Over the Roth IRA Income Limit? Considering a "Backdoor" Roth IRA?

The Roth IRA is a popular individual retirement account (IRA), especially for investors who expect to be subject to higher taxes down the road. Simply put, investors may be able to make contributions from after-tax money into a Roth IRA, and then they don’t pay taxes from qualified distributions when they withdraw funds from their Roth during retirement—including on investment earnings. Given the benefit of having tax-free income in retirement, it’s no surprise that many retirement income plans highly suggest having Roth assets.

But the Roth IRA may not be for everyone. For one thing, there are income limits on who can contribute new money. If your income prevents you from contributing to a Roth IRA, but you’re interested in accessing potentially tax-free earnings in retirement, there is a possible approach: the “backdoor” Roth IRA contribution. 

How does it work? Basically, you put new IRA contributions (limited to $6,500 for 2023) into your traditional IRA first, then convert the funds into a Roth IRA. A Roth IRA currently allows this even if your income is too high to put the contributions directly into the Roth IRA. Thus, the backdoor Roth IRA makes it possible for investors to tweak the rules a bit. If you have a traditional IRA, you can convert funds into a Roth IRA, whatever your income level.

But before you decide on a backdoor Roth IRA contribution, it’s important to understand the implications (and also make sure you aren’t eligible to simply make a regular contribution to a Roth IRA). Additionally, currently proposed tax laws may eventually take away the ability to do a backdoor Roth IRA contribution. 

Not everyone is going to benefit from a backdoor Roth IRA. Before you move forward, make sure you understand the tax consequences and know what you’re getting into. The rules of a backdoor Roth IRA contribution are often oversimplified. 

Roth IRA Income Limits

First off, double-check in case you’re actually eligible to invest new money into a Roth IRA. Don’t assume that your income level is too high this year just because it was too high in a previous year. Use your modified adjusted gross income (MAGI) and compare that to the IRS thresholds, not your salary. The Internal Revenue Service (IRS) outlines how to determine MAGI. The thresholds are adjusted each year, so it’s possible you could make a partial Roth IRA contribution directly—without having to do a backdoor Roth IRA conversion.

If your income is above the threshold set by the IRS, you can’t make new contributions to a Roth IRA, but you can still make new traditional IRA contributions. That said, the traditional IRA contribution may or may not be tax deductible. If it’s not tax deductible anyway, many investors prefer to convert it to a Roth IRA because the earnings in a Roth IRA can be withdrawn tax-free. This is where the “backdoor,” or conversion, comes in: The Roth income thresholds don’t currently apply to “converting” an existing IRA contribution into a Roth IRA. 

Exploring the Backdoor Roth IRA

There are two main ways to potentially take advantage of a Roth IRA even if your income is above the IRS threshold:

1. Contribute new money to a traditional IRA, then convert that money to a Roth IRA in the same year. (This is the backdoor Roth IRA contribution.)
2. Take money already accumulated in a traditional IRA and roll it into a Roth IRA. (This is a typical Roth conversion.)

With the first method, you can get around the income limits to Roth IRA contributions. But the second method can also help you make a bigger contribution to a Roth IRA than the $6,500 allowed in 2023, because you can convert any amount from a traditional IRA into a Roth IRA.

It’s not as simple as just taking money from a traditional IRA and moving it into a Roth IRA, though. Because of the different tax treatments between traditional IRA and Roth IRA accounts, you could find yourself with a hefty surprise tax bill. 

Tax Treatment of the Backdoor Roth IRA

Before you just convert the money in your traditional IRA into a Roth IRA, ask yourself the following questions. How you answer them will help determine the tax bill related to your backdoor Roth IRA.

1. Did you get a tax break on your traditional IRA contributions?

If you got a tax deduction for making your traditional IRA contributions, you’ll need to pay taxes on the amount you convert over to the Roth IRA. If your traditional IRA assets originally came from a workplace plan, like a 401(k) or SEP-IRA, you have not been taxed on some or all of that money yet, so converting that to a Roth IRA will also require you to pay taxes.

So, if you have $200,000 in a traditional IRA, and you convert it to a Roth, you’ll have to pay taxes on the entire amount as if it’s income in the year you convert.

But suppose you decide to convert just your IRA contributions from this year—the typical goal of the backdoor Roth IRA contribution. So, you contribute $6,500 to your traditional IRA, then convert that contribution (plus any earnings) to your Roth IRA. You’ll have to pay taxes on the original contribution, plus the gains associated with it. This works well if you only have one traditional IRA with no other contributions other than the ones you plan to “backdoor” into the Roth IRA. But watch out if you have multiple IRAs or do not plan to convert all your traditional IRA assets (see #3 below).

2. Have you made nondeductible traditional IRA contributions?

Not every contribution you make to a traditional IRA is tax deductible.

For instance, if you or your spouse participate in a workplace plan like a 401(k), then your income needs to be below a certain amount to get the full $6,500 deduction for 2023 in your traditional IRA. Any income level can contribute, of course. Many people try to use the backdoor Roth to remove these nondeductible contributions and just convert those to the Roth IRA because nondeductible contributions are essentially after-tax contributions—just like Roth IRA contributions. That sounds great, but it’s not that simple.   

Even if all you have in your traditional IRA is a $6,500 nondeductible contribution, you would still have earnings on that $6,500 that would be taxable. IRS regulations require that any conversion include both earnings and the nondeductible contributions. This means that almost any Roth IRA conversion is going to be partially taxable. As you can see, it starts getting complicated, because you have to consider which money has been taxed and which hasn’t.

For example, let’s say you made a $6,000 nondeductible traditional IRA contribution. You have no other IRAs, and you want to convert this nondeductible contribution to your Roth IRA now. Suppose that during the time your nondeductible contribution was invested in the IRA, you earned $3,000 on it.

If you tried to convert just the $6,000 to a Roth IRA, so that none of your conversion would be taxable, you’d find that part of the $6,000 is still taxable. Basically, the IRS formula requires that your nondeductible contributions be used in proportion to your total IRA balance. If your taxable earnings are 33% of your account, then 33% of your conversion would be taxable—no matter what amount you convert. This often comes as a surprise to those who have nondeductible traditional IRA contributions and try the backdoor Roth contribution. In our example, you made a $6,000 non-deductible traditional IRA contribution and are only “backdoor” converting that $6,000 to your Roth IRA. But because you earned $3,000 on the $6,000 (33% of your IRA is earnings) that means that 33% of your $6,000 conversion to the Roth IRA would be reportable as income and taxed. Even though you tried to leave the $3,000 in earnings behind in the traditional IRA, that is not allowable.

3. Do you have money in multiple IRAs?

For some retirement investors, the situation is even more complicated. Maybe you have SEP or SIMPLE IRAs in addition to your traditional IRA. Or maybe you even have multiple traditional IRAs or rollover IRAs from old employer plans like 401(k)s.  Maybe you want to keep your money in those other accounts and convert only a portion using the backdoor Roth IRA strategy.

This is where you really have to think about the situation, because you owe taxes based on your total IRA balances. You can’t just focus on the IRA that you’re using for the backdoor Roth. Similar to the situation outlined in #2, you have to consider ALL your traditional IRAs to determine how much of your conversion (whether a “backdoor” or normal conversion) is taxable.

Let’s look at an example. Say you contribute $5,000 to a traditional IRA and decide to convert it. But you also have $300,000 in a SEP-IRA on top of the remaining $100,000 in your traditional IRA after making the contribution. Your entire $400,000 would be considered one big pot. Let’s say $50,000 of that (which includes your current contribution) consists of after-tax/nondeductible contributions as described above. According to the pro rata rule, 12.5% of your total portfolio is nondeductible, so only 12.5% ($625) of your current contribution and conversion amount isn’t subject to tax. The remaining $4,375 is taxable.

Having multiple IRAs can change the equation, so it’s important to talk to a professional before you decide to move forward with a backdoor Roth IRA. And get all your records in order, so you reduce surprises. And remember, if you do have nondeductible contributions in your traditional IRA, you need to keep track of them on IRS Form 8606—otherwise you may eventually be taxed on money you already paid tax on.

Is a Backdoor Roth IRA Contribution for You?

Before you decide if a backdoor Roth IRA contribution is the right move, carefully consider your reasons for making the conversion. Once done, it can’t be undone.

If you expect to owe a little less in taxes for the year, and you can handle the tax bill for a Roth conversion now, it can certainly make sense. You pay taxes now, but later on, if taxes go up or if you’re in a higher bracket, you currently wouldn’t have to pay taxes on your Roth withdrawals. And you won’t have to take any required minimum distributions (RMDs) from your Roth IRA once you reach age 72. Avoiding RMDs during your lifetime may allow you to leave more assets to your heirs, because they won’t be taxed on the Roth IRA assets that they inherit either (although heirs of Roth IRAs do have RMDs).

However, in some cases, it might not make sense to go through with a backdoor Roth IRA contribution.

If you want Roth benefits, there are other alternatives. You might be able to contribute to your workplace 401(k) if it allows Roth contributions or contribute to an individual/solo 401(k) with Roth contributions if you own your own business—even as a freelancer or side gig. There are no income limits on Roth 401(k) eligibility, and the contribution limits are much higher than what you see with IRAs: $22,500 versus $6,500 for 2023. Also, be aware that currently proposed tax laws may take away the ability to do a backdoor Roth IRA contribution. Make sure to review the rules before you take action.

In the end, it’s important to understand the implications and run the numbers to see what will work best in your situation. The backdoor Roth IRA contribution can be a great strategy for some retirement investors, but it’s not for everyone.

TD Ameritrade does not provide tax advice. We suggest you consult with a tax-planning professional with regard to your personal circumstances.