Backdoor Roth IRA 101
A Backdoor Roth IRA is a strategy for individuals to contribute to a Roth IRA account—even if their income exceeds the IRS limits for direct contributions to a Roth IRA.
Roth IRA vs. Backdoor Roth IRA
The IRS sets income limits for individuals who want to contribute directly to a Roth IRA. Each year, the IRS sets income limits for an individual’s eligibility to be able to contribute directly to a Roth IRA.
However, a Backdoor Roth IRA allows individuals to contribute to a Traditional IRA account and then convert that Traditional IRA to a Roth IRA. This strategy is available to individuals of any income level, regardless of whether or not they are eligible for direct contributions to a Roth IRA.
To execute a Backdoor Roth IRA, an individual first contributes to a Traditional IRA account. Because there are no income limits for contributions to a Traditional IRA, anyone can contribute to a Traditional IRA account.
Contribution Limits
It's important to note that there are contribution limits for Traditional IRA accounts, which generally increase slightly each year and have an extra allowance for individuals over the age of 50.
Conversion Process
Once the individual has contributed to the Traditional IRA account, they can convert that account to a Roth IRA. This conversion can be done in the same year as the contribution, and there are no income limits or restrictions on the amount that can be converted from a Traditional IRA to a Roth IRA.
Watch out for the "Pro-Rata Rule”!
The Pro-Rata Rule requires that when converting funds from a traditional IRA to a Roth IRA, the converted amount must include a proportionate share of both pre-tax and after-tax contributions. Any existing pre-tax contributions in the Traditional IRA will be subject to taxes when converted to a Roth IRA, so it's important to consult with a tax professional before executing a Backdoor Roth IRA to avoid any unexpected tax liabilities. In other words, it’s advised that you do not have any pre-existing pre-tax IRA funds when executing this backdoor strategy.
You can also “hide” your pre-existing pre-tax IRA funds inside of your employer’s 401(k) plan, though, as 401(k) plans are governed by a separate set of rules and regulations. In doing so, you must transfer those pre-tax IRA funds into your 401(k) through a rollover process. Once completed, then you can consider the backdoor strategy. Again, it’s best to consult a tax professional before executing.
A Backdoor Roth IRA can be an effective way for individuals to contribute to a Roth IRA account even if they are not eligible for direct contributions due to income limits—as long as you understand this strategy's potential tax implications and consult with a financial advisor or tax professional before executing it.
There also is an even more robust strategy called Mega Backdoor Roth IRA which we’ve written about here!
If you need any help with your retirement plan, we’d love to assist!
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