You may think a high income will shut you out of Roth IRA eligibility, but there’s another way in: a backdoor Roth IRA. And it can save you thousands of dollars in taxes.
Roth IRAs are retirement accounts that allow you to sock away money you’ve already paid taxes on. One of their big selling points is that you get to withdraw that money — and any investment gains — tax-free when you retire. So if you’re in, say, the 15% tax bracket now but expect to be in the 28% tax bracket when you retire, a Roth IRA can save you a ton of money later in life.
“High earners can't contribute to Roth IRAs. But they can convert a traditional IRA into a Roth.”
Here’s the thing, though: High earners can’t contribute to Roth IRAs. For 2017, the government allows only those people with adjusted gross incomes below $196,000 (married filing jointly) or $133,000 (single) in the front door. (Use our calculator to find out your Roth IRA contribution limit.)
The rules are different for traditional IRAs: Anybody can contribute, regardless of income. If you’re also covered by an employer retirement plan, however, your ability to deduct your contribution begins to phase out at a certain income level. (You can view a chart of those phase-out ranges in our post about IRA contribution limits).
So why not just put the money in a traditional IRA and leave it at that? One word: taxes. Remember, withdrawals from a Roth IRA in retirement are tax-free. If you were shut out of a Roth IRA and still want your tax break in retirement, a backdoor Roth gives you that chance.
What is a backdoor Roth IRA?
A backdoor Roth IRA boils down to some fancy administrative work: You put money in a traditional IRA, convert the account into a Roth IRA, pay some taxes and, lo and behold, you’ve got tax-free income in retirement. Even though you didn’t qualify for a Roth IRA to start, you get to sneak in the back door anyway.
It all works because, in 2010, the federal government removed the income limits for IRA conversions, creating a Roth IRA loophole. Of course, you’ll need to get the mechanics right. Here’s a step-by-step guide on how to make a backdoor Roth IRA conversion.
Put money in a traditional IRA account. You might already have an account, or you might need to open one and fund it. If you’re opening an account specifically to do a backdoor IRA, you can fund your account with post-tax dollars and not have to worry about paying taxes on that money, and what it earns, in retirement. (See our picks for the best traditional IRA providers.)
Convert the account to a Roth IRA. Your IRA administrator will give you the instructions and paperwork. If you already have a Roth IRA with the IRA administrator, your “converted” balance will probably go right into your existing Roth IRA. If you don’t already have a Roth IRA, you’ll open a new account during the conversion process. (See our list of the best Roth IRA accounts.)
Pay taxes on the contributions to your traditional IRA. Remember, only post-tax dollars get to go into Roth IRAs. So if you deducted your traditional IRA contributions and then decide to convert your traditional IRA to a backdoor Roth, you’ll need to give that tax deduction back. In other words, you’ll need to pay taxes on the money you contributed, just like everyone else who invests in a Roth IRA.
Pay taxes on the gains in your traditional IRA. If the money in that traditional IRA has been sitting there awhile and there are investment gains, you’ll need to pay taxes on the gains as well when you convert to a Roth IRA. You will report this on your federal income tax return.
One side note: If you have a traditional IRA and you’ve been able to deduct the contributions, you may be tempted to throw in some extra cash over and above the amount you’re allowed to deduct. The strategy here is to then convert just that extra, nondeductible portion into the Roth IRA. Think again. The IRS requires rollovers from traditional IRAs to Roth IRAs to be done pro rata. That means if you convert, say, 20% to a Roth IRA, the IRS requires you to convert 20% of the contributions that were deductible and 20% of the contributions that weren’t. You can’t cherry-pick.
This post was updated March 23, 2017.