What you need to know about backdoor Roth conversions 

Some high-income earners have the problem of not being able to contribute to their Roth accounts since their incomes exceed the threshold set by the IRS. Fortunately, there is a way to bypass this rule and still be able to make regular contributions to their Roth accounts.  

In wealth management and retirement planning, this is what’s known as the Backdoor Roth IRA. This is not an existing type of IRA account per se but is more of a financial strategy. If you have some high-earning clients, it’s worth knowing the intricacies of this financial maneuver. So, let’s get into it.  

The Backdoor Roth IRA sounds great, but what is it exactly?  

At first glance, the backdoor Roth IRA sounds like a type of investment retirement account, but it is not.  

It’s a financial strategy or technique used by high-income earners. Their main issue is that their incomes disqualify them from making contributions to their Roth IRA.  

The backdoor Roth IRA is essentially a loophole or “backdoor” that allows them to get around the income limits imposed by the IRS, then indirectly put money into their Roth IRA accounts.  

Is the backdoor Roth allowed in 2024? 

Yes, even though the Build Back Better Act in 2004 was drawn up to end backdoor Roth IRAs by 2020, this financial strategy remains in place for now. It is unknown, however, whether any future legislation will remove the backdoor Roth.  

Is the backdoor Roth an illegal move? 

No, the backdoor Roth is not considered illegal. The IRS does not classify the backdoor Roth as a form of tax evasion but could best be described as a form of tax avoidance.  

If you have any misgivings about this financial maneuver in a specific situation, you can consult a more experienced tax professional.  

How much can you convert to a backdoor Roth? 

The maximum IRA contribution limit for 2024 is $7,000 for most account holders and $8,000 for those aged 50 or older. Should your client wish to open an IRA then use the backdoor IRA to convert it to a Roth, then those are the maximum amounts that can be contributed.  

IRA contributions can be made on or before the tax deadline. If a contribution is made after New Year’s Day, that’s effectively making two contributions at once.  

What are the Roth IRA income limits for 2024? 

o give you an idea of how much money your client may need to place in a backdoor Roth IRA, here are the income limits set by the IRS in 2024:  

When it comes to married couples filing separately, the income limits can differ significantly depending on whether they lived together or not at any time during the tax year. Note also that:  

• Married couples filing separately who did not live together may contribute their full Roth IRA amount if their combined MAGI (Modified Adjusted Gross Income) is less than $146,000 for 2024. This often applies to couples who are in the process of divorcing but are still legally married as of tax time. 
• If the married couple files separately and still lived together at any time during the year, their income limit is less than $10,000. This means they cannot contribute anything if their income was $10,000 or more. 

Do you pay taxes on a backdoor Roth conversion? 

The easy answer is no, if executed in the correct way. In most cases, taxes are only paid once on a backdoor Roth. However, there can be taxes owed when the conversion from a traditional IRA to a Roth IRA is done according to the Pro-Rata rule. As for the withdrawals, there are no taxes to be paid if the 5-year rule and other requirements are satisfied.  

What is the Pro-Rata rule on Roth conversions? 

The Pro-Rata Rule applies when a traditional IRA contains a mix of pre-tax and after-tax contributions. This rule is used to determine the ratio of pre-tax and after-tax contributions contained in the conversion. Since a Backdoor Roth conversion involves withdrawing traditional IRA funds and transferring them to a Roth IRA, the Pro-Rata rule is used in this case. 

The taxpayer cannot choose only the after-tax amount when doing a Roth conversion. But if they didn’t contribute any after-tax money into a traditional IRA, then the total amount converted is taxed at the usual rate and the Pro-Rata rule doesn’t apply. This is to prevent taxpayers from bypassing the Roth IRA income limit to use the funds and reduce their tax bill.  

Sample calculation applying the Pro-Rata rule 

If the Roth conversion consists of both pre- and after-tax contributions, the taxable and non-taxable amounts must be computed. To determine the taxable amount, the following equations are applied:  

1. (Non-deductible amount) / (Total of all non-Roth IRA accounts) = non-taxable percentage 

2. (Amount for Roth IRA conversion) x (non-taxable percentage) = amount of after-tax money converted to Roth IRA 

For example, Mark has made after-tax contributions of $7,000. The total amount in his traditional IRA account is $90,000. As a result, 7.78% of his contributions are not subject to tax. 

(Non-deductible amount of $7,000) / (Total of all non-Roth IRA accounts $90,000) = non-taxable percentage of 7.78% 

Let’s assume Mark wants to convert $50,000 into a Roth IRA, then 7.78% of that amount is not taxable, or $3,890. (Amount for Roth IRA conversion, $50,000) x (non-taxable percentage of 7.78%) = $3890 

The rest of the money to be converted, $46,110, is therefore the taxable amount.  

What is Form 8606? 

This is the form that taxpayers must use when making non-deductible contributions to a Traditional IRA or when converting a Traditional IRA to a Roth IRA. Form 8606 is the document used to inform the IRS that a conversion took place, and what portion of this conversion consists of tax-free money. The form also indicates which amount of the conversion is taxable. 

How do the 5-year rules apply to a Roth conversion? 

There are actually two 5-year rules that apply to Roth conversions:  

• The first 5-year rule states that even if the account owner is over 59½, their withdrawals from the Roth IRA earnings are subject to taxes and penalties. The first contribution must have been made at least 5 years ago. Typically, the account owner should be able to make withdrawals at any time without paying penalties or taxes.  
• The second 5-year rule states that since a backdoor Roth IRA is a conversion and not a contribution from a traditional IRA, then none of the funds can be accessed without penalty. A five-year period must elapse after the conversion for withdrawals to be free of penalties.   

This simply means that if you use a backdoor Roth IRA, be prepared to let its funds sit for five years or pay a penalty for an “early” withdrawal.  

Read more: Roth IRA guidelines on early withdrawals 

Should the account owner do a Roth conversion every year, then to avoid penalties they must wait for at least 5 years prior to withdrawing from each converted amount.  

The only exception to these rules is if the account owner dies or becomes disabled, then their withdrawals are free of penalties.  

Read more about the guidelines for Roth IRA conversions here.

How to do a backdoor Roth IRA Conversion 

Doing the Backdoor Roth IRA is generally a simple process, and done via these steps:  

Step 1. Contribute the money you want to convert into a Traditional IRA account. 

Step 2. Convert that Traditional IRA account into a Roth IRA account. This usually requires filling in Form 8606. The form is usually provided and processed by most brokerages.  

Step 3. Pay the appropriate taxes on the conversion. The taxes should be paid within the tax deadline for the year you convert to a Roth, but it’s best to pay the taxes to the IRS right away to be safe.  

Should your client consider a backdoor Roth IRA? 

Having your client consider this financial strategy will depend on their circumstances, such as their financial goals and budget. Consider the implications of implementing a Roth conversion for your client before proceeding.  

Who would benefit from a Backdoor Roth IRA? 

• High earners whose income has exceeded the limits, thereby disqualifying them from contributing under current Roth IRA rules. 
• Those who can afford to pay the additional taxes from a Roth conversion and want to take advantage of future tax-free growth. Although it should be noted that paying for the conversion from another source of funds may not make much difference.  
• Those with no other Roth accounts or assets.  
• Retirees who wish to avoid taking the required minimum distributions (RMDs). 
• High earners who don’t plan to use their Roth IRA to fund their retirement but rather, continue to contribute to their Roth IRA, let it grow tax-free, then leave it as an inheritance.   

Who may not benefit from a backdoor Roth IRA? 

• Taxpayers whose annual income is within the threshold for making regular Roth IRA contributions. 
• Investors who will need to use Roth IRA funds within the next 5 years. Note that the five-year rule applies to Roth conversions as well.  
• Investors who are under the age of 59½ who need to access converted funds during the first five years. 
• Those with other traditional IRAs that, under the aggregate and pro-rata rules, could complicate matters such that the tax consequences of a Roth conversion would undermine their benefits. 

A simple question that could be answered by this video is, “are Backdoor Roths for everyone?” As with most financial questions, it depends on certain factors. Watch the video to know more about which types of investors would reap the most benefits: 

The Backdoor Roth IRA is a financial strategy that may not be around forever. But while it’s still around, advisers and investors have no reason not to use it and leverage its benefits. They and their heirs still stand to benefit from certain tax breaks. After all, it’s a legal loophole in the tax laws that many high-income earners have used in the past to reduce their tax obligations and allow their assets to grow tax-free.  

Remember that while there are some clients who will benefit from a backdoor Roth IRA conversion, not all clients are the same. Always assess the needs, financial goals, and other important factors before recommending this financial strategy to clients.  

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