also to have a plan for where you'll find the cash to pay the taxes due upon your tax filing. 

Any deductible contributions (contributions deducted from your taxable income for the year in which the contributions were made) or investment earnings on deductible and nondeductible contributions are always taxable in a Roth conversion at your marginal tax rate or higher. 

If you have more than one traditional IRA, you must first figure out what kind of contributions are in y our accounts. There could be two types: deductible contributions and/or nondeductible contributions. (The nondeductible contributions are tracked separately each year on IRS Form 8606; it might be a good idea to check with your tax professional to ensure it's filed.) Deductible contributions and any earnings will generally be taxable in conversion, while nondeductible contributions generally won't. 

However, you don't get to cherry-pick and only choose to convert your nondeductible contributions. Instead, the tax liability on a conversion will be based on the ratio of deductible contributions and earnings to nondeductible contributions across all your traditional IRA accounts. (It does not include spousal or inherited IRAs.) That's because the IRS uses the IRA aggregation rule when calculating taxes owed on a conversion, which means it views all your traditional IRAs as a single tax entity. If you have five different traditional IRAs, the IRS considers them as one entity that you are converting from. 

For example, suppose you have combined traditional IRAs worth $50,000, composed of 10% in nondeductible contributions and 90% in deductible contributions. If you want to convert $5,000 to a Roth IRA, then 90% of the money you decide to convert would be taxable. You'd pay your applicable tax rate on $4,500, or 90% out of $5,000. 

Please remember that you'll also need to consider state taxes and taxes owed at the federal level.

Roth IRA income and contribution limits

A backdoor Roth IRA may particularly appeal to those who earn too much to contribute directly to a Roth IRA. Here's how those contribution limits stack up for the 2023 tax year. Note: A contribution using this backdoor Roth IRA strategy must be made by December 31 of the tax year in which a conversion happens. 

Roth IRA Income Requirements 2023

backdoor roth ira

Internal Revenue Service Publication 590

*Married (filing separately) can use the limits for single individuals if they have not lived with their spouse in the past year. 

Good to know: People 50 or older are entitled to an additional catch-up contribution of $1,000.

Backdoor Roth IRAs: Pros and Cons

Here are some trade-offs to consider as you evaluate whether a backdoor Roth IRA is the right strategy for you. 

Pros:

  • Once it's in a Roth IRA, you can take withdrawals in retirement tax-free.*
  • You will have no RMDs from your Roth IRA (unlike many other retirement accounts), which can help with your retirement planning. 
  • A Roth can also be an important estate-planning tool. Among other options, spouses can roll an inherited Roth IRA into a Roth IRA in their name and treat the assets like their own. If the original account was a Roth and the assets were in the account for five years or more, distributions could be tax-free.

Cons:

  • All or part of a backdoor Roth IRA conversion could be taxable. You may have to pay federal, state, and local taxes on converted earnings and deductible contributions. 
  • Conversions could kick you into a higher tax bracket for the year. 
  • You must observe a 5-year aging rule to be eligible for tax-free distributions.

Some more details on that last point: Generally, to be eligible for tax-free distributions from the account, you must be at least 591/2  and have kept your converted funds in the new account for at least five years. Note that the aging rules for Roth conversions differ from those for direct Roth IRA contributions. With direct Roth IRA contributions, you can generally withdraw contributions penalty-free and tax-free at any time, while only earnings are subject to the 5-year restrictions. The converted amount is subject to its own 5-year restriction for Roth conversions and is independently calculated for each conversion. Any withdrawals that include the converted amount, taken within five years, are subject to a 10% penalty unless there is an existing exception to the penalty that applies. 

How to set up a Roth IRA to make a backdoor contribution 

The steps for setting up a backdoor Roth IRA are relatively straightforward:

  1. If you don't already have a traditional IRA, set one up and fund it with after-tax contributions. (If you have an existing IRA, consider how the IRA aggregation rule mentioned above will affect the conversion.)
  2. If you don't have a Roth, set one up and initiate the conversion of the after-tax contribution using instructions from the IRA administrator. File Form 8606 each year to track your basis.
  3. Pay taxes on any converted earnings or deductible contributions. Remember, a conversion must be completed by December 31 to be included in the current year's taxable income. Consider reviewing the potential tax impact of a backdoor Roth IRA with a tax professional. 

Is a backdoor Roth a good idea?

A backdoor Roth IRA contribution can be a valuable strategy for high earners who want to access the potential benefits of a Roth account. High earners who haven't maxed out their 401(k) contributions for the year may also consider contributing to a Roth 401(k) if their employer offers one, but there are differences between a Roth 401(k) and Roth IRA. 

Both traditional 401(k) and Roth 401(k) accounts have RMD requirements. However, in order to avoid RMDs, the participant would have to roll their Roth 401(k) into a Roth IRA. Starting January 1, 2024, RMDs from Roth 401(k)s are no longer required due to changes in the Secure 2.0 Act

Will backdoor Roth IRA be eliminated?

While Congress has considered placing limits on backdoor Roth conversions, current retirement legislative efforts have focused on the benefits of contributing to a Roth rather than conversions. Nevertheless, if you're considering using a Roth conversion or the backdoor Roth as part of your retirement savings strategy, be sure to closely follow rules on conversions and speak with a tax advisor about the impact a conversion could have on your financial situation. 

Key Takeaways 

A "backdoor Roth IRA" is just a name for a strategy of converting nondeductible contributions in a traditional IRA to a Roth IRA. 

The strategy can be helpful for those who earn too much to contribute directly to a Roth IRA. 

While Roth IRAs can come with certain advantages, it's important to understand that converting to a Roth is a taxable event. 



*A qualified distribution from a Roth IRA is tax-free and penalty-free. To be considered a qualified distribution, the 5-year aging requirement has to be satisfied and you must be age 59½ or older or meet one of several exemptions (disability, qualified first-time home purchase, or death among them).

This information is intended to be educational and is not tailored to the investment needs of any specific investor.

Fidelity does not provide legal or tax advice. The information herein is general and educational in nature and should not be considered legal or tax advice. Tax laws and regulations are complex and subject to change, which can materially impact investment results. Fidelity cannot guarantee that the information herein is accurate, complete, or timely. Fidelity makes no warranties with regard to such information or results obtained by its use and disclaims any liability arising out of your use of, or any tax position taken in reliance on, such information. Consult an attorney or tax professional regarding your specific situation.
Fidelity Brokerage Services LLC, Member NYSE, SIPC, 900 Salem Street, Smithfield, RI 02917

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