The Backdoor Roth: Is It Right for You?

Roth IRAs can be a great way to save for retirement since they can provide tax-free growth and tax-free withdrawals. However, strict income caps on contributions restrict many higher-income earners from contributing to these accounts directly.

Some advisors suggest these limits can be avoided by taking a "backdoor" route, whereby an investor opens and funds a traditional IRA using after-tax dollars and soon after, converts (aka "rolls over") the funds to a Roth IRA. This end around can help get funds into a Roth, but be aware, the IRS hasn't officially stated that this strategy is permissible.

If you're considering a backdoor Roth conversion, it's highly recommended that you work with a tax advisor or wealth manager before you take any actions. Here's what to know.

With a Roth IRA, you get no up-front tax deduction, as you would with a traditional IRA, 401(k) retirement plan, or other tax-deferred account. Instead, you contribute after tax dollars to the account, earnings accumulate tax-free, and after age 59½ your withdrawals are also tax-free, so long as you've had the Roth for five years.

Another perk of a Roth account is that you'll never be required to take distributions—unlike with a traditional IRA or 401(k)—which could appeal to those wanting to leave the money to heirs.

The downside, however, is that Roth IRAs technically are available only to those whose modified adjusted gross income (MAGI) is below certain limits.

In 2024 those limits are: 

• $240,000 for married couples filing jointly
• $161,000 for single filers

To get around these limits, some investors opt to convert their way into a Roth account using a two-step process. It works like this:

1. Open a traditional IRA and make after-tax contributions to it. For 2024, you're allowed to contribute up to $7,000 ($8,000 if you're age 50 or older) per year. Make sure you file IRS Form 8606 every year you do this.
2. Rollover the assets from the traditional IRA to a Roth IRA. You can make this transfer (known as a Roth conversion) at any point in the future.

If the assets in the traditional IRA appreciate between the date you fund the account and the date you convert it, you will owe taxes on the appreciation (as the appreciation would have accrued on a tax-deferred basis). If this is your first and only IRA account, figuring out your tax obligation should be simple. The contribution was made with after-tax dollars, and so only the appreciation should be taxable.

However, if you have other IRA accounts with pre-tax contributions in them, the situation becomes a bit more complicated thanks to the "pro rata rule." In such cases, the IRS requires you to calculate the value of your after-tax IRA contributions relative to your total pre-tax IRA assets. Then, you use the resulting ratio to determine how much of your conversion is taxable. Spoiler alert: The more pre-tax assets you have, the larger the tax bite could be.

Here's an example: Say you make a $7,000 after-tax contribution to a traditional IRA,¹ but you also have another traditional IRA holding $93,000 in pre-tax contributions. So:

• After-tax contribution = $7,000
• Pre-tax contributions = $93,000
• Total IRA assets = $100,000
• $93,000 pre-tax contributions / $100,000 total = 0.93 (this is the portion of your conversion subject to tax)
• $7,000 conversion * 0.93 = $6,510

In other words, you would owe income tax on $6,510 of your $7,000 conversion—even though your original $7,000 nondeductible IRA contribution was made with after-tax dollars. Because of the pro rata rule, the IRS sees the conversion as a mix of pre- and after-tax dollars.

That may diminish the appeal somewhat, but once the account has been converted, earnings compound tax-free. Distributions from the Roth IRA are tax-free as well, so long as you are 59½ and have held the Roth for at least five years. If you're not 59½ or older, a 10% penalty may apply, and any distributed earnings from the conversion will be taxable as ordinary income.

Although this strategy has existed for many years, the IRS hasn't provided formal guidance on whether it violates the "step-transaction rule." (When applied, this rule treats a multi-step transaction as if it was a single transaction for tax purposes.) The lack of a definitive ruling means there is some risk involved. So, bottom line, if you use this backdoor Roth strategy solely to sidestep the earnings limits on Roth IRA contributions, you should be aware of the risks and seek the counsel and support of a tax professional.