Converting from a traditional individual retirement account (IRA) to a Roth IRA is possible—even if your taxable income exceeds the limit for a Roth account. This is possible via the backdoor Roth IRA loophole. What does a backdoor Roth IRA conversion mean, how do you do it, and should you?
Quick breakdown: What is a backdoor Roth IRA conversion? Investors contribute to a traditional IRA (which is usually tax-deferred), then rollover those annual contributions to a Roth IRA. This lets high-income earners get past the Roth IRA contribution income limits that the Internal Revenue Service (IRS) sets.
Upsides and downsides of a backdoor Roth IRA
Roth IRAs have income caps for after-tax contributions (for the 2022 tax year, the modified adjusted gross income, or MAGI, limit is $144,000 for single filers and $214,000 for married filing jointly).
Many high earners get priced out of Roth accounts, either having to reduce their contribution limit or being unable to contribute at all. Traditional IRAs don’t have these income restrictions, and you can roll over contributions into a Roth IRA account without penalty.
Roth accounts have tax benefits because they let your investments grow tax free, which helps you build wealth without worrying about income and capital gains taxes down the road. By paying income taxes now, you avoid costlier tax liability when you’re (potentially) in a higher tax bracket closer to retirement age.
You also aren’t required to take required minimum distributions (RMDs) in a Roth account, giving you more control over your retirement plan.
The five-year rule still applies for a backdoor Roth contribution. If you perform a backdoor Roth conversion each year, you need to wait five years after each contribution to make those distributions.
Roth accounts do not allow for tax deductions in any instances, though certain people qualify to deduct traditional IRA contributions.
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How to do a backdoor Roth IRA contribution
- Speak with a tax professional or financial advisor. Make sure you fully understand the backdoor Roth strategy before embarking on this journey.
- Open a traditional IRA and make contributions. You can do this with pre-tax dollars (but be prepared to pay a tax bill).
- Open a Roth IRA and rollover the contributions. This lets people with higher income bypass restrictions on Roth accounts.
- Keep your traditional IRA open. You can do more backdoor conversions over the years.
Aggregation rule and pro-rata rule, explained
Aggregation rule: The IRS looks at your retirement accounts as a whole. Taxpayers should make sure they don’t have other pre-tax retirement accounts in addition to a nondeductible traditional IRA so as not to exceed contribution limits.
Pro rata rule: The rule on taxation goes like this: “If your account balance contains both pretax and after-tax money, any distribution will generally include a pro rata share of both.” This means if your distributions consist of 50% post-tax dollars and 50% pre-tax dollars, you’ll be taxed accordingly. You cannot distribute only after-tax dollars, according to the IRS.
Bottom line on backdoor Roth IRA conversions
A backdoor Roth IRA strategy can boost retirement savings for high-income earners. Knowing how a backdoor Roth IRA works is key in building your long-term investing strategy. As a brokerage, Public understands the need for long-term investments, which is why we offer a Long-Term Portfolio feature to help you lock those investments in.