Earning a higher income may seem like the key to a more comfortable retirement, but it can actually be a barrier to some kinds of tax-advantaged retirement savings. That’s because a larger salary can shut you out of contributing to a Roth IRA. Fortunately, there is a way around the Roth IRA roadblock for affluent taxpayers: a backdoor Roth IRA.
Roth IRA Income Limits
For 2022, Roth IRA contributions are not allowed for single filers with a modified adjusted gross income (MAGI) of $144,000 or more or married couples filing jointly whose MAGI exceeds $214,000.
Traditional IRAs, on the other hand, have no income limits for eligibility. However, contributions to a traditional IRA are not tax-deductible if the taxpayer (or their spouse) has a retirement plan at work and earns over a certain amount.
In other words, high earners can’t contribute directly to a Roth IRA, but they can to a traditional IRA—and that is where a backdoor Roth IRA comes into it.
There have been moves in Washington to eliminate the backdoor Roth IRA strategy. Most recently, the Build Back Better Act—passed by the House of Representatives but stalled in the Senate—would have curtailed its use. Similar legislation may eventually succeed.
How a Backdoor Roth IRA Works
A backdoor Roth IRA involves converting traditional IRA assets into Roth IRA assets. It’s a multistep process.
The first step is contributing to a traditional IRA.
The next step is converting that IRA into a Roth IRA. (There are no income limits on who is eligible to make a Roth conversion.)
You can complete the conversion using an existing Roth account, or you may open a new Roth IRA if you don’t have one. The easiest way to execute a conversion is via a trustee-to-trustee transfer. The financial institution holding your traditional IRA contributions transfers them directly to the institution that holds your Roth IRA. (It can also be the same financial institution, in what’s known as a same-trustee transfer.) The conversion is reported on IRS Form 8606 when you file your taxes for the year.
After the conversion is complete, the money in your Roth IRA becomes subject to Roth IRA distribution rules. The primary benefit to you is that any future earnings from investments in your account would not be subject to taxes when you (or your heirs) withdraw them.
In addition, Roth IRAs aren’t subject to required minimum distributions (RMDs). With a traditional IRA, you’d be required to begin taking distributions from your account at age 72 or face a hefty tax penalty. With a Roth, there are no RMDs during your lifetime.
One Catch: The Roth Conversion Tax Bite
While converting to a Roth can minimize your tax liability in retirement, you won’t be able to avoid taxes completely. Untaxed amounts in your traditional IRA are taxed at the time the conversion is completed, just as if you were withdrawing them. Both pretax contributions and investment gains may be subject to tax.
A conversion could add significantly to your tax bill in the year you make the conversion, especially if a large sum is involved. For that reason, you might want to spread the process over several years.
If all of your traditional IRAs were nondeductible IRAs, the conversion should be relatively simple. Because you didn’t receive a tax deduction on your contributions when you made them, only the earnings on the IRAs will be taxable.
However, if you have a mix of deductible and nondeductible IRAs, the math gets more complicated. You can’t simply convert the nondeductible portion into a Roth IRA. Instead, you must treat all of your IRAs as one collective IRA and convert a proportional share of the pretax and after-tax dollars in the account. So, for example, if the money in your IRAs is 60% pretax and 40% after-tax, a $100,000 conversion would be 60% taxable.
The IRS does offer a workaround, however. If your employer allows it, you may be able to roll the pretax part of your traditional IRA contributions into your 401(k), leaving only the nondeductible portion behind for the conversion. This is known as a reverse rollover.
When Does a Backdoor Roth Make Sense?
A backdoor Roth IRA may be appealing if you’ve been blocked from contributing to a Roth because of your income. However, it’s important to consider your retirement timeline. The further you are from retirement, the more a conversion may make sense. That’s because the tax-free growth in your Roth account will have more time to make up for the immediate tax hit you’ll take by converting.
Another consideration is whether you expect to be in a significantly higher tax bracket in the future than you are today—which might happen if, for example, tax rates overall rise significantly in the years ahead. That could argue for converting to a Roth and paying the taxes now so you won’t have to pay even higher ones in the future.
How Much Can You Contribute to a Roth IRA?
If you’re eligible for a Roth IRA, you can contribute up to $6,000 in 2022 if you’re under age 50 or $7,000 if you’re 50 or older. The same maximum applies to traditional IRAs and to your IRAs in total. In other words, if you have both a Roth IRA and a traditional IRA, your total contribution to the two accounts can’t exceed $6,000 or $7,000.
Are There Income Limits for Converting to a Roth IRA?
Not anymore. Prior to 2010, however, taxpayers with adjusted gross incomes over $100,000 were ineligible.
How Are Traditional IRA Distributions Taxed?
Distributions from a traditional IRA are taxed as ordinary income. That means you’ll pay a rate equal to the highest marginal tax bracket that your other income puts you into (such as 24%). If your distributions plus your other income exceed the maximum for that bracket, a portion of your distributions will be taxed at the rate of the next-highest bracket (such as 32%).
The Bottom Line
A backdoor Roth IRA can allow high-income taxpayers to enjoy the tax benefits of a Roth IRA. Though the conversion itself isn’t difficult, untangling the tax issues associated with the process can be. Consulting a knowledgeable tax advisor to weigh the pros and cons could be worth the cost.