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.
Here’s the thing, though: High earners can’t contribute to Roth IRAs. The government allows only those people with adjusted gross incomes below $194,000 (married filing jointly) or $132,000 (single) in the front door. (Check the Roth IRA contribution limits and the traditional IRA contribution limits.)
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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. NerdWallet has a quick calculator to show you how much of your traditional IRA contribution is deductible.
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.
» MORE: Roth IRA calculator
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.
Best providers for your Roth IRA
TD AMERITRADE: AMONG BEST OVERALL
TD Ameritrade is one of our picks for best overall IRA providers. The popular online broker has wide customer appeal for IRA account holders and beginner investors alike for several reasons: helpful customer service, a $0 minimum balance requirement and a large selection of commission-free exchange-traded funds (ETFs) and no-transaction-fee mutual funds. Advanced, active traders also gravitate to the company because of its two top-notch trading platforms — including widely renowned thinkorswim — and its research and data. The downside: The company’s trade commissions are on the high side at $9.99.
E-TRADE: NO ACCOUNT MINIMUM
E-trade is one of our picks for best providers with no account minimum for IRA accounts. One of the best-known online brokers, the company is loved by investors because of its user-friendly online experience on both its website and mobile app. E-Trade has a large selection of no-transaction-fee mutual funds and commission-free ETFs. Research and data are free, and E-Trade’s tiered commission structure means frequent traders can keep costs down.
WEALTHFRONT: GOOD FOR HANDS-OFF INVESTORS
Wealthfront, one of our top picks for hands-off IRA investors, was one of the first robo-advisors in the game. It remains one of the largest, and it regularly adds new features and tools for its investors. The company is a great option for IRA account holders who are looking for investment management, particularly beginners, because it waives its 0.25% account management fee on balances of $10,000 or less. Wealthfront has a $500 account minimum and invests its clients in a portfolio of ETFs with expense ratios that average a modest 0.12%.
BETTERMENT: NO MINIMUM, TIERED FEES
Betterment, our other top pick for hands-off investors, has carved out a place as the largest independent robo-advisor. It caters to the retirement market with innovative goal-based tools to help investors save more. The company requires no minimum investment and offers a tiered management fee that starts at 0.35% for balances under $10,000 (with auto-deposits of at least $100 a month). The fee drops to 0.25% on balances between $10,000 and $100,000; balances over $100,000 pay just 0.15%. Betterment’s portfolio of ETFs have expense ratios that range from 0.09% to 0.17%.
» MORE: See our full list of top Roth IRA providers
Tina Orem is a staff writer at NerdWallet, a personal finance website. Email: email@example.com.
This post was updated November 23, 2016.