What is a Backdoor Roth IRA?
You may already know that contributing to a Roth individual retirement account (IRA) is off-limits for people with high annual incomes. If your earnings put Roth IRA contributions out of reach, a backdoor Roth IRA conversion is a legal option that lets you enjoy the tax benefits of a Roth IRA.
How Does Backdoor Roth IRA Work?
A backdoor Roth IRA isn’t a special type of individual retirement account. Rather, a backdoor Roth IRA is a strategy that helps you save retirement funds in a Roth IRA even though your annual income would otherwise disqualify you from accessing this type of individual retirement account.
A backdoor Roth IRA works like this: You open a new traditional IRA, make non-deductible contributions to it, then convert it into a Roth IRA. There are no income thresholds limiting who can make nondeductible IRA contributions, although you still need to obey the annual IRA contribution limits.
Step-By-Step Guide to Backdoor Roth IRAs
To complete a backdoor Roth IRA conversion, you need to proceed methodically to avoid penalties or taxes. Closely follow these three steps:
Step 1: Open and Fund a Traditional IRA
Start by opening a new traditional IRA. If you already have a traditional IRA with an existing dollar value, STOP HERE. When a Roth IRA conversion is processed, the IRS requires that all IRA accounts be converted to a Roth. The funds you have in your traditional IRA will have tax consequences if you convert them. That’s because of the IRA aggregation and pro-rata rules. YOU SHOULD CONSULT WITH A QUALIFIED FINANCIAL OR RETIREMENT PLANNER FOR GUIDANCE. We can provide the tax consequences, but it requires a tax projection project (note: we are unable to do tax projections between January 1-April 15). Scroll down to "What happens if I already have an existing traditional IRA?"
Step 2: Understand How a Roth IRA Conversion Works
Check with your IRA provider(s) about the required paperwork for a Roth IRA conversion. If your traditional IRA will be with the same account provider as your Roth IRA, the process may be a relatively simple same-trustee transfer.
If you have separate providers for each IRA, a trustee-to-trustee transfer—where one company wires the money to another—shouldn’t be complicated.
If your IRA provider won’t manage the transfer of funds and hands you a check, you can still do a backdoor Roth IRA. But you must deposit the check in a new Roth IRA account within 60 days. Otherwise, it may be considered an early withdrawal, with potential taxes and penalties.
Step 3: Convert Your Traditional IRA to a Roth IRA
Immediately convert your new traditional IRA to a Roth IRA. Doing the conversion as rapidly as possible prevents the non-deductible contributions you put in your new traditional IRA from accumulating investment gains, which would mean you’d owe tax on these gains when you made the Roth IRA conversion.
Congratulations! You’ve Completed a Backdoor Roth IRA Conversion. Most brokerages can help you handle a Roth IRA conversion, especially if you opened your traditional IRA with them. If you’re opening a traditional IRA for the first time, choose a brokerage that offers traditional and Roth IRA options that meet your needs.
Special Considerations for a Backdoor Roth IRA
When attempting a backdoor Roth IRA conversion, you need to be aware of the quirks of IRAs and some special tax considerations.
There Are Two Five-Year Rules for Backdoor Roth IRAs
The five-year rule states that in most cases—even if you’re over 59 ½—you generally cannot withdraw Roth IRA earnings free of taxes (and often penalties) unless your first contribution to a Roth account was made at least five years ago. You’re usually allowed to withdraw contributions from your Roth IRA at any time, free of penalties or taxes.
There is a second five-year rule, however, for backdoor Roth conversions. Because a backdoor Roth IRA is categorized as a conversion—not a contribution—you cannot access any of the funds held in the converted Roth IRA without penalty for the first five years after conversion.
If you do a backdoor Roth IRA conversion every year, you must wait five years to tap each portion you convert. Otherwise you risk paying additional penalties on money that’s already been taxed. There are exceptions to this requirement, though, if you’re 59 ½ or older or if you become disabled or die.
What happens if I already have an existing Traditional IRA?
The IRS views all of your traditional IRAs as a single account when determining the taxes you owe on distributions. Unfortunately, from the IRS’s standpoint, “distributions” include Roth IRA conversions. This fact greatly complicates backdoor Roth IRA conversions for people who already hold existing balances in traditional IRAs.
In practice, this means you may owe taxes on money you intend for a backdoor Roth IRA conversion—even if the money has already been taxed. This happens when the IRS’ aggregation rule intersects with the pro-rata rule.
The pro-rata rule states that once money enters an IRA, you cannot separate the portion that’s already been taxed from the portion that was deducted from taxes. You may hear this described as the “cream in your coffee” rule. Once cream hits the coffee, it’s impossible to separate back out the dairy. The same goes for your pre-tax and post-tax IRA contributions.
Let’s say 80% of the funds in your combined IRAs earned tax deductions, and 20% did not. When you undertake a backdoor Roth IRA conversion, you can’t separate out the already taxed funds for conversion, much like the cream cannot be separated from the coffee. In this example, 80% of the money being converted to a Roth IRA would be taxed in a Roth IRA conversion.
If you’re considering a backdoor Roth conversion, speak with a financial advisor or retirement planner to decide.
Some States Tax Backdoor Roth IRA Conversions
Most states that charge income taxes treat a backdoor Roth conversion in the same way as federal tax law. But some states will exempt some part of a pension or IRA distribution from taxes if the person is over a certain age.
Some states may exclude the entire conversion amount from tax, and states without an income tax law also don’t tax any conversion amounts. Sitting down with a tax professional can help you navigate any state or federal taxes your backdoor Roth may incur.
How Does Backdoor Roth IRA Work?
A backdoor Roth IRA isn’t a special type of individual retirement account. Rather, a backdoor Roth IRA is a strategy that helps you save retirement funds in a Roth IRA even though your annual income would otherwise disqualify you from accessing this type of individual retirement account.
A backdoor Roth IRA works like this: You open a new traditional IRA, make non-deductible contributions to it, then convert it into a Roth IRA. There are no income thresholds limiting who can make nondeductible IRA contributions, although you still need to obey the annual IRA contribution limits.
Step-By-Step Guide to Backdoor Roth IRAs
To complete a backdoor Roth IRA conversion, you need to proceed methodically to avoid penalties or taxes. Closely follow these three steps:
Step 1: Open and Fund a Traditional IRA
Start by opening a new traditional IRA. If you already have a traditional IRA with an existing dollar value, STOP HERE. When a Roth IRA conversion is processed, the IRS requires that all IRA accounts be converted to a Roth. The funds you have in your traditional IRA will have tax consequences if you convert them. That’s because of the IRA aggregation and pro-rata rules. YOU SHOULD CONSULT WITH A QUALIFIED FINANCIAL OR RETIREMENT PLANNER FOR GUIDANCE. We can provide the tax consequences, but it requires a tax projection project (note: we are unable to do tax projections between January 1-April 15). Scroll down to "What happens if I already have an existing traditional IRA?"
Step 2: Understand How a Roth IRA Conversion Works
Check with your IRA provider(s) about the required paperwork for a Roth IRA conversion. If your traditional IRA will be with the same account provider as your Roth IRA, the process may be a relatively simple same-trustee transfer.
If you have separate providers for each IRA, a trustee-to-trustee transfer—where one company wires the money to another—shouldn’t be complicated.
If your IRA provider won’t manage the transfer of funds and hands you a check, you can still do a backdoor Roth IRA. But you must deposit the check in a new Roth IRA account within 60 days. Otherwise, it may be considered an early withdrawal, with potential taxes and penalties.
Step 3: Convert Your Traditional IRA to a Roth IRA
Immediately convert your new traditional IRA to a Roth IRA. Doing the conversion as rapidly as possible prevents the non-deductible contributions you put in your new traditional IRA from accumulating investment gains, which would mean you’d owe tax on these gains when you made the Roth IRA conversion.
Congratulations! You’ve Completed a Backdoor Roth IRA Conversion. Most brokerages can help you handle a Roth IRA conversion, especially if you opened your traditional IRA with them. If you’re opening a traditional IRA for the first time, choose a brokerage that offers traditional and Roth IRA options that meet your needs.
Special Considerations for a Backdoor Roth IRA
When attempting a backdoor Roth IRA conversion, you need to be aware of the quirks of IRAs and some special tax considerations.
There Are Two Five-Year Rules for Backdoor Roth IRAs
The five-year rule states that in most cases—even if you’re over 59 ½—you generally cannot withdraw Roth IRA earnings free of taxes (and often penalties) unless your first contribution to a Roth account was made at least five years ago. You’re usually allowed to withdraw contributions from your Roth IRA at any time, free of penalties or taxes.
There is a second five-year rule, however, for backdoor Roth conversions. Because a backdoor Roth IRA is categorized as a conversion—not a contribution—you cannot access any of the funds held in the converted Roth IRA without penalty for the first five years after conversion.
If you do a backdoor Roth IRA conversion every year, you must wait five years to tap each portion you convert. Otherwise you risk paying additional penalties on money that’s already been taxed. There are exceptions to this requirement, though, if you’re 59 ½ or older or if you become disabled or die.
What happens if I already have an existing Traditional IRA?
The IRS views all of your traditional IRAs as a single account when determining the taxes you owe on distributions. Unfortunately, from the IRS’s standpoint, “distributions” include Roth IRA conversions. This fact greatly complicates backdoor Roth IRA conversions for people who already hold existing balances in traditional IRAs.
In practice, this means you may owe taxes on money you intend for a backdoor Roth IRA conversion—even if the money has already been taxed. This happens when the IRS’ aggregation rule intersects with the pro-rata rule.
The pro-rata rule states that once money enters an IRA, you cannot separate the portion that’s already been taxed from the portion that was deducted from taxes. You may hear this described as the “cream in your coffee” rule. Once cream hits the coffee, it’s impossible to separate back out the dairy. The same goes for your pre-tax and post-tax IRA contributions.
Let’s say 80% of the funds in your combined IRAs earned tax deductions, and 20% did not. When you undertake a backdoor Roth IRA conversion, you can’t separate out the already taxed funds for conversion, much like the cream cannot be separated from the coffee. In this example, 80% of the money being converted to a Roth IRA would be taxed in a Roth IRA conversion.
If you’re considering a backdoor Roth conversion, speak with a financial advisor or retirement planner to decide.
Some States Tax Backdoor Roth IRA Conversions
Most states that charge income taxes treat a backdoor Roth conversion in the same way as federal tax law. But some states will exempt some part of a pension or IRA distribution from taxes if the person is over a certain age.
Some states may exclude the entire conversion amount from tax, and states without an income tax law also don’t tax any conversion amounts. Sitting down with a tax professional can help you navigate any state or federal taxes your backdoor Roth may incur.
