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

It’s no secret that the Roth IRA is one of my favorite ways to save for retirement.

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

Unfortunately, the IRS says that high-income earners are not allowed to open up or contribute to a Roth IRA . . . well, at least not directly. For all you high-income earners out there, there is a way to get your money into a Roth account. It’s time to introduce you to the backdoor Roth IRA.

What Is a Backdoor Roth IRA?

A backdoor Roth IRA is a convenient loophole that allows high-income individuals to enjoy all the tax benefits that a Roth IRA has to offer by converting a traditional IRA into a Roth IRA.   

With a backdoor Roth, you basically start the money off in a traditional IRA, transfer it to a Roth IRA and then pay the taxes you owe on that money now so that you can let your investments grow tax-free and enjoy tax-free withdrawals later. It’s that simple and it’s perfectly legal.

You see, there are income limits set up by the IRS designed to keep high-income earners from opening up and contributing to a Roth IRA based on how much they make a year. In 2020, if you’re single and make more than $139,000 or married and earn more than $206,000, then Uncle Sam says you cannot open or contribute to a Roth IRA.1

That’s why the backdoor Roth IRA is a great option for many high-income earners who still want to enjoy the tax benefits that a Roth IRA offers.

Backdoor Roth IRA: Pros and Cons

Now, how do you know whether or not it’s worth the trouble of converting your traditional IRA into a Roth IRA? There are several things you need to consider before doing a backdoor Roth, like how much you’ll need to pay in taxes in order to convert those retirement funds.

First, let’s look at a few of the key advantages to doing a backdoor Roth IRA:

  • No income limit or conversion limit: No matter what your income is, everyone who earns an income is eligible for a traditional IRA that can be converted into a Roth IRA afterward. Plus, if you already have money sitting inside an existing traditional IRA, you can convert as much of that money into a Roth IRA as you want.
  • Tax-free gains and withdrawals: If you convert your traditional IRA to a Roth, you pay the taxes up front and get to enjoy tax-free growth and withdrawals (once you reach age 59 1/2). Those are two very good reasons to get a backdoor Roth! 

Sounds great, right? But I’ve got to warn you up front that there are a couple of downsides and limitations to doing a backdoor Roth IRA:

  • Income taxes: When you convert from a traditional to a Roth IRA, you’re going to have to pay taxes on that money. You need to 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! Doing a backdoor Roth IRA is going to feel like ripping off a Band-Aid—it’ll hurt right now, but now that money gets to grow tax-free and you won’t have to pay taxes on that money when you take it out at retirement. That’s a pretty good trade-off! 
  • Contribution limits: You cannot invest more than $6,000 in an IRA each year ($7,000 if you’re 50 or older).2 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. If you have $50,000 already sitting in a traditional IRA, for example, you could convert all of that money at once if you wanted to!

How to Create a Backdoor Roth IRA

You might feel intimidated by the idea of doing a backdoor Roth IRA, but the truth is it’s really not that hard to set up. You can convert a traditional IRA into a Roth IRA in just a few easy steps:

Step 1: Invest into a traditional IRA.

Unlike a Roth IRA, there are no income restrictions for a traditional IRA . . . which means anyone can open up a traditional IRA and put money into it. So, the first step toward doing a backdoor Roth IRA is to contribute to a traditional IRA you already have or open one.

If you don’t have a traditional IRA, you can connect with an investment professional who can help you set up an account and pick the right mutual funds to put into your traditional IRA.

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

Once you have money invested into your traditional IRA, the next thing you have to do is convert those funds into a Roth IRA. There are three ways to get that done:

  1. 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 risky, 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. I’d recommend doing one of the following transfers instead.
  1. 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 direct the institution that holds your traditional IRA to transfer the money to the Roth at the other institution.
  1. Same-trustee transfer: Have 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.

Again, if you have a bunch of money already inside a traditional IRA and want to convert all of it to a Roth, you could do that! While there are limits to how much you can invest in an IRA each year, there are no restrictions on how much you can convert to a Roth IRA.

But you have to be really careful, because you will 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.

OK, here comes the not-so-fun part. Some people get this idea that doing a backdoor Roth IRA is some kind of a 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.

Now, traditional IRAs are usually funded with pre-tax money, which means you aren’t paying taxes on that money yet. You get a tax break now, but you’ll have to pay taxes on that money you take out in retirement. Uncle Sam will get his fair share eventually!

So if you put $6,000 into a traditional IRA and want to convert that into a Roth IRA, you’ll have to pay taxes on that $6,000. On top of that, you’ll have to pay taxes on whatever money your investments earned between the time you invested inside the traditional IRA and when you convert it to a Roth.

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—that might bump you into a higher bracket for the year.

I can’t stress this 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 and that defeats the purpose of the conversion in the first place.

That’s why you’ll want to talk with a tax 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! Invest. 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. It helps to have an investment professional in your corner to help you make sure that the process is done the right way each year.

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 today!