Backdoor Roth IRA strategy for high earners

Since they first became available in 1998, Roth IRAs have become a “rock star” among retirement accounts. Their appeal is based on several different factors, starting with favorable tax treatment: You can withdraw contributions and earnings tax-free if you are 59½ years of age or over and have owned the account for at least five years.

Another benefit is that Roth IRA funds can grow tax-free indefinitely because they’re not subject to required minimum distributions (RMDs) beginning at age 73. These two factors combined have made Roth IRAs a popular retirement savings vehicles for many Americans.

But there’s one major catch with Roth IRAs: If you earn too much money, you can’t open or contribute to one.

Roth IRA MAGI thresholds

Individuals and married couples filing jointly with modified adjusted gross income (MAGI) below a specific income threshold are eligible to open and contribute to a Roth IRA; those with MAGI in the “phaseout” income threshold can make a partial Roth IRA contribution, and those above the income threshold are ineligible to open and contribute to a Roth IRA.

However, it’s possible for couples and individuals with higher income levels to enjoy the benefits of Roth IRAs through a backdoor Roth IRA.

What is a backdoor Roth IRA?

A backdoor Roth IRA is a strategy — not a different type of IRA — that individuals and couples whose income exceeds income limits can use to convert a traditional IRA to a Roth IRA.

The process is relatively simple: You make an after-tax, non-deductible contribution to an existing traditional IRA and then immediately roll over the funds to a Roth IRA. It’s important to do the rollover soon after making the non-deductible traditional IRA contribution, before any earnings accumulate, so you don’t have to pay tax on the earnings. The rollover must be deposited into the Roth IRA, directly to the Roth IRA provider, within 60 days.

Backdoor Roth vs. Roth conversion

A backdoor Roth conversion is different than a Roth IRA conversion, which is the transfer of tax-deductible contributions previously made to a traditional IRA into a Roth IRA. With a Roth IRA conversion, you can roll over as much money as you want, even if it exceeds the annual IRA contribution limit, which in 2024 is $7,000 ($8,000 if you’re 50 years of age of over).

A Roth IRA conversion is fully taxable in the year of conversion. This could result in a large lump-sum tax payment and possibly bump you into a higher tax bracket during the tax year.

Benefits of a backdoor Roth IRA

Backdoor Roth IRAs may offer several potential benefits for higher-income couples and individuals. For starters, once funds are rolled over from a traditional to a Roth IRA, they can be withdrawn tax-free in retirement if you’re at least 59½ years old and have owned the account for at least five years. This can help retirement funds last longer.

There are no RMDs from Roth IRAs, so funds can continue to earn tax-free returns for longer if you don’t need them to meet retirement expenses.

In addition, spouses can roll funds from an inherited Roth IRA into their own Roth IRA, which offers estate planning benefits. Withdrawals will generally be tax-free if the original account was a Roth IRA and the assets were held in the account for at least five years.

The five-year rule for backdoor Roth IRAs

As mentioned above, the five-year rule applies to withdrawals from Roth IRAs that are funded with direct contributions. With backdoor Roth conversions, there are two five-year rules.

1. You must wait five years to make tax-free withdrawals of earnings from your Roth IRA conversion (backdoor or non-backdoor), no matter your age.
2. To avoid penalties, you must maintain your backdoor Roth account for at least five years or until you turn 59 ½ (whichever comes first) before making a withdrawal. If you make a withdrawal before that, you might have to pay a 10% early withdrawal penalty on every dollar you withdraw, no matter if it’s a contribution or earnings.

So, as long as you hold a backdoor Roth IRA conversion for at least five years, these rules are relatively straightforward. Where it can get complicated is if you hold multiple Roth conversions — for example, if you make a conversion every year. Each conversion has its own five-year clock. You may want to work with a financial or tax professional to help you keep your Roth accounts and their timing straight, making sure you avoid tax or early withdrawal penalties.

What is a mega backdoor Roth?

Another type of backdoor Roth, known as a mega backdoor Roth, could allow you to contribute even more money to a Roth account – but this conversion isn’t available to or appropriate for everyone. The key requirement is that you have access to a 401(k) or other workplace retirement plan.

In a nutshell, a mega backdoor Roth is a two-part process:

1. You make after-tax contributions to your 401(k) or other workplace retirement plan.
2. You convert those after-tax contributions to a Roth IRA or Roth 401(k).

The after-tax contributions are what make a mega backdoor Roth so effective for higher earners. The annual elective deferral limit for 401(k)s – in other words, the pre-tax contributions you can make to a 401(k) each year – is $23,000 in 2024 ($30,500 if you’re 50 or older). But if your workplace retirement plan allows after-tax contributions, then your total allowed contribution, including employer match, increases to $69,000 per year ($76,500 if you’re 50 or older).

To make a mega backdoor Roth possible, your workplace plan must offer a Roth 401(k) with the option of an in-plan Roth conversion and/or in-service withdrawals of after-tax contributions.

A mega backdoor Roth is a complex strategy; you should examine your workplace retirement plan in detail and consult a tax or financial professional to determine if a mega backdoor Roth is available and right for you.

The pro-rata rule for backdoor Roth IRA

One of the potential drawbacks to a backdoor Roth IRA is what’s referred to as the pro-rata rule, which determines what amount of the rollover is subject to taxes. As noted earlier, the best way to avoid paying tax on a backdoor Roth IRA is to roll over the funds quickly so no taxable earnings accumulate.

However, funds from all your traditional IRA accounts will be considered when taxes are computed, and funds must be rolled over from each account proportionally. For example, if 80% of your combined traditional IRA balances consist of non-deductible contributions and 20% consist of deductible contributions, the 80/20 ratio will determine what percentage of funds rolled over to a Roth IRA will be taxable. In other words, 80% of the amount you convert will be considered taxable.

An example helps illustrate the pro-rata rule: Let’s say you make a non-deductible $7,000 contribution to a traditional IRA this year and immediately roll it over into a Roth IRA. But you also own another traditional IRA that contains $100,000 of deductible contributions. Your $7,000 rollover to a Roth IRA equals 6.5% of your total IRA balance of $107,000, so only that percentage of the rollover ($455) is tax-free. The rest of the rollover ($6,545) is considered to be from deductible contributions, which makes it (along with earnings) subject to income tax.

Backdoor Roth IRA: Right for you?

Depending on your circumstances, a backdoor Roth IRA could be a good strategy for you – especially if your income prevents you from reaping the benefits of a Roth IRA.

Considering reviewing your portfolio with a financial professional to determine if a backdoor Roth IRA is right for you.