Backdoor Roth IRAs stand out as a sophisticated strategy for high-income folks who are otherwise unable to contribute directly to a Roth IRA due to income limits.

For instance, people's ability to make direct Roth IRA contributions phases out at $153,000 Modified Adjusted Gross Income (MAGI) or $228,000 for married couples filing jointly.

The Backdoor Roth strategy generally involves a two-step process: 

1. Making a contribution to a traditional IRA (deductible or non-deductible),
2. Then, converting that amount into a Roth IRA.

The process might sound simple: “contribute to a traditional IRA, then convert it to a Roth IRA– got it!” 

Yet, this is where simplicity ends and complexity begins. It requires precise reporting (especially for non-deductible IRAs) and accurate IRS Form 8606 filings to document any non-deductible contributions.

Further complicating things, the “IRA Aggregation Rule” requires all IRA accounts to be considered collectively, or else you’d end up with a convoluted mess of partial conversions, especially if you already have existing IRA funds. 

This, and a heap of other considerations, can turn a straightforward backdoor Roth into a desk full of paperwork and a never-ending series of tabs on Google Chrome full of explainer videos, guides, and forum discussion threads. 

Fear not– we’ll break down everything you need to know about the Backdoor Roth IRA and avoid the web of complexity. 

Backdoor Roth IRA 101

Enter the world of Backdoor Roth IRAs, a strategy so cleverly legit it almost feels like you're getting away with something. However, it's all above board, but it does require a scrupulous eye to the details (or, more realistically, a financial planner who speaks IRS-ese).

This financial maneuver isn't just about sneaking your way into the Roth club; it's about entering through the backdoor, avoiding taxes and penalties. 

The concept of the Backdoor Roth IRA started gaining traction after the income limits on Roth IRA conversions were eliminated in 2010. Before that, if your income exceeded a certain threshold, you couldn't convert a Traditional IRA to a Roth IRA.

The Tax Increase Prevention and Reconciliation Act of 2005 removed this conversion income limit, effective in 2010, indirectly creating the Backdoor Roth IRA pathway. 

This change allowed higher-income earners, normally ineligible to contribute directly to a Roth IRA, to fund a Traditional IRA and then convert those funds to a Roth IRA, regardless of their income level.

Granted, the “Backdoor Roth” isn’t an IRS piece of legislation; it’s more of a tax loophole the IRS and Congress are aware of but have not made any specific effort to prevent or close it. 

Is a Backdoor Roth Right for Me?

Before we get into the thick of it, let’s think for a moment– is all the work of a Backdoor Roth worth the effort?

I wouldn’t be writing about it if it weren’t, but let’s examine the details. 

The Backdoor Roth is typically popular among high-earners who have been excluded from being able to make direct Roth IRA contributions due to their substantial income or filing status.

Most of the "High Earners, Not Rich Yet" (HENRY) community falls into this category. 

The limits aren’t as high as you’d think. In 2023,  the income thresholds for direct Roth IRA contributions are as follows:

• Single filers: The ability to contribute begins to phase out at modified adjusted gross incomes (MAGI) of $138,000 and is completely phased out at $153,000.
• Married couples filing jointly: The phase-out starts at $218,000 and ends at $228,000, beyond which direct contributions are not allowed

These thresholds are periodically adjusted by the IRS to account for inflation and other economic factors, but they tend to be rather conservative in increases.

As described above, the Backdoor Roth strategy is a relatively recent technique that enables high-earners to benefit from the substantial benefits of the powerful wealth-building account that is the Roth IRA. 

As a quick refresh– contributions to the Roth IRA are made with after-tax dollars; it offers tax-free growth and tax-free withdrawals in retirement. Unlike traditional IRAs, contributions to a Roth IRA are made with after-tax dollars, meaning you don't get a tax deduction when you contribute. 

However, the benefit is that when you withdraw funds in retirement, you won't owe any taxes on your contributions or earnings, provided you follow the rules (withdrawals are tax-free after age 59½ and once the account has been open for at least five years).

The growth potential of a Roth IRA over about 30 years can be significant– let's say you contribute a maximum of $6,500 annually for 30 years, and your investments yield an average annual return of 7%. 

 

After 20 years, your Roth IRA would grow to approximately $663,474. The same contributions to a taxable account would grow to about $481,000– a $182,000 difference! 

Backdoor Roth Contribution Limits

“Wow, the Roth IRA is great– can I just throw all my funds in taxable accounts in here through the Backdoor Roth?”

Not so fast– the contribution limit to a Backdoor Roth IRA is indirectly governed by the traditional IRA contribution limits since the Backdoor Roth starts with a contribution to a traditional IRA. 

For 2023, the contribution limit for traditional and Roth IRAs is $6,500, or $7,500 if you're age 50 or older. This means you can use the Backdoor Roth strategy to contribute and convert the same amounts.

How to Do a Backdoor Roth IRA

Step One: Contribute to a Traditional IRA.

Your contribution to a traditional IRA may be tax deductible, depending on a few factors like income, filing status, and whether a retirement plan at work covers you or your spouse.

Whether your contribution is deductible or not doesn't matter in the grand scheme of things—you're setting the stage for the next move.

Step Two: Convert to a Roth IRA.

Transform your traditional IRA into a Roth IRA. 

If you contribute pre-tax dollars into a Traditional IRA and then convert it into a Roth, you pay tax upon the conversion. Yes, you will have to pay taxes on the conversion at current ordinary income rates—but that’s just how Roth IRAs work.

If you contribute post-tax dollars into a Traditional IRA and then convert it into a Roth, you do not pay tax upon the conversion (aside from any gains on the pre-tax dollars), and you don’t need to worry about the pro-rata rule below unless you had a prior Traditional IRA balance. 

Some financial planners can do this for you, but the process often begins with checking a box ☑️. 

 

The view on Vanguard. 

While direct Roth contributions have income caps, conversions do not, making this a game-changer. Keep in mind that your contribution amount is still limited to the IRS amount—for 2023, the contribution limit is $6,500 if you're under 50 years old. 

One of the most common points of confusion in this step has to do with the mixing of your pre-tax and after-tax funds—“What happens if I already have a Traditional IRA I’ve contributed to with both pre-tax and after-tax money?”

The “Pro-rata” Rule (we’ll discuss this more below) specifies that you can’t selectively choose only after-tax funds for a tax-free transfer to the Roth IRA. This rule melds your pre-tax and after-tax funds, treating them as a single unit for conversion purposes. 

It's akin to the "Cream in the Coffee" analogy, where the two elements (taxable and non-taxable contributions) become indistinguishably combined once mixed. As such, a proportional calculation is made based on the entirety of your IRA funds, not just the ones being converted. 

Backdoor Roth Considerations and Complications

While the Backdoor Roth IRA might sound like a secret handshake, it’s actually just a two-step process that requires skillful attention to detail for the many potential complications.

1. Reporting Requirements: IRS Form 8606: This form is your ticket to documenting non-deductible IRA contributions, which is crucial in the backdoor process. It ensures you don't pay taxes twice on the same dollar.
    
2. Timing and Accounting: While the IRS doesn't mandate a specific waiting period between contribution and conversion, clarity is key. Separating these transactions by at least a month can provide a clearer audit trail, making it easier to illustrate the two-step process if the IRS comes knocking.
    
3. IRA Aggregation Rule under IRC Section 408(d)(2): When assessing the tax implications of an IRA distribution, such as a Roth conversion, the total value of all your IRA accounts is combined to calculate the tax due.
    
4. The "pro rata" rule under IRC Section 72(e)(8): The “Cream in the coffee” rule once combined, each sip contains both elements. In other words, once you pour cream into the coffee, every sip is both cream and coffee. Similarly, once you blend non-deductible contributions with your total IRA funds, every withdrawal or conversion includes a mix of taxable and non-taxable amounts. However, unlike coffee, where cream might eventually separate if left untouched, the 'cream' in your IRA — the non-deductible part — remains blended forever, necessitating pro-rata distributions until all IRA accounts are depleted.

In other words, every time you take money out or convert some to a Roth IRA, a part of it will be considered taxable (the cream), and a part of it won't be taxed again (the coffee). 

The real stinger is that you'll have to keep track of this mix for as long as you have money in your IRAs, dealing with a bit of a tax headache every time you withdraw or convert until you've taken out all the money or converted it all to a Roth.

5. The early withdrawal penalty under IRC Section 72(t)(1) is a tax rule that imposes a 10% additional tax penalty on distributions taken from retirement accounts, like IRAs or 401(k)s, before the account holder reaches the age of 59½. This penalty is applied on top of the regular income tax that the account holder must pay on the distribution.

I wrote an article on how to access retirement account funds early and avoid early withdrawal penalties, outlining the specific ways to access your funds quicker. 

We weren’t joking when we said it’s a very involved process! Let’s take a breather because that’s not all. 

Backdoor Roths and Your Tax Basis

Imagine if you're saving money in a special savings jar (your IRA) where you usually get a reward (tax deduction) for every dollar you put in. 

But, if you earn too much money, the rules say you can only get the full reward for some dollars you save. If you're in this middle zone—earning too much for the full reward but not too much to contribute—you end up putting some dollars in the jar without getting a reward for them. These are your non-deductible contributions, or "after-tax dollars."

Usually, when you take money (distributions) out of this jar in the future, you don't have to pay tax on the dollars you already paid taxes on.

However, to ensure you don't pay taxes on these dollars again, you need to keep track of them using a form (Form 8606).

However, if you don't keep track of when it's time to take money out, you might end up paying tax on the dollars you didn't get a reward for, essentially paying tax twice on the same money. 

That's what's meant by "lost basis" – you lose track of the money you've already paid tax on, leading to potential double taxation. It's like forgetting which dollars in the jar already had their taxes paid and accidentally paying taxes on them again when you take them out.

This avoidable oversight requires excellent record keeping that can stand the test of time since, one day; you may need to prove your reporting from potentially decades ago. 

Making Cents of Backdoor Roth IRAs

Financial planning should never be an afterthought, but Backdoor Roths, in particular, really need that attention to detail. 

It’s likely you’ll work with a multitude of different financial planners, CPAs, bookkeepers, and tax attorneys throughout your wealth-building career. 

In all matters, but especially with the backdoor Roth strategy, coordination is key– we can’t stress this enough. There needs to be communication and continuity with your financial planning and record-keeping to avoid any unwelcome tax surprises– especially if they pop up as you’re about to retire formally. 

Not to beat a dead horse, but if tax rates are even higher in the future, which many predict, the mistakes made by poor record keeping or intra-team communication could be magnified. 

Plus, establishing synergy between you, your financial team, and your goals is better done sooner rather than later. 

Still, let’s not let these closing words advocating for structure and attention to detail scare you away from Backdoor Roths—just a few simple acts done right could add hundreds of thousands of dollars to your retirement accounts.

“Done right” means having safeguards in place against unexpected tax issues and ensuring every decision is made with a comprehensive understanding of your financial landscape.