Back Door IRAs

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What is a back door IRA?

A backdoor Roth IRA lets you convert a traditional IRA to a Roth, even if your income is too high for a Roth IRA.

Who should be using one?

A backdoor Roth IRA is a way for people with high incomes to sidestep the Roth’s income limits. Essentially, it allows you to capture the same advantages of a Roth IRA, when you don’t qualify to contribute to a Roth IRA directly.

Why should you use one?

It allows your money to grow tax-free. That is, only post-tax dollars go into Roth RIAs. Come tax season, you’ll have to pay income tax on the money you converted into a Roth IRA, but when you take it out for use during retirement, there won’t be any taxes to pay (aka you’ll get to use everything in that account).

It’s probably not the right fit if:

  1. The only way to pay the taxes that would be due (either income tax or investment gainstax) is with the money from your IRA withdrawal. This act sacrifices any future investment growth on that money, but also if you’re under 59.5 years old, you would be required to pay the 10% early withdrawal penalty on that money.
  2. You need the money in five years or less. For Roth IRAs, you owe taxes and pay a 10% penalty on withdrawals that take place within the first five years.
  3. The withdrawal from your IRA will push you into a higher tax bracket. It’s best to convert just enough that you’re not pushed into paying a higher tax rate for the year.

When should you use one?

Roth IRA’s have income limits. For 2020, only those whose modified adjusted gross incomes are below $206,000 (married filing jointly) or $139,000 (single) are allowed to contribute to a Roth IRA. In the 2021, the limit is $208,000 (married filing jointly) or $140,000 (single).

For those with an income above these limits, the backdoor Roth IRA is a great solution to continue to save money for retirement faster.

Where can you set one up? How do you set it up?

  1. Put money in a traditional IRA. This can be done through the account you own currently, or you may need to open one up.
  2. Then, convert the account to a Roth IRA. If you have a Roth IRA account already, your IRA administrator will give you the instructions and paperwork. If you don’t currently have a Roth IRA account, you will open a new account during the conversion process.
  3. Pay taxes on contributions. The money that goes into the Roth IRA is post-tax (i.e. money that you’ve already deducted the taxes from).
  4. Pay taxes on gains. If the money that you’re moving to the Roth IRA from the traditional IRA has already collected investment gains during its time in the traditional IRA, you will still owe taxes on those gains at that time.

Things to keep in mind to avoid penalties

1. Types of transfers. The conversion needs to be one of the following:

  1. a rollover: where you receive the money from your IRA and deposit it into the Roth within 60 days
  2. a trustee-to-trustee transfer, where the IRA provider sends the money directly to your Roth IRA provider
  3. a “same trustee transfer”, where your money goes from the IRA to the Roth at the same financial institution

2. The pro-rata rule

1. The IRS requires rollovers from traditional IRAs to Roth IRAs to be done pro rata. What this means is that the IRS will look at the combined proportion of all your traditional IRA accounts to determine the composition of the accounts (e.g. 70% pre-tax money and 30% post-tax money). This ratio then determines what percentage of the money you covert to a Roth will be taxable. So, basically you can’t decide you only want to convert the post-tax money accounts – the IRS won’t allow it. In this example, 70% of the money you convert, regardless of the account it comes from, will be taxable. One final note on the timing: the IRS applies this rule to your total IRA balance at year-end, not at the time of conversion.