Backdoor Roth IRA

A backdoor Roth IRA is a method that taxpayers can use to place retirement savings in a Roth IRA, even if their income is higher than the maximum the IRS allows for regular Roth IRA contributions. Backdoor Roth IRA is an informal name for a complicated, IRS-sanctioned method for high-income taxpayers to put money in a Roth; it is not the formal name for an official type of retirement account. The best brokers for IRAs and Roth IRAs provide assistance with figuring out these methods.

A Roth IRA lets taxpayers set aside a few thousand dollars from after-tax income for retirement in a special account where growth and distributions are tax-free. It's important to note that the IRS doesn't allow taxpayers whose modified adjusted gross income is above a certain threshold to participate in a Roth IRA in full. At a higher threshold, they cannot participate at all. 

For example, in 2018, single taxpayers with an AGI between $120,000 and $134,999 have their contributions limited, and the same is true for married taxpayers filing jointly with an AGI between $189,000 and $198,999. Single taxpayers with an AGI of $135,000 or higher and married taxpayers filing jointly with an AGI of $199,000 or higher aren’t normally eligible to contribute at all to a Roth IRA. 

The backdoor Roth is an option for higher-income taxpayers because, since 2010, the IRS hasn’t had income limits that restrict who can convert a traditional IRA to Roth IRA. As a result, taxpayers who ordinarily couldn't contribute to a Roth can instead make a non-tax-deductible contribution to a traditional IRA and convert it to a Roth IRA.

Another way to make a backdoor Roth contribution is by making an after-tax contribution to a 401(k) plan and then doing a rollover to a Roth IRA.

Why would taxpayers want to take the extra steps involved in making a backdoor Roth contribution?

For one, Roth IRAs don’t have required minimum distributions, which means account balances can see tax-deferred growth for as long as the account holder is alive. Another reason is that a backdoor Roth contribution can mean significant tax savings over the decades since Roth IRA distributions, unlike traditional IRA distributions, are not taxable. Vanguard estimates that the tax savings could reach a quarter of a million dollars by age 90 for a taxpayer who started making maximum backdoor contributions at age 30. That projection assumes the law will continue to allow backdoor contributions.

There is usually a tax bill associated with a Roth conversion, but a backdoor Roth minimizes the tax hit. Since the investor has already paid tax on the money being converted to a Roth IRA, the transaction only creates a tax bill under two circumstances: The taxpayer has investment earnings from the date of the nondeductible IRA contribution through the date of the conversion or has deductible IRA assets, in which case the pro-rata rule applies, which can make a significant percentage of the nondeductible contribution taxable upon conversion.