The “Backdoor Roth IRA” refers to the strategy of making a non-deductible after-tax IRA contribution and subsequently converting it to a Roth IRA. Anybody with earned income (or a spouse with earned income) can contribute to a non-deductible IRA, up the limit of $6,000 per year if you're under age 50 and $7,000 per year if you're over age 50. Similarly, any individual can convert IRA dollars for assets to a Roth IRA. There are no income limits that apply to non-deductible IRA contributions or Roth IRA conversions.
If you wish to directly contribute to a Roth IRA, the income and contribution limitations for 2021 are:
Income Limit for Single Filers (MAGI)
Income Limit for Married Filing Jointly (MAGI)
Income Limit for Married Filing Separately (MAGI)
Maximum Contribution per Individual (under age 50)
Maximum Contribution per Individual (age 50 or over)
*MAGI = Modified Adjusted Gross Income
A common misconception of the Backdoor Roth IRA is that if you make over a certain amount of money (see table above) that you cannot put money into a Roth IRA each year. The Backdoor Roth IRA contribution, i.e. contributing to the non-deductible IRA and converting to a Roth IRA, circumvents this restriction.
Some important items to note when considering this strategy are:
- When converting IRA money to Roth, all IRAs are taken into account. This is defined as the pro-rata rule. In other words, when you convert your non-deductible IRA to a Roth IRA a portion of the conversion will be taxable. The amount that is taxed is calculated by dividing your tax-deferred IRAs by your total IRA accounts. For example, assume you have a traditional tax-deferred IRA with $100,000 in it. You make a $7,000 non-deductible IRA contribution and convert that to your Roth IRA. Using the pro rata rule, your tax-deferred IRA value of $100,000 would be divided by your total IRA value of $107,000. As a result, 93.45% of your $7,000 contribution would be taxable.
- A common strategy to alleviate a taxable event as described in #1 is to roll over smaller IRAs into your employer sponsored retirement plan, such as a 401(k), 403(b), or 457 account. This should be done in the current year and then the Backdoor Roth IRA strategy should be implemented in the following year.
- Another key point with regards to backdoor Roth IRAs is timing. A best practice would be to make the contribution in one month and the conversion in the subsequent month to avoid the illusion of a Step Transaction under IRS rules.
- Backdoor Roth IRA contributions are commonly confused with the Mega-Backdoor 401(k) strategy, but they are not the same! To learn about this strategy, check out our Mega-Backdoor Roth 401(k)… Deconstructed
As of the time of this article, The House Ways and Means Committee has proposed to end both the Backdoor Roth IRA and the Mega-Backdoor 401(k) strategy. This is not law yet, but if this proposal is passed, 2021 might be the last year these strategies are available.
Executing these strategies correctly can be difficult. Talk to your tax advisor to understand the tax implication in your situation. If you have questions about your financial situation, we’re here to help!
Source of Roth IRA income and contribution limits - https://www.schwab.com/ira/roth-ira/contribution-limits