What is a backdoor Roth IRA, and how do they work?

Summary 

What is a backdoor Roth IRA? 

A backdoor Roth IRA is a way for high-income earners to open (and reap the rewards of) a Roth IRA regardless of IRS-imposed limitations.  

If your income is over the Roth IRA eligibility limits, this is how you can still have a Roth IRA.  

Opening a backdoor Roth IRA is something many high-net-worth individuals do, and it’s legal and lawful. 

For context, the 2024 IRS-imposed income limitation for regular Roth IRAs is $161,000 for singles and $240,000 for joint-filing married couples.

If you earn more than that, you don’t qualify for a regular Roth IRA account – but you can open a backdoor version.  

Typically, high-income earners cannot open Roth IRAs because the interest rates are considered too high.  

But with a backdoor Roth IRA, you can open an account and let your money grow tax-free – all without technically qualifying for a traditional Roth IRA.  

How do I open a backdoor Roth IRA? 

Opening a backdoor Roth IRA is not a complicated process. 

Here are three steps anyone can follow to set one up regardless of their income bracket: 

1. Deposit money into a traditional IRA account 

Before you can create a backdoor Roth IRA account, you need a traditional Roth IRA account.

You can open a traditional IRA online or set one up with your bank or financial institution of choice and deposit your money into it.

The best company to open your account with will depend on your financial situation, preferences, and future goals.  

2. Convert the amount into a Roth IRA 

Once your traditional IRA account is set up, you can convert it to a Roth IRA.

The IRA provider you choose will provide all of the necessary paperwork for it.

If you're unsure aboutt his process or want expert help, consider hiring a financial advisor to take the responsibility off your hands. 

3. Prepare for taxes and convert to a backdoor Roth IRA 

The only kind of money that can go into Roth IRAs is post-tax dollars.

Once you have deducted your regular IRA contributions, you then need to give that tax deduction back. This is the action that will convert your Roth IRA into a backdoor Roth IRA.

When annual taxes need to be paid, be prepared to cover the income tax you have just converted into the backdoor Roth IRA account.

Playing by the rules of a backdoor Roth IRA is crucial.  

What are the rules of a backdoor Roth IRA? 

There are two main rules of a backdoor Roth IRA that every person hoping to open this type of account needs to know.  

They include: 

When the IRS determines your annual tax bill, it will consider all of your regular IRA accounts combined.  

The ratio between your pre-tax and after-tax income will determine how much of the money in your Roth account is taxable. This is called the pro-rata rule, and it is essential to apply it to your annual IRA tax balance.  

There are only a few types of transfers that are compatible with a backdoor Roth IRA: a rollover transfer, a trustee-to-trustee transfer, and a “same trustee” transfer.  

Your conversion needs to meet the requirements of one of these three transfers in order to be successful.  

What are the tax implications of a backdoor Roth IRA? 

Opening a backdoor Roth IRA may enable you to sidestep Roth IRA income limits, but it will also require you to pay income taxes on any money being rolled into the account that has not been previously taxed.  

If your account is going to be very active, you may end up with a high annual tax burden.  

Is it worth opening a backdoor Roth IRA? 

There are benefits and limitations that need to be considered before opening a backdoor Roth IRA.  

A qualified financial advisor can help you to understand if this is the right option for you.  

Opening this type of account is probably worth it if you are an investor who wants to contribute to a Roth IRA but earns too much within a typical tax year to do so.   

However, opening a Roth IRA using the backdoor method will probably not be worth it if your withdrawals will push you into an even higher tax bracket if you’re going to need the money you make from the account in less than five years, or if the only way you are able to pay taxes is via your IRA withdrawal.  

Get expert financial advice  

Opening a backdoor Roth IRA account is an effective way to continue growing your wealth as a high-income earner without needing to increase your tax burden.  

To get help with your Roth IRAs and financial management strategies, get matched with an expert financial advisor at Unbiased.