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Planning for retirement

Backdoor Roth IRA What it is and how to set it up

If you are a high-income earner, a Backdoor Roth IRA may be a good retirement investment option for you. Learn what it is and how to set up this type of retirement plan.
6 minute read
  •  
March 01, 2023
Planning for retirement
Roth IRAs
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Taxes

"Backdoor Roth IRA" is simply a term to describe a strategy used by high-income earners who can't contribute to a Roth IRA because their income is above certain limits. Rather than contribute directly to a Roth, you contribute to a traditional IRA, and then convert it to a Roth.

A Roth IRA is a popular retirement savings account to which you contribute after-tax dollars, and if you meet certain requirements, you can withdraw both the invested money (principal) and earnings accrued on the money tax-free in the future. You might be a good candidate if you think you'll be in a higher tax bracket when you retire. The benefit of a Roth IRA is that it offers tax-free growth. 

Backdoor Roth IRA income limits

If your modified adjusted gross income (MAGI) is above certain income limits, then the amount you can contribute to a Roth IRA is phased out. The phaseout occurs between $146,000 and $161,000 for single filers and $230,000 and $240,000 for joint filers in 2024. The backdoor method allows those with higher incomes who can't contribute in the typical manner to still take advantage of a Roth IRA.

How to set up a backdoor Roth IRA

There are 2 ways to set up a backdoor Roth IRA:

1. Contribute money to an IRA, and then roll over the money to a Roth IRA. For this strategy to work, you should contribute to a traditional IRA with no balance. If there's a balance in the IRA, there could be a taxable event when you convert. Once you contribute to the account and wait for any required holding period, you'll then convert the account to a Roth IRA. Any money earned due to market performance before the conversion takes place is subject to taxes. The contribution is considered nondeductible once you fill out IRS Form 8606 and complete your tax return. Note that there's no tax benefit for the year you establish a backdoor Roth IRA.

2. If your 401(k) plan allows, you may be able to do a mega backdoor Roth conversion. Some 401(k) plans permit automatic Roth conversions, which means you can make after-tax contributions and have them automatically convert to Roth within their accounts. Check with your plan to see if this option is available to you. 

When should you not consider this strategy?

A backdoor Roth IRA doesn’t make sense for everyone. If you're able to make a Roth IRA contribution the standard way, then you don't need to use the backdoor method.

If you have a balance in a rollover IRA and plan to contribute to that account, you may not want to make a backdoor Roth conversion because of the "pro rata" rule. This rule requires all IRA distributions to be taken proportionally from your pre-tax and after-tax contribution sources. This could limit the tax benefits you'd receive from a Roth conversion. For example, if you have a total of $1 million in IRA assets, and $100,000—or 10%—is after-tax money, then 10% of any withdrawal must be taken from after-tax money. For a $10,000 withdrawal, $1,000 would have to be after-tax money.

It's important to keep in mind when you plan to use the money. If you're looking to withdraw the money within 5 years, you may not receive all the Roth tax benefits.* Also, when creating a backdoor Roth IRA, you'll have to work with an accountant to file tax forms to ensure you complete it accurately.

FAQs

The difference is the way you make your contribution. High-income earners use the backdoor technique to establish a Roth IRA since they're unable to contribute in the standard way because of the Roth IRA income limits.

If you contribute money to an investment that accrues earnings before you complete the conversion, then you'll have to pay taxes on those earnings. Once the money is in a Roth IRA, your withdrawals will be tax-free if you meet certain requirements. If you're subject to the pro rata rule, your IRA distributions must be taken proportionally from your pre-tax and after-tax contribution sources.

You should consult with an advisor or tax professional to discuss your personal situation. It's best to sit down with an advisor who can help you determine if a backdoor Roth IRA would be beneficial to your situation.

You can contribute up to $7,000 ($8,000 if age 50 and older) to a Roth IRA in 2024, if your income is below the phaseout amounts.

If your income is above the phaseout amount and you don't want to complete a backdoor Roth conversion, then your alternative is to invest in taxable accounts. They won't offer the same tax benefits but will give you an opportunity to diversity your investments. 

Questions? If you have additional questions about setting up a Roth IRA, call us at 888-476-1936.

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*The 5-year holding period for Roth IRAs starts on the earlier of: (1) the date you first contributed directly to the IRA, (2) the date you rolled over a Roth 401(k) or Roth 403(b) to the Roth IRA, or (3) the date you converted a traditional IRA to the Roth IRA. If you're under age 59½ and you have one Roth IRA that holds proceeds from multiple conversions, you're required to keep track of the 5-year holding period for each conversion separately.

Withdrawals from a Roth IRA are tax free if you are over age 59½ and have met the 5-yar holding period requirement; withdrawals taken prior to age 59½ or 5 years may be subject to ordinary income tax or a 10% federal penalty tax, or both. (A separate 5-year period applies for each conversion and begins on the first day of the year in which the conversion contribution is made).

Neither Vanguard nor its financial advisors provide tax and/or legal advice. This information is general and educational in nature and should not be considered tax and/or legal advice. Any tax-related information discussed herein is based on tax laws, regulations, judicial opinions and other guidance that are complex and subject to change.  Additional tax rules not discussed herein may also be applicable to your situation. Vanguard makes no warranties with regard to such information, or the results obtained by its use, and disclaims any liability for positions taken in reliance on, such information. We recommend you consult a tax and/or legal adviser about your individual situation.

The IRS has not officially commented or provided formal guidance on the “Backdoor Roth IRA” strategy. If the IRS decides that the loophole is a violation, you could owe a 6% excise tax for overfunding your Roth. And if restrictions do come into play at some point, they could require backdoor Roth converters to pay a penalty, or they might include a grandfather clause. 

All investing is subject to risk, including the possible loss of the money you invest. Diversification does not ensure a profit or protect against a loss.