The “Backdoor Roth IRA” is the only way high income earners can make Roth IRA contributions. The good news about the strategy is that it can technically be done every year assuming the IRS does not change the rules. This would allow high income earners the ability to maximize contributions annually, and get those funds into a Roth.
History of the “Backdoor Roth IRA” Strategy
Beginning January 1, 2010, thanks to the changes resulting from the Tax Increase Prevention and Reconciliation Act (TIPRA), anyone can convert a pretax IRA to Roth no matter your income level. Prior to that, anyone that had income above $100,000 was not allowed to do a Roth IRA conversion. This prevented one to make an after-tax IRA contribution and then convert it to Roth. As a result of the 2008 financial crisis, tax revenue was significantly reduced. One way to increase tax revenue was to encourage IRA holders to convert their pretax IRAs to Roth since the converted amount is subject to ordinary income tax. Therefore, due to the passing of TIPRA in 2010, the Backdoor Roth IRA was created.
Related: Is the Backdoor Roth IRA Going Away?
Roth IRA Rules for 2023
In 2023, the maximum Roth IRA contribution limit is $6,500 or $7,500 if at least age 50. For high income individuals, contributing funds to a Roth IRA is only possible through the Backdoor Roth. This is because the IRA rules impose income limitations on Roth contributions but no longer include income limitations on Roth IRA conversions. In general, in 2023, if one is single and earns more than $153,000 or is married and files jointly and earns more than $238,000, one is not permitted to make direct Roth IRA contributions.
However, under the Backdoor Roth IRA strategy, one who earns more than the Roth income limitations can make an after-tax IRA contribution and then immediately convert the funds to Roth. Best of all, no taxes will be due.
- The Backdoor Roth is a popular strategy among high income earners
- One can perform one annually if they wish
- The Roth is the best, legal way to amass tax-free savings
How the “Backdoor Roth IRA” Works
After-tax contributions are contributions made to a traditional IRA that are not treated as tax deductible (no upfront tax break). However, income and gains on those contributions would be subject to tax. This is why making traditional, after-tax contributions other than for purpose of a Backdoor Roth, makes little tax sense.
Essentially, you lose the tax advantage of the IRA since both contributions and distributions would be taxable. However, for high income earners, making an after-tax contribution is necessary in order to take advantage of the Backdoor Roth IRA strategy.
Below are the steps necessary to perform a Backdoor Roth IRA:
- Open a traditional IRA account
- Contribute up to $6,500 or $7,500, depending on your age to the IRA
- Treat the contribution as after-tax and do not report the contribution on your tax return as tax deductible
- Open a Roth IRA account
- Notify the IRA custodian that you wish to convert the after-tax traditional IRA to Roth
- IRA custodian will issue a 1099-R to the IRS indicating a zero-tax conversion
Learn More: Backdoor Roth vs Roth Conversion
The Pro Rata Rules
As we touched on earlier, when you immediately convert after-tax funds to Roth, there is generally no tax due on the conversion. This is because you are not subject to double taxation in an IRA. The conversion should be done immediately so that there are no gains in the traditional plan; gains would be taxable. For example, if you contribute $5,000 after-tax to an IRA, and your investments generate $500 of income before you convert, those gains would be subject to tax.
The pro rata rules are most important when you already have pretax IRA funds. Those need to be considered when you wish to perform a conversion because you cannot choose which funds get converted; all funds are considered, as per the IRS. So, if you have $50,000 in pretax IRA funds, and contribute $5,000 in after-tax funds to the IRA. Now you have $55,000 in a traditional IRA, over 90% of it is pretax. Therefore, when you perform a conversion, 90% of the converted amount would be taxable.
Below is a set of examples of how the Backdoor Roth IRA solution works:
Example 1: Paula is married, and she and her husband have income over $228,000 for 2023. Paula could not make a Roth IRA contribution because her income is too high. Thus, Paula can make a traditional IRA contribution and not take a tax deduction (after-tax contribution) and can then immediately convert the after-tax funds to Roth. Let’s assume she has no other IRA funds, there would be no tax on the conversion from after-tax to Roth.
Example 2: Same facts as Example 1, but assume further that Paula wishes to make a Backdoor Roth IRA contribution of $5,000 in 2023 but had a traditional IRA worth $5,000 she started in 2018. Under the pro-rata conversion rule, half of the amount converted would be taxable since she has 50% pretax and 50% after-tax IRA funds.
Roth IRA Advantage
The primary advantage of having a Roth IRA is that all income and gains can be distributed tax free. In order to do so, they must be qualified distributions. You must satisfy two conditions: you must be at least age 59 1/2, and any Roth must have been open for at least five years. Once satisfied, you will never pay income tax or capital gains on a Roth withdrawal.
Further, contributions made to a Roth (assuming you are under the income thresholds) can be withdrawn at any time without tax or penalty. This is a great way to start an emergency fund. Use those contributions as needed, but remember not to touch earnings since those will be taxed and penalized until they are qualified.
In addition, the Roth IRA is not subject to required minimum distributions. You can grow the account unhindered for as long as you want. This is a great estate planning tool if you won’t need that money during retirement.
Learn More: Real Estate Investing in a Roth IRA
The Roth IRA is a powerful savings tool. High income earners must use the backdoor to take full advantage of the plan. The Backdoor Roth IRA gives one the ability to max out IRA contributions each year, and get those funds into a Roth, no matter your income. Although the government has presented legislation to limit Roth accounts, nothing major has passed yet, but that could change in the future. Take advantage of the opportunity while it’s still there.