In a perfect world you would arrive at retirement with both pre-tax (such as traditional 401(k)s and IRAs) and post-tax (Roth 401(k)s and Roth IRAs) retirement accounts to allow for tax bracket optimization and wider tax planning opportunities.
Let’s take a look at the difference between traditional and Roth IRAs, and see how you can contribute to a Roth IRA even when you are over the income limits.
How Traditional and Roth IRAs Work
When you make a contribution to a traditional IRA, you might get a tax deduction up to the amount of the contribution. This makes your traditional IRA a pre-tax account, meaning taxes will need to be paid on it at withdrawals of both original contributions and accumulated investment earnings.
Roth IRAs work in the opposite direction - there is no tax deduction for your contribution, but qualified withdrawals of both contributions and investment earnings are tax-free. Roth IRAs are post-tax accounts - since the contribution did not receive a tax deduction, no further taxes are going to be paid at qualified withdrawals of both contributions and related investment earnings.
The annual limit for your total IRA contribution is $7,000 for 2024 ($8,000 if you are over 50), regardless whether it’s traditional or Roth. In other words, you can’t double up the $7,000 by making a contribution to each traditional and Roth IRA. This limit usually increases every few years.
Income Limits for Roth IRA Contributions
Unfortunately, once you reach a certain income limit, you are no longer eligible to make contributions directly into your Roth IRA. For 2024, Roth IRA contributions are completely disallowed at these adjusted gross income (AGI) totals: $161,000 for single filers and $240,000 for married couples. These limits are inflation-adjusted annually.
Even though IRA accounts are maintained on an individual basis and are never joint, total combined income figure is used to determine eligibility for married couples filing a joint tax return.
“Backdoor” Roth IRA contributions can come to the rescue when you are over the Roth IRA income limits.
Mechanics of “Backdoor” Roth IRA Contributions
Step 1: Make a non-deductible traditional IRA contribution into your traditional IRA.
Step 2: Once the contribution has been posted, convert the balance in that traditional IRA into a Roth IRA, effectively transferring the contribution into your Roth IRA. Since you never received a tax deduction for that traditional IRA contribution, the conversion is not taxable (but it needs to be reported on your tax return for the year when the conversion took place).
Step 3: Invest the new contribution in your Roth IRA.
A important condition for a tax-efficient “backdoor” Roth contribution is absence of a traditional IRA balance (or SEP/SIMPLE IRA) previously funded with tax-deducted contributions, otherwise the “pro rata rule” would kick in (more on that below).
Processing a “backdoor” Roth IRA contribution requires having two IRA accounts with the same brokerage: a traditional IRA that is used only for making the initial non-deductible contributions, and a Roth one for holding and investing the funds after the conversion.
Tax Reporting of “Backdoor” Roth IRA Contributions
You report both the contribution and the conversion on your tax return on Form 8606. IRA contributions can be made even after the year is over, up to the due date of the tax return (around April 15). A contribution is reported on the tax return of the year for which it was meant to be made, and a conversion is reported on the tax return of the year when the conversion actually took place. Let’s say you made a 2023 IRA contribution retroactively in March of 2024, and subsequently converted into Roth in the same month. The contribution will be reported on your 2023 tax return, and the conversion will go on the 2024 one.
The Pro Rata Rule
A Backdoor Roth contribution works well only if you have NO traditional IRA or SEP/SIMPLE IRA balances with tax-deducted contributions. If you do have an IRA with tax-deducted contributions, then a portion of the traditional to Roth conversion of the “backdoor” process will be taxable due to the pro rata rule. This makes things messier to report and at least partially defeats the tax-savings purpose of the strategy.
Here is an example of the pro rata rule application:
Let’s say you have a traditional IRA balance of $60,000 funded with tax-deducted contributions. You would like to make a Roth IRA contribution, but your income is too high for a “straight into Roth” IRA contribution. You make a non-deductible contribution to your traditional IRA of $6,000, which is step one in the “backdoor” process. After subsequently converting that contribution to Roth in step two, you now have a new total IRA balance of $66,000. Out of that balance, 90% or $60,000 is in pre-tax dollars (old balance, still needs to be taxed) and 10% or $6,000 in post-tax dollars (the new non-deductible contribution). When processing that conversion, 90% of the $6,000 will be considered taxable income. You effectively blend the traditional IRA balances all together, then convert from partially “old” untaxed balance and partially the “new” taxed balance, on a pro rata basis.
If you decide to make a non-deductible contribution to a traditional IRA and skip the conversion to Roth, then a qualified withdrawal of that contribution will indeed be tax free, but earnings on that contribution will still be taxable. That move defeats the purpose of funding a Roth IRA, and can technically be less tax-advantageous than contributing the funds to your brokerage - since there is no preferential long term capital gains tax rate available for taxable IRA withdrawals, regular income tax rates would apply. If you instead invested those funds in your taxable brokerage account, earnings could be subject to the lower capital gains tax rates.
Strategies for Avoiding the Pro Rata Rule
If a traditional/SEP/SIMPLE IRA balance is standing in the way of your annual backdoor Roth IRA contributions, here is what you can do:
Consider rolling the pre-tax IRA into the 401(k) plan of your current employer, assuming the plan allows for incoming rollovers. Many plans do, and most of them require you to be a current employee. It might require some paperwork, but this one time exercise could clear the path for annual “backdoor” Roth IRA contributions.
If you are in a low-income year (starting a business, taking time off, going back to school, etc.), you could take advantage of the lower income tax brackets and convert your pre-tax IRA into a Roth IRA. You would pay tax on the entire balance (assuming all of the contributions were tax-deductible), but all future qualified withdrawals would be free of tax. This could be particularly useful for those who have many years ahead before needing to draw funds for retirement.
Beware of the 5-Year Rule for “Backdoor” Contributions
Contributions made straight into a Roth IRA can be withdrawn at any point without taxes or penalties. “Backdoor” Roth contributions, however, are subject to the 5-year rule - they need to sit in the account for at least 5 years to be allowed for tax-free and penalty-free treatment at withdrawal.
Earnings in Roth IRA accounts are also subject to the 5-year rule. In addition, you need to be at least 59.5 years old to avoid taxes and penalties on withdrawals of Roth IRA earnings.
Breaking either of these rules would result in distributions being subject to your ordinary tax rates plus a 10% penalty.
Picking between Funding a Roth IRA and a 401(k) plan
Participating in your 401(k) plan to max out the employer match (aka free money) is highly recommended.
If you have to pick between funding a Roth IRA (a post-tax account) and your employer's traditional 401(k) (a pre-tax account), then the main consideration is your tax bracket is for the current tax year v expected tax bracket in Roth IRA withdrawal year(s).
If your 401(k) plan allows for Roth contributions and you would prefer to make contributions to a Roth account, you could kill two birds with one stone (Roth + match).
Splitting your contribution between a Roth IRA and a 401(k) is always an option.
Since IRA contributions can be made after a year ends and up through the due date of the tax return (April 15 of the following calendar year), you could focus on the 401(k) first and “top off” with any remaining available funds before April 15.
If you are in a fortunate position where you are maxing out your pre-tax 401(k) contributions and are funding Roth IRA through backdoor contributions, AND your employer offers a “Mega Backdoor Roth” within the 401(k) plan, it might be a good idea to to participate in that, as well.
If you would like to learn more about retirement savings strategies, take a look at our collection of posts on the topic.