Many high-income earners believe that they can’t contribute to a Roth IRA because of income restrictions. If this sounds familiar, you’re not alone. However, there’s a little-known strategy that allows you to bypass these income limits and still get money into a Roth IRA: the backdoor Roth IRA.
In this post, I’ll walk you through everything you need to know about the backdoor Roth IRA, including the income and contribution limits, the step-by-step process, and how to avoid the pro rata rule.
Roth IRA Income and Contribution Limits
For 2024, individuals making under $146,000 (based on MAGI) are eligible to contribute directly to a Roth IRA. However, if you exceed this income threshold—$230,000 for married couples filing jointly—you’ll need to consider the backdoor Roth IRA.
The contribution limit for Roth IRAs in 2024 is $7,000, or $8,000 if you’re over 50. While this may not seem like a large amount, consistently contributing each year can lead to substantial tax savings down the road, especially when considering the tax-free growth Roth IRAs provide.
What is the Backdoor Roth IRA?
The backdoor Roth IRA isn’t a special account type—it’s simply a strategy. Here’s how it works:
- First, you contribute money to a traditional IRA. Importantly, this must be a non-deductible IRA, meaning you don’t get a tax deduction for the contribution.
- Next, you convert those funds to a Roth IRA. Since the traditional IRA contributions weren’t deducted from your taxable income, you don’t have to pay taxes on the conversion.
While this sounds simple, there are some important nuances to keep in mind, especially when it comes to managing your other IRA accounts.
Step-by-Step Guide to Executing a Backdoor Roth IRA
Here’s how to complete a backdoor Roth IRA:
- Open both a traditional IRA and a Roth IRA.
- Contribute funds to your traditional IRA.
- Convert the funds in your traditional IRA to your Roth IRA (just be sure you don’t deduct these contributions on your taxes).
- Invest the funds as you see fit within your Roth IRA.
- Report your backdoor Roth IRA contribution using IRS Form 8606.
When to Complete the Backdoor Roth IRA
You have until the tax filing deadline of the following year to complete the contribution for the previous year. For instance, to contribute for 2024, you have until April 15, 2025, to make the $7,000 contribution.
Avoiding the Pro Rata Rule
The pro rata rule is a crucial factor to consider when executing a backdoor Roth IRA. Here’s why:
If you have other pre-tax IRA balances—such as those in traditional IRAs, SEP IRAs, or SIMPLE IRAs—the IRS won’t let you selectively convert only your non-deductible (after-tax) contributions. Instead, the IRS applies the pro rata rule, meaning it looks at your entire IRA balance, including both pre-tax and after-tax funds.
Let’s consider an example to see how this works:
- You have $7,000 in a non-deductible IRA and decide to contribute $7,000 to a traditional IRA for the backdoor Roth IRA.
- However, you also have $7,000 in a traditional IRA that was funded with pre-tax dollars.
In this case, the IRS would treat your backdoor Roth IRA contribution as 50% taxable, because half of your IRA balance is pre-tax, and half is after-tax. The formula would look like this:
$7,000 (after-tax) / $14,000 (total IRA balance) = 50% taxable.
This means that half of your Roth IRA conversion would be subject to taxes, which can be avoided with proper planning.
How to Avoid the Pro Rata Rule
To sidestep the pro rata rule, the key is to remove any pre-tax IRA balances before making your backdoor Roth contribution. You can do this by rolling over pre-tax IRA funds into a 401(k), 403(b), or Solo 401(k) plan, which doesn’t trigger the pro rata rule.
This is why it’s critical to address any IRA balances before December 31st of the year you plan to do the Roth conversion. If you don’t, the IRS will include your pre-tax IRA balances in the calculation, potentially costing you more in taxes.
Conclusion
The backdoor Roth IRA is an incredibly powerful tool for high-income earners who want to take advantage of Roth IRA benefits despite income restrictions. By following the steps outlined here and avoiding the pro rata rule, you can significantly increase your retirement savings without worrying about taxes on future withdrawals.
Take the time to properly plan your Roth conversions, and consider consulting a professional if you’re unsure about how to navigate the process. By understanding the rules and strategically executing the backdoor Roth IRA, you can ensure a tax-free future for your retirement savings.
