What’s a Backdoor Roth IRA?

by Team eLocal
A Wooden piggy bank with words backdoor Roth IRA.

If you want to enjoy the tax advantages of a Roth IRA but don't qualify because you earn too much, you may be interested in an investment strategy known as a backdoor Roth IRA.

Here’s what you should know about this personal finance sleight-of-hand.

What Is a Roth IRA?

A Roth IRA is a tax-advantaged investment account designed to provide income to retirees. Because plan contributions aren't deductible, account holders won't have to pay taxes on qualified withdrawals during retirement. Roth IRA funds may be invested in a savings account or CD or used to purchase stocks, bonds, ETFs or mutual funds. Investors may also opt for less traditional assets, such as gold and cryptocurrencies.

Roth IRAs don’t require a minimum contribution, so they're a great way for lower-income individuals to start saving for retirement. On the other hand, high-income individuals are usually disqualified from opening an account because a participant's income must fall below a legal threshold.

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What Is a Backdoor Roth IRA?

According to Investopedia, the term “backdoor Roth IRA” refers to a legal investment strategy that lets high-income individuals reap the tax advantages of a Roth IRA by circumventing the account’s qualifying income limits. To do so, they must first open a traditional IRA, which doesn’t have income limits. The investor may then fund the account with non-deductible contributions up to the annual limit. Then, because Roth conversion rules don’t include income limits, the account holder may convert it to a Roth IRA.

A 401(k) plan may also be converted to a Roth IRA using this backdoor strategy. However, because contributions are tax-deductible, investors may owe taxes on converted funds.

Who Is a Backdoor Roth IRA for?

Although anyone can execute a backdoor Roth IRA conversion strategy, it’s often used by individuals whose income exceeds the legal threshold for direct investment in a Roth IRA. By creating a backdoor IRA, these investors can enjoy the tax advantages inherent in the plan without violating tax laws.

What Should You Consider Before Executing a Backdoor Roth IRA?

A backdoor conversion may make sense for some high-income individuals. However, investors should look into applicable tax and legal regulations, including the pro-rata rule, which governs how pre- and post-tax converted funds are handled. A knowledgeable retirement planner or financial adviser can provide valuable advice.

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