What Is a Backdoor Roth IRA? And How Does It Work?

The Roth IRA is one killer way to save for retirement. We recommend it a lot. Like, a lot a lot.

Because what’s not to love? Not only do you get to enjoy watching your investments inside of a Roth IRA grow tax-free, but you’ll also be able to take that money out in retirement without having to pay any taxes on it. It’s the best of both worlds!

The downside? The IRS rules that high-income earners can’t open or contribute to a Roth IRA . . . not directly, anyway. Enter the backdoor Roth.

What Is a Backdoor Roth IRA?

A backdoor Roth IRA is a different strategy as opposed to a different type of account. It’s a convenient workaround to the income limits on opening and contributing to a Roth. What do you do if you make too much money—which doesn’t have to be Bill-Gates-level income, by the way—to open a Roth? Go through the back door by putting your money into a traditional IRA and then converting the money over to a Roth.

When you transfer money from a traditional to a Roth IRA, you pay the taxes you owe on that money now—“now” meaning on your next federal tax filing—so that you enjoy tax-free withdrawals later. It’s simple and it’s perfectly legal.

Why the Backdoor? Roth IRA Income Limits

The IRS sets yearly income limits to keep high-income earners from opening up and contributing to Roth IRAs. Here’s where the limits stand for 2021.¹  Those “not eligible” spots on the chart are the reason the backdoor strategy came to be—as a way to give more income earners access to the Roth IRA.

Filing Status	Yearly Income (minus deductions)	Allowed Roth IRA Contributions
Married Filing Jointly	Less than $198,000 $198,000–207,999 $208,000+	Full Amount Reduced Amount Not Eligible
Married Filing Separately	Less than $10,000 $10,000+	Reduced Amount Not Eligible
Single, Head of Household	Less than $125,000 $125,000–139,999 $140,000+	Full Amount Reduced Amount Not Eligible

 

*The reduced amount is a multi-step calculation and depends on your income.²

Backdoor Roth IRA: Pros and Cons

So, is it worth the trouble of converting funds from your traditional IRA into a Roth IRA?

There are some big advantages to using the backdoor Roth IRA strategy.

• No income limit to start the traditional IRA: Everyone who earns an income is eligible for a traditional IRA.

• Tax-free gains and withdrawals: If you convert your traditional IRA funds to a Roth, you pay the taxes up front, which will theoretically be less than what you’d pay if they were taxed down the road post-growth. You get to enjoy tax-free growth and withdrawals (as long as you wait till you reach age 59 1/2 to withdraw). 

The downsides:

• When you convert from a traditional to a Roth IRA, you’re going to have to pay taxes on that money because the money wasn’t taxed before you put it into the traditional IRA. Make sure you have the cash on hand to pay those income taxes—do not use money from your investments to pay your tax bill!
   
• You cannot invest more than $6,000 in an IRA each year ($7,000 if you’re 50 or older).³ But remember: If you already have a traditional IRA, there’s no limit on how much you can convert from that account to a Roth IRA each year. Heck, you could convert $50,000, if you had it, from a traditional IRA to a Roth. You’d pay a hefty tax bill, but you could do it as long as you had the cash to cover it!

How to Set Up a Backdoor Roth IRA

You might feel intimidated by the idea of doing a backdoor Roth IRA—just the name “backdoor” sounds a little insider-y—but the truth is it’s pretty simple. You can convert a traditional IRA into a Roth IRA in just a few easy steps:

Step 1: Open up a traditional IRA.

If you don’t have one yet, you can connect with an investment professional who can help you set up a traditional IRA account, pick the right mutual funds, and make your first contribution.

Step 2: Convert the traditional IRA funds into a Roth IRA.

Once you have money in your traditional IRA, you have to convert those funds into a Roth IRA. There are three ways to get that done:

• Same-trustee transfer: Are your IRAs with the same financial institution? Fantastic! All you have to do is tell your financial institution to transfer the money from your traditional IRA into the Roth account.
   
• Trustee-to-trustee transfer: If you have your traditional and Roth IRAs at different financial institutions (or want to open a new Roth account at a different institution), you can have the institution that holds your traditional IRA transfer the money to the Roth at the other institution.
   
• Rollover: In this scenario, you’ll get a check from your IRA provider and you will have to deposit that money into a Roth account within 60 days. Doing a backdoor Roth this way is riskier, because if you forget to deposit that money for whatever reason, you’ll have to pay a withdrawal penalty on top of the taxes you owe. That’s why we made this number three on the list!

Again, if you have a bunch of money already inside a traditional IRA and want to convert all of it to a Roth, you can. While there are limits to how much new money you can contribute in an IRA each year, there are no restrictions on how much you can convert from an existing investment account to a Roth IRA.

Market chaos, inflation, your future—work with a pro to navigate this stuff.

But as we mentioned before—keep in mind, you have to pay taxes on all the money you convert into your Roth account. Which brings us to . . .

Step 3: Pay the taxes you owe on the money you invested.

Some people get this idea that doing a backdoor Roth IRA is some kind of tax dodge. But that’s not the case at all—you’re just deciding to pay your taxes on your retirement savings now instead of later.

So if you put $6,000 into a traditional IRA and convert that into a Roth IRA, come tax season, you’ll have to pay taxes on that $6,000 plus on whatever your investments earned since you opened the traditional IRA.

And heads up! The money you’re converting will probably count as income for the year and—depending on how much you earn and how much money you’re converting—it might bump you into a higher tax bracket for the year.

Talk with a professional who can give you an idea of how much you’ll owe in taxes when you do the conversion. That way, you won’t have a panic attack when you get your tax bill next April! 

Step 4: Repeat the process every year and enjoy tax-free growth!

That’s it! Contribute. Convert. Pay your taxes. And then do it all over again year after year so that you can enjoy watching your investments grow tax-free.

When You Shouldn’t Do a Backdoor Roth IRA

Can the backdoor Roth backfire? We’re big fans, but it’s definitely in your best interest to strictly follow the rules around the Roth—otherwise, you could take a hit on your investment, and that’s not what you want! Talk it through with your financial advisor before you take the leap.

• The Five-Year Rule. If you’re going to need to withdraw the money fairly soon, rethink this strategy. Once you convert a traditional IRA to a Roth IRA, you need to wait at least five years before you withdraw from it—any sooner, and you’ll likely owe taxes and pay a penalty.

• Paying the Taxes. Can’t stress this one enough. You should only do a backdoor Roth IRA if you have the cash on hand to pay the taxes you owe without taking money out of the traditional IRA itself. That would just undercut your future gains, defeating the whole purpose of the conversion.
   
• The Pro-Rata Rule. Long story short, this rule means that if you have multiple traditional IRAs, particularly if they’re a mix of pre-tax and post-tax money, you might decide the backdoor isn’t worth it.⁴  You may get taxed more than you want to pay (let’s be real—you don’t want to get taxed at all, but in this case, it might be even more than you expected). Work with your pro to determine if pro-rata is a dealbreaker.

Work With an Investment Pro

Don’t have an investment professional? Our SmartVestor program can connect you with a pro who can walk you through the process of creating a backdoor Roth IRA. That way, you can breathe easier knowing that you won’t have to worry about paying taxes on that money when you reach retirement.

Find a SmartVestor Pro near you!