A Roth IRA is an individual retirement account where you contribute after-tax dollars but will benefit when you withdraw your contributions tax-free at retirement. These are often directed at younger people who are in a low tax bracket today (so they don’t pay as much when they contribute after-tax money) but may be in a higher bracket at retirement (and benefit from the tax-free withdrawals).
Yet there are income limits on who can contribute to a Roth IRA. For 2024, single individuals must have a MAGI (modified adjusted gross income) of $146,000 or less to make a full contribution; married couples must have a MAGI under $230,000.
But there is a way people making more can contribute indirectly to a Roth IRA. It’s called the backdoor Roth IRA.
How to set up a backdoor Roth IRA
Contribute to a traditional IRA. People who are ineligible to contribute directly to a Roth IRA due to income limits can contribute to a traditional IRA instead. The contribution to the traditional IRA is considered a “nondeductible” contribution, meaning it is made with after-tax dollars.
Convert the traditional IRA to a Roth IRA. After making the contribution to the traditional IRA, the account holder then converts the traditional IRA to a Roth IRA. Any earnings on the contributed amount that accrued before the conversion will be taxable as part of the conversion. Most people choose to make the conversion as quickly as possible to limit any tax due.
Benefits of a backdoor Roth IRA
Obviously, one of the biggest benefits to a backdoor Roth is that high-earners can contribute to a Roth IRA even if they exceed the IRS’ income limits. This allows their contributions to grow tax-free, and withdrawals during retirement are also tax free. Additionally, Roth IRAs have no required minimum distributions (unlike traditional IRAs) so your money can continue growing if you don’t need it during retirement. Finally, if you’re planning to provide generational wealth, a Roth IRA can be passed down to heirs tax free.
Drawbacks of a backdoor Roth IRA
One item I mentioned above is you may owe taxes. This can arise from earnings on after-tax money that you contributed to the traditional IRA, or could arise if you are converting an older traditional IRA that you built with pre-tax contributions. You should fully understand the tax consequences, and consider converting a large IRA over several years to lessen the chance you’ll be pushed into a higher tax bracket.
Additionally, for a Roth IRA, you must wait five years after establishing the account before earnings can be withdrawn tax free. This applies to all Roth IRAs, even if the account holder is 59½ or older. If fewer than five years have passed, the withdrawal may be subject to taxes or penalties. Money you will need over the next five years should be kept separate so you aren’t paying taxes or penalties.
Finally, some accountants and financial planners are very conservative when it comes to backdoor Roth IRAs. They will require their clients to set up a separate IRA every year so each conversion is a separate entity – mainly to make record-keeping easier in case the IRS comes sniffing around. This means you could have several open accounts that you have to manage, which may become burdensome.
The backdoor Roth IRA can be a useful tool for high-income earners to access the benefits of a Roth IRA, but it requires careful planning and consideration of the tax implications. This might be a good time to talk with an accountant or financial planner to make sure you’re precisely following IRS regulations and paying the least tax possible.