This article has been updated for the 2023 tax year. In it, we’ll cover the basic Backdoor Roth IRA details, how-to steps, and whether they might make sense for you. To kick things off, in my previous Roth IRA basics post, I received the following question from a reader, Julia:
Great summary, but I think it’d be interesting to hear about the Backdoor Roth IRA option. Doesn’t the Back Door Roth essentially eliminate all income restrictions on Roths?
It’s a great question. I’ve been neglecting the Backdoor Roth IRA topic entirely for reasons I’ll discuss towards the end of this post. But, before we go there, let’s first cover what a Backdoor Roth IRA is and how it works.
What is a Backdoor Roth IRA?
A Backdoor Roth IRA is a way for high income earners to make Roth IRA contributions through the ‘back door’ by first making non-deductible contributions to a Traditional IRA, and then converting those contributions to a Roth IRA (which are also non-deductible, but have income limits for contributions). Doing so allows for incremental positive long-term tax-advantaged retirement savings.
High income earners, specifically those who are above the Roth IRA income limits, cannot contribute directly to a Roth IRA. In order to reap the benefits of a Roth IRA, they must take advantage of an IRS loophole and contribute through the non-deductible Traditional-to-Roth conversion instead. There is no income limit on making a non-deductible contribution to a Traditional IRA.
You heard “non-deductible contributions” right. Traditional IRA contributions are typically deductible, whereas Roth IRA contributions are not (with Roths, you pay tax now, but future earnings and withdrawals are tax free at retirement). This is the key component that makes the Backdoor Roth conversion possible.
Note: if you are below the Roth IRA income limits, then you can contribute directly to a Roth IRA (or even better, in my opinion, make a deductible contribution to a Traditional IRA) and conveniently forget all about the Backdoor Roth.
Backdoor Roth IRA Steps: How to do a Backdoor Roth IRA Conversion
At its simplest level, here are the Backdoor Roth IRA conversion steps:
Step 1: Taxpayer has both a Traditional IRA and Roth IRA with the same broker (if not, they can open them with an online discount broker).
Step 2: Taxpayer reaches an income level that is over the Roth IRA contribution income limit in a given year.
Step 3: Taxpayer makes a non-deductible contribution to a Traditional IRA for that tax year (up to the maximum IRA contribution).
Step 4: After the contribution posts to the account (typically as soon as next day or after), taxpayer then converts 100% of the funds from the Traditional IRA to a Roth IRA.
Step 5: Taxpayer does not claim a deduction for the IRA contribution and fills out IRS Form 8606 when completing their taxes.
Backdoor Roth IRA Dangers (e.g. the Pro-Rata Rule & Step Transaction Doctrine)
Backdoor Roth IRAs are not foolproof. If you do them incorrectly, they can result in over-taxation or worse.
If you have any pre-existing deductible funds in any Traditional IRA, SEP IRA, or SIMPLE IRA, these types of accounts are all lumped together for the conversion and you cannot convert just the non-deductible amount. This is called the pro-rata rule. It’s best illustrated with an example.
- You have $50,000 in total IRA assets.
- $10,000 of those assets are non-deductible contributions.
- 20% ($10,000/$50,000) of your assets are non-deductible.
Due to the pro-rata rule, in this example, any partial conversion is considered 80% taxable and only 20% non-taxable, which would wipe out much of the benefit of making the conversion because those who need to do the Backdoor conversion in the first place are in high tax brackets and would be paying high taxes on the deductible portion.
Therefore, it makes sense to roll-over any deductible SEP-IRA, SIMPLE IRA, Traditional IRA funds into an employer-sponsored 401K (which are considered separate funds and don’t count towards the pro-rata rule) first before executing a Backdoor Roth IRA conversion, or else you could be stuck with a significant tax bill for the previously deducted portion of the conversion. Not every 401K allows this type of conversion, however.
Sound complicated? It is.
There is also the matter whether Backdoor Roth IRAs are technically legal. There is no mention of the Backdoor Roth IRA on the IRS website because the IRS does not acknowledge their own loopholes.
The Step Transaction Doctrine essentially states that if an individual act is not permitted, then it is also not permitted through a series of legal steps. Backdoor Roth IRA Conversions are common and the IRS coming after people is unlikely, yet just the threat may be reason enough to stay away.
This post is not an endorsement or advice to use the Backdoor Roth IRA conversions. Understand the risks and consult with a professional before executing a Backdoor Roth IRA conversion. Most readers here will not earn enough income to need to use the Backdoor Roth (check the limits). And those who do who are aware of the risks should proceed with caution.
What About the Mega Backdoor Roth?
A mega backdoor Roth, is a way for you to make after-tax contributions to a 401K and then convert them to a Roth IRA or Roth 401K. If your employer allows them, and you have the cash for to make it work, they are worth exploring further to give an extra boost to your retirement savings.
Wow! I feel famous! ;). Haha- thanks for the post GE! Very informative.
I love tax loopholes.
Great to point out that step transaction doctrine problem. I know a lot of folks just gloss over it like it’s no big deal, but I can see potential risk on that front. Honestly, I didn’t even know the step transaction was a thing for a long time because every backdoor Roth tutorial never even mentioned it.
Great job explaining this issue. Thanks, GE.
The pro-rata rule is definitely a risk people overlook.
I’ve heard there are rumblings in congress on the backdoor Roth. Some want to make sure people can’t use the backdoor roth-IRA loophole in the future. Like you said it’s probably unlikely that it will go away, but it’s always something in the back of my mind.
Thanks for sharing, will definitely bookmark for future reference.
Thanks for this explanation / article. Very helpful and educational.
If non-deductible and deductible IRA are coexisting rendering Backdoor IRA difficult due to pro-rata rules, roll IRA basis (previously contributed nondeductible IRA as reported on past 8606) to 401k. You just managed to separate fat and water from milk!! Now convert to Roth IRA without any basis tax
This is very helpful! Based on my income, I would have to consider a backdoor IRA or a traditional IRA without the possibility of a tax deduction. Is it worth having a traditional IRA without the possibility of a tax deduction, or should I consider other investment options that might provide more return? I’m unaware of what those options might be and am leaning towards starting a traditional IRA.
Wouldn’t it just be easier to set up a separate IRA so that the deductible issue wouldn’t matter? Therefore you just put the ~ $5,500 or bow $6,000 in the traditional IRA and then roll the whole balance into a Roth IRA the next day?