What Is a Backdoor Roth IRA? And How to Set One Up

Written by Kim PinnelliUpdated: 15th Jan 2021
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If you have a high income, you may not be eligible for a Roth IRA. That doesn’t mean you can’t invest in it though.

Using the backdoor Roth IRA technique (it’s legal don’t worry), anyone can take advantage of a Roth IRA. Keep reading to find out what a Backdoor Roth IRA is and how it works. Plus, we will show you how to set one up.

What is a Backdoor Roth IRA?

The name sounds suspicious, I know. But it has the name ‘backdoor’ because the Roth IRA only has an income limit, not a conversion limit.

In other words, anyone could convert a traditional IRA to a Roth IRA no matter how much they make.

Basically, you invest in a traditional IRA and then turn around and convert it to a Roth IRA. You aren’t under any certain timeline to do it either.

But if you convert after you take the tax deduction for the traditional IRA, you’ll have taxes to pay (more on this below).

Learn More: Roth IRA vs Traditional IRA

How Does a Backdoor Roth IRA Work?

There isn’t an account called a backdoor Roth IRA. It’s just a funny name for shuffling money around and doing a little administrative work.

After you invest in an individual retirement account (IRA), you can open a Roth IRA and request to transfer your IRA over. You don’t have to worry about proving your income for the Roth IRA conversion – anyone can convert the funds, so there’s no worry about making too much.

Once your funds are in the Roth IRA, the money grows tax-free. You’ll pay the taxes owed on the funds when you set it up (more on that below), and then everything grows tax-free.

If you withdraw after age 59 ½, you get 100% of the available funds without any tax obligations.

Backdoor Roth IRA Contribution Limits

Roth and traditional IRA contribution limits are $6,000 for 2021. If you are over 50-years old, you may contribute an additional $1,000, for a total of $7,000.

Any amount you contribute above this amount is nondeductible. In other words, you contribute after-tax funds – these are the funds you want to convert to a Roth IRA, but the IRS has a way to make sure you pay your taxes no matter the amount.

You can contribute your IRA funds up until April 15 of the year following the tax year. For example, you have until April 15, 2021, to contribute for your 2020 taxes.

How to Set Up a Backdoor Roth IRA (Step-by-Step)

Follow our steps to set up a backdoor Roth IRA right now.

Step #1. Contribute to a Traditional IRA Account

Find a stock broker that offers traditional IRAs with a Roth IRA conversion option. Many brokers offer it but don’t assume. Read the fine print to make sure they have what you want.

You can contribute your funds in one lump sum or throughout the year, but you may only contribute up to $6,000 (or $7,000 if you’re over 50).

Step #2. Convert Traditional IRA to Roth IRA

Complete the paperwork to convert to a Roth IRA. If you don’t have a Roth IRA yet, the broker will set one up for you.

If you have one, they’ll likely add the funds to your existing account. You do all this through your broker – it takes just minutes.

Step #3. Know the Tax Implications of Backdoor Roth IRAs

Prepare yourself for the tax consequences of converting to a backdoor Roth IRA. If you took the tax deduction for the contribution to the traditional IRA and then decided to convert, you’ll owe taxes on the money you convert.

Keep in mind, this could be not only the amount you contributed but any earnings your traditional IRA earned until you converted.

You can pay the taxes right away (recommended), but you have until the tax filing date to pay, or April 15.

What to Watch Out For:

  • Pro-Rata IRS Rules: Here’s where the IRS gets you. Make any IRA after-tax IRA contributions, you may think you can just convert that amount over to a Backdoor Roth IRA and not worry about taxes. That’s not the case. The IRS Pro-Rata Rule ensures that you pay the taxes due. They’ll determine your pre-tax versus after-tax contributions as a percentage of the IRA’s total balance. You’ll pay taxes accordingly. For example, if your IRA is 65% pre-tax funds and 35% after-tax funds, 65% of the funds you convert to a Roth IRA are taxable.
  • IRS Form 8606: When you convert your IRA to a Roth IRA, you must complete IRS Form 8606 which lists your nondeductible (over the limit) contributions.
  • Type of Transfer: Make sure you only do a conversion. Don’t withdraw the funds with the intent to roll them into a Roth IRA. If you make too much money and don’t qualify for a Roth IRA, your only option is the backdoor or conversion.
  • Five-Year Rules: Any money in a Roth IRA must sit there for 5 years. If you withdraw before 5 years, even if you’re of retirement age, you’ll pay a 10 percent tax penalty.

Advantages of Backdoor Roth IRAs

  • Lower taxes during retirement – No one can predict their tax bracket, but knowing that you don’t owe taxes on your retirement funds is a good feeling. You know that the amount in your account is yours to use.
  • You can withdraw contributions at any time – It’s not recommended, but again, we can’t predict life. If you need your contributions (not the earnings) for something, you may withdraw them from a Roth IRA without penalty or taxes.
  • No required minimum distributions – Unlike a traditional IRA which has Required Minimum Distributions starting at age 72 ½, you can leave your Roth IRA funds untouched as long as you want.
  • Tax-free gains – Your money grows in a Roth IRA tax-free. Once you pay your taxes on the contributions, you don’t owe any more taxes on the money no matter how much you earn/withdraw.
  • No income limit – Traditional and Roth IRAs limit you based on your income, but anyone can use the backdoor IRA conversion.

Disadvantages of Backdoor Roth IRAs

  • Big tax bill – Depending on how much you convert, you could be hit with a hefty tax bill at tax time for the conversion.
  • Low contribution limits – While it’s not exclusive to the Roth IRA, all IRAs have a contribution limit of $6,000. This doesn’t apply to any money already in your IRA though, you can covert as much as you want, but be prepared to pay taxes on the money converted.

Who Should Use a Backdoor IRA?

If you’ve maxed out your traditional IRA contributions and/or make too much to contribute to a Roth IRA, you may benefit from the backdoor IRA.

The idea is to make nondeductible contributions to your IRA and then convert them. This way, you avoid the tax consequences and enjoy the tax-free growth in the Roth IRA.

If you include pre-tax IRA contributions in your conversion or you already took the tax deduction for your IRA contributions, there will be a tax consequence, so keep that in mind.

Is a Backdoor Roth IRA Worth It?

The backdoor Roth IRA is worth it in some cases, not all. It’s best to work with your tax professional to determine how the conversion would affect you.

If you can leave the funds for at least five years, you have the money to cover the tax liabilities it incurs, AND the withdrawal won’t push you into a higher tax bracket it could be worth it.

If, however, you think you may be in a lower tax bracket when you retire, you’re better off leaving your funds in a traditional IRA and paying the lower taxes when you withdraw the funds rather than now.

Bottom Line: Backdoor Roth IRAs

Whether or not a Roth IRA makes sense depends on your tax situation. If you’re in a low tax bracket now, it makes sense to take advantage of today’s deductions, using a Roth IRA.

If you think you’ll be in a lower tax bracket when you retire, though, you’re better off with the traditional IRA and paying the taxes in retirement.

It’s a fine line that your tax advisor or financial professional should help you figure out. Some people benefit from it and enjoy the lack of Required Minimum Distributions and can handle the tax uncertainty.

Others want to pay the taxes now and let their retirement funds grow without worrying about tax rates.

Kim Pinnelli
Kim Pinnelli

Kim Pinnelli is a Senior Writer, Editor, & Product Analyst with a Bachelor’s Degree in Finance from the University of Illinois at Chicago. She has been a professional financial writer for over 15 years, and has appeared in a myriad of industry leading financial media outlets. Leveraging her personal experience, Kim is committed to helping people take charge of their personal finances and make simple financial decisions.