Earning a high income is certainly an effective way to provide more ammunition to fund your retirement nest egg. You have more financial resources at your disposal, obviously, making it easier to build your retirement nest egg.
Another benefit? A high income also forgives a lot of financial mistakes. It provides a cushion to absorb financial losses (such as those from poor investment decisions or unexpected expenses), and it allows you to rapidly build savings without needing to rely on unrealistic investment returns to reach your financial goals.
But a high income doesn’t guarantee financial security, nor are its advantages limitless.
One key area where high earners often face limitations is contributing to Roth retirement accounts. Roth accounts offer the potential for tax-free growth and withdrawals in retirement, but frustratingly, many high-income individuals can’t directly contribute to Roth accounts because of income caps.
That said, Roth accounts aren’t necessarily out of your reach. One potential solution is a backdoor Roth conversion. This strategy involves contributing to a traditional retirement account, then converting the funds to a Roth account. While there may be some tax implications, it’s a way for high-income earners to take advantage of a Roth account’s benefits as they save for retirement.
Keep reading to learn what a backdoor Roth conversion is, including how it works, its tax consequences (and benefits), the advantages and disadvantages of using one, and how to set one up.
Disclaimer: This article does not constitute personalized tax advice. This information appears for your education only. Act at your own discretion, and consider talking to a financial and/or tax professional about these and other tax strategies.
What Is a Roth Conversion?
A Roth conversion is the act of moving assets from tax-deferred retirement accounts like a traditional IRA, 401(k), 403(b), or 457(b) into a Roth account—typically a Roth IRA, but in rare cases, a Roth 401(k) or other Roth account.
Converting to a Roth account results in tax consequences in the year of conversion. This can never be undone, but the remaining funds can generally both grow and be withdrawn tax-free going forward.
What Is a Backdoor Roth IRA Conversion?
A backdoor Roth IRA conversion is a tax-aware way of simultaneously contributing nondeductible contributions to a traditional IRA and then completing a Roth conversion shortly thereafter. (This differs from a traditional Roth conversion, in which you transfer deductible contributions from a traditional retirement account to a Roth account.)
When done correctly, a backdoor Roth conversion can change your nondeductible traditional IRA contributions to Roth IRA funds that enjoy the same tax- and required minimum distribution (RMD)-free treatment as any other Roth account. Most importantly: You avoid the income limitations on making Roth IRA contributions while finding an additional way to save more tax-advantaged funds for retirement.
Just be warned: This strategy isn’t without risks or drawbacks.
While a backdoor Roth IRA conversion might seem simple, the process can get complicated. Among other things, you’ll need to figure out the taxes you might owe on the conversion, and you’ll have to understand when your funds have been fully collected and settled by the financial custodian.
Does a Backdoor Roth Conversion Have Tax Consequences?
Indeed, there are several tax consequences when you execute a backdoor Roth conversion. Three major considerations:
1. Pro Rata Rule
When you have both pre- and after-tax money in a traditional IRA, you’ll need to be aware of something called the pro rata rule. When you commingle these funds and wish to convert the after-tax funds to a Roth IRA, a portion of the pre-tax funds get converted as well. This creates a tax liability many might not expect and complicates the tax consequences of a contribute-then-convert strategy (like a backdoor Roth conversion).
Let’s look at an example of how the pro rata rule works in practice—and how it makes a backdoor Roth conversion more complex than it might otherwise seem.
You have an existing traditional IRA with $100,000 in pre-tax funds. You decide to contribute $7,000 in nondeductible funds to that traditional IRA, with the intention of eventually converting those funds to a Roth IRA. When you convert, you don’t pay taxes for a second time on the $7,000 nondeductible contribution—but, per the pro rata rule, you do pay taxes on a portion of the pre-tax funds you already have in the account.
In this example, to determine your tax liability, you would have to factor in both your IRA’s nondeductible funds ($7,000) and the existing traditional IRA’s funds ($100,000), which combine for a total value of $107,000 ($100,000 + $7,000).
Accordingly, when you convert the $7,000 of nondeductible funds in your traditional IRA …
- $457.94 is non-taxable ($7,000 / $107,000 * $7,000).
- The remaining $6,542.06 balance is subject to income tax.
In effect, you pay a proportional amount of taxes on the existing traditional IRA’s pre-tax contributions and earnings.
Related: How Much Should I Contribute to My 401(k)?
2. IRA Aggregation Rule: Internal Revenue Code 408(d)(2)
The pro-rata rule doesn’t just apply if you hold both pre-tax and after-tax funds in the same traditional IRA. If you have more than one traditional IRA, Internal Revenue Code 408(d)(2) (or “the IRA Aggregation Rule”) applies.
The IRA Aggregation Rule stipulates that when you engage in a backdoor Roth conversion, you must calculate the income tax consequences by aggregating all of your IRAs, subjecting your pre-tax IRA funds held in other traditional IRAs to tax consequences.
Here’s an example of how the IRA Aggregation Rule works using similar numbers as the above example.
Say you contribute $7,000 of nondeductible funds to a new traditional IRA you’ve opened with the intention of converting it to a Roth IRA. You also have an existing traditional IRA with $100,000 in assets.
When you attempt to convert your newly created traditional IRA with the $7,000 in nondeductible funds, you can’t simply convert at a tax basis of $7,000 because the IRA Aggregation Rule applies. Instead, you have to factor in both your new IRA’s nondeductible funds ($7,000) and the existing traditional IRA’s funds ($100,000), which combine for a total value of $107,000 ($100,000 + $7,000).
Accordingly, when you convert the $7,000 of nondeductible funds in the new traditional IRA …
- $457.94 is non-taxable ($7,000 / $107,000 * $7,000).
- The remaining $6,542.06 balance is subject to income tax.
Much like only having one traditional IRA involved in the conversion, the IRA Aggregation Rule ensures your pre-tax funds also fall subject to the Pro Rata Rule.
As a note: If you choose to “roll-in” an IRA into a 401(k), you can generally remove your existing IRA from the total value of your aggregated IRAs used in the conversion calculation.
Related: How Much to Save for Retirement by Age Group [Get on Track]
3. Prorated Interest
When you add money to an investment account—be it a taxable brokerage account or a tax-advantaged account like an IRA or HSA—a common financial institution default is to place any uninvested funds into a high-yield savings account or money market mutual fund so that idle cash earns interest. This interest is paid monthly but earned daily, meaning you might earn a prorated amount of interest on your contributed funds before you engage in the conversion.
This prorated interest is considered pre-tax money when inside a traditional IRA, even if your contributions are nondeductible. Therefore, you’ll need to account for this when filing your taxes.
The same goes for any earnings (capital gains, dividends, or interest income) on investments made inside the IRA.
Related: IRA vs. 401(k): How These Retirement Accounts Differ
Advantages of a Backdoor Roth Conversion
Among the perks of pulling off a backdoor Roth conversion:
Allows High-Earners to Save for Retirement in a Roth Account
Perhaps the greatest advantage of a backdoor Roth conversion is the ability for high-income individuals to contribute (indirectly) to a Roth IRA. While designated Roth 401(k) plans don’t have income limitations, earning too much can bar direct contributions to a Roth IRA. However, by making nondeductible traditional IRA contributions that you subsequently convert to Roth funds, you can still contribute money to a Roth IRA.
Locks in Lower Tax Rates Before They Increase in Retirement
While you probably imagine your peak earning (and thus tax-paying) years will happen before entering retirement, that isn’t always the case. In fact, if you have contributed a significant amount of money to your tax-deferred retirement accounts, expect a healthy Social Security benefit, and possibly even have substantial retirement income sources, your tax rates might go up in retirement. If that’s the case, you might consider a Roth conversion to lock in lower tax rates during your working years.
Avoids RMDs and Maximizes Your Estate for Your Heirs
By contributing money to a Roth account, you’re free from having to withdraw that money when you don’t need it. That’s because Roth IRAs (and Roth 401(k) plans starting in 2024) don’t have RMDs—you can leave your money invested and never worry about planning ahead for minimum distributions and their impact on your taxes.
Not only does this give you more freedom to manage your assets as you wish, but you can also leave these funds to your heirs without them (or you) worrying about the tax consequences. Unlike inherited IRAs with accelerated RMD schedules and taxes paid on all withdrawals, inherited Roth IRAs don’t require beneficiaries to pay taxes on withdrawn contributions, and generally don’t require taxes to be paid on earnings unless the inherited Roth account is less than five years old at the time of the withdrawal.
Diversifies Your Accounts by Tax Treatment
A further benefit of converting traditional IRA funds to Roth IRA funds comes from the optionality of where you pull funds from during retirement.
One tax-savvy retirement withdrawal strategy calls for structuring your account drawdowns around the order that lets your most advantaged accounts grow untouched longest. That means withdrawing money in order of tax impact—first from taxable accounts, then from tax-deferred, then lastly from tax-free accounts. By delaying your withdrawals from your tax-deferred and tax-free accounts, it gives them more time to grow.
Others advocate for withdrawing simultaneously from your taxable accounts, then your tax-deferred, and finally your tax-free accounts to smooth out the impact on your taxes.
In either circumstance, you need to have funds in each of these account types to take advantage. If you currently have less money in your tax-free accounts but more in your tax-deferred than you would like, a Roth conversion might help bring those into better balance.
Related: Roth IRA for Kids: Can I Open a Custodial Roth IRA for a Child?
Disadvantages of a Roth Conversion
There are a few downsides, however.
Pay Taxes Upfront
Just like taking a tax deduction upfront for traditional IRA contributions is an advantage, paying taxes during the year of a Roth conversion is a disadvantage.
If you have a major tax hit coming from the conversion, you’ll need to have money set aside to pay the taxes due. You might also have to sell assets to cover the bill—a compounding problem, as selling those assets might entail additional tax consequences. Therefore, you’ll want to think hard about whether a Roth conversion makes sense for you.
However, if you made nondeductible traditional IRA contributions and couldn’t claim a deduction in the first place, converting those funds into a Roth IRA can add some salve—in the form of the resulting tax-free growth potential—to the tax sting.
You Have to Wait to Withdraw the Money
There’s no impediment to taking distributions from your Roth IRA if it’s at least five years old and you’re 59½ or older, disabled, buying your first home, or you inherited the Roth IRA. In all those cases, earnings you withdraw are considered “qualified” and thus tax- and penalty-free.
On the other hand, if you convert and are under 59½, you must comply with a separate five-year rule on your converted funds to avoid a 10% penalty. This rule applies separately for each Roth conversion, so be mindful of when you convert your funds.
Can’t Undo a Roth Conversion
As a result of tax reform in 2017, you can’t undo or “recharacterize” Roth conversions. Therefore, if you’ve converted funds, you can’t go back.
Related: How to Max Out Your 401(k) + Other Retirement Accounts
How to Set Up a Backdoor Roth Conversion
If a Roth conversion makes sense for your situation, converting a traditional IRA into a Roth IRA is a three-step process:
- Open a traditional IRA.
- Make after-tax (nondeductible) contributions into your newly opened account. For 2024, IRA contribution limits are $7,000 (an additional $1,000 catch-up contribution is allowed for you if you’re 50 or older). You should file IRS Form 8606 every year that you make a nondeductible IRA contribution so you can accurately track the basis of your traditional IRAs and the conversions made into Roth IRAs.
- Ask your financial custodian to transfer the desired assets from the traditional IRA to a Roth IRA. Once your nondeductible funds settle into your traditional IRA, you can initiate this transfer and conversion to your Roth IRA at any point in the future. To avoid the risk of a step transaction doctrine (described below), some advisors suggest waiting a few months after opening the Roth IRA.
Mind the Step Transaction Doctrine Risk
Tax elements aside, one additional risk to engaging in a backdoor Roth conversion is whether the IRS will continue allowing the practice to happen and instead apply the step transaction doctrine to block the loophole.
The step transaction doctrine is a judicial principle that combines a series of separate steps, which results in the tax treatment being awarded to a single integrated event.
In the case of someone using the “contribute-then-convert” strategy, the IRS could make the argument that you didn’t treat these transactions separately, and that the overall result of the discrete steps made them all part of a single, cohesive transaction. That means the IRS could constructively view this set of steps as an ineligible person making a Roth IRA contribution—something expressly prohibited by the rules of the tax code. If the IRS determines that is what has happened, they can tax that accordingly.
Yes, Roth contributions aren’t a taxable event themselves—they’re made with after-tax funds. However, if you made a Roth IRA contribution, but by virtue of the step transaction doctrine weren’t actually eligible based on your income, you would fall subject to a 6% per year, per contribution excess contributions tax.
For now, the IRS has allowed the transaction to happen, but that doesn’t mean it always will. Therefore, you should be aware of the possible consequences should the IRS change its position. The most orthodox change the IRS could make would be to only enforce penalties and taxes on future backdoor conversions while grandfathering previous actions. A more unorthodox (and the most draconian) change it could make would be to enforce penalties and taxes on past actions until you unwind the moves.
Ask a Financial Professional
A backdoor Roth conversion is another tool for both building wealth and making your money more flexible. But before making a decision on a conversion, you should consider consulting with a qualified financial advisor. They can help you assess your individual financial situation, explain the potential tax implications, and determine whether a Roth conversion is right for you.
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