A backdoor Roth individual retirement account (IRA) is an account that’s established by converting a traditional IRA or other tax-deferred account into a Roth IRA. Using a backdoor Roth IRA conversion, account holders who aren’t typically Roth IRA-eligible because of income limits can still contribute to a Roth IRA, which then grows tax-free and can be withdrawn tax-free in retirement.
How a Backdoor Roth IRA Conversion Works
A backdoor Roth IRA conversion is a process that allows investors to convert funds from a tax-deferred account into a Roth IRA. Many high-earners are prohibited from contributing directly to Roth IRAs because they exceed income limits. Roth IRA conversions allow investors to get around these limits and convert assets from a tax-deferred account into a Roth IRA.
Anyone who has assets in a traditional IRA or other tax-deferred account can establish a backdoor Roth IRA. The only requirement is that you have money in a tax-deferred retirement account like a traditional IRA, savings incentive match plan for employees (SIMPLE) IRA or simplified employee pension (SEP) IRA. There is no minimum period that funds must remain in a tax-deferred account before being transferred using a backdoor Roth IRA conversion.
In order to do a Roth IRA conversion, all you have to do is pay income taxes on the amount you convert — or contribute — to the backdoor Roth IRA, report the conversion, complete the conversion within 60 days and follow other Backdoor Roth IRA rules.
Some of the accounts that you can convert into a backdoor Roth IRA include:
- Traditional IRA: IRAs set up by individuals without employer sponsorship to make up to $5,500 in tax-deferred contributions per year
- SIMPLE IRA: An employer-sponsored IRA structured like a 401(k) that has required employer matching for employee deferrals up to 3 percent of compensation
- SEP IRA: Employer-sponsored plans that employers use to contribute up to $55,000 per year — or 25 percent of income — and make proportional contributions to all eligible employees
Some criteria that may make a backdoor Roth IRA appropriate include:
- Income exceeds Roth IRA income limits: If your income is too high to contribute to directly to a Roth IRA, you can use a backdoor Roth IRA conversion to get money into a Roth IRA by converting assets from another account
- Want tax-free withdrawals in retirement: By using a backdoor Roth IRA, you can pay taxes on an account balance now then let the account grow tax-free and withdraw money tax-free in retirement
- Pay taxes on an account when its value has fallen temporarily: Investors who have short-term losses in tax-deferred accounts can do a Roth IRA conversion and pay taxes while the account value is low, then they’ll never owe additional taxes on their account
- High passive income: If you have a high income that will be the same or higher in retirement, you may want to convert their account to a Roth IRA to lower their tax burden during retirement
Who a Backdoor Roth IRA Conversion is Right For
A Roth IRA conversion is a great tool for many investors, but it isn’t always the best idea. A backdoor Roth IRA may also not be right for you depending on your current or future income. To decide whether a Roth IRA conversion is right for you, it’s important that you expect your account to continue growing and for your tax rate to be higher in retirement than it is now.
“The best candidates for Roth IRA conversions are those with investment time horizons of 10-plus years. The way you win with a Roth IRA is to get as much growth as possible in the account because the growth is what becomes tax-free. The longer we can leave the account alone, the better chance we have of tax-free growth. The hardest part is navigating the paperwork. Most companies are helpful walking through the necessary paperwork. It is generally wise to work with a certified financial planner to accomplish a successful Roth IRA conversion.”
— John Cavanaugh, CRPC, CFP, Financial Planner, Cavanaugh Financial Group
Some instances when a Roth IRA conversion may not be beneficial include:
- Eligible for backdoor Roth IRA contributions: If you’re eligible to contribute directly to a Roth IRA, you may not need to do a Roth IRA conversion to take advantage of the tax benefits offered by a Roth IRA
- Particularly high-income year: If you’re having a high-income year and your tax rate will be higher, you may also want to avoid doing a Roth IRA conversion this year
- Expect lower income in retirement: If you have a very high income now but expect to earn much less in retirement, may want to leave money in tax-deferred accounts to take advantage of lower tax rates
6 Steps to do a Backdoor Roth IRA Conversion
The process of how to do a backdoor Roth IRA conversion is relatively simple. The process can be even easier if you aren’t changing investments or providers at the same time you’re doing your conversion. However, it’s important to make sure that you choose the right provider for your conversion and report the conversion to the IRS.
The six steps for how to do a backdoor Roth IRA conversion are:
1. Contribute to a Traditional IRA
In order to do a backdoor Roth IRA conversion, it’s first important to have something to convert. This means having a traditional, SIMPLE or SEP IRA with a balance that you can convert. Be sure that you have one of these accounts and that you contribute regularly.
2. Identify a Backdoor Roth IRA Provider
Depending on the type of account that you’re converting to a backdoor Roth IRA, you may be able to complete your conversion with your current provider. Most providers have the same fees for Roth IRAs as for tax-deferred accounts, but if you want to change providers, a Roth IRA conversion can be an excellent opportunity.
3. Initiate Backdoor Roth IRA Conversion
To begin the backdoor Roth IRA process, you may mean to initiate the process with the current provider of your tax-deferred account. This is done by requesting a check made out to an account for your benefit. However, this step is typically skipped by having your new provider initiate the transfer or by completing your Roth IRA conversion with your current provider.
4. Complete Roth IRA Conversion
In order to finish your Roth IRA conversion, the next critical step is to deposit your funds into a backdoor Roth IRA. To avoid penalties or additional taxes, deposit the full amount of funds you started to convert within 60 days. This step usually involves opening an account at your provider and funding it. This is typically just a matter of paperwork with your provider.
5. Report Roth IRA Conversion
Once you’ve completed your Roth IRA conversion, you must report your conversion and pay taxes on the balance that you convert. To ensure that you report your Roth IRA conversion correctly, be sure to follow IRS instructions carefully.
6. Let Your Backdoor Roth IRA Grow
After completing your backdoor Roth IRA conversion, the last step is to invest and let your account grow tax-free. You must hold your Roth IRA for at least 5 years before taking distributions. However, if you’re age 59 1/2 and older and have held your Roth IRA for 5 or more years, you can take tax-free withdrawals from your account.
Backdoor Roth IRA Rules
To set up a backdoor Roth IRA, it’s important that you follow several backdoor Roth IRA conversion rules. Failure to follow these rules can cause you to incur a 10 percent IRS penalty on your account balance or expose you to unexpected tax burden. It’s also important that you report Roth IRA conversions using IRS Form 8606.
The seven most important backdoor Roth IRA rules are:
1. Pay Taxes on Your Converted Balance
The biggest consideration for Roth IRA conversions is that you have to pay taxes on the balance that you convert to a Roth IRA. The balance is being converted comes from a tax-deferred account and may include contributions and gains that wouldn’t have been taxed if the contributions had gone directly into a Roth IRA rather than being converted.
One important exemption to this rule, however, is that you are not required to pay tax on the full balance converted to a Roth IRA if the converted balance includes contributions to a tax-deferred account that you didn’t deduct from your taxable income when you originally contributed.
2. Must Complete Conversion within 60 Days
Once a backdoor Roth IRA conversion is started, any funds being converted must be deposited into a Roth IRA account within 60 days. Failure to complete the rollover within 60 days can mean the converted funds are treated as IRA distributions and lead to early distribution penalties.
3. No Withdrawals During Conversion
Once you start a Roth IRA conversion, you must contribute the entire balance to a Roth IRA account within the 60-day conversion window. Failing to complete the conversion on time can cause you to incur additional taxes or incur 10 percent early distribution penalties on the difference.
4. Can Do Partial Roth IRA Conversion
If you have a traditional IRA, SIMPLE or SEP and want to do a Roth IRA conversion, you aren’t required to convert your full account balance. However, you must complete your Roth IRA conversion for whatever part of your account balance you start to convert.
The requirement that backdoor Roth IRA conversions is similar to the 60-day rollover window that is required for IRA rollovers. For more information on the 60-day rollover window, be sure to check out our ultimate guide to Rollover IRAs.
5. Report Roth IRA Conversion to the IRS
Whenever you do a backdoor Roth IRA conversion, the conversion must be reported to the IRS using IRS Form 8606. Included in this form is information on the amounts originally contributed to your tax-deferred account, the tax-deductible portion of these accounts, and the amount converted to a backdoor Roth IRA.
6. Can’t Convert Required Distributions
This rule only applies if you’re age 70 1/2 or older and required to take minimum distributions from a tax-deferred account including a traditional, SEP, or SIMPLE IRA. If you have to take required minimum distributions (RMDs) for a tax-deferred account, you aren’t allowed to convert those RMDs to a backdoor Roth IRA.
7. Multiple Roth IRA Conversions Are Allowed
There is no limit on the number of Roth IRA conversions you do, nor is there a restriction on how many conversions you do in a month or a year. However, it’s important that you follow backdoor Roth IRA rules for each conversion and that you report each conversion to the IRS.
Backdoor Roth IRA Taxes
Backdoor Roth IRA taxes are the most important consideration when deciding whether to convert a tax-deferred account to a Roth IRA. The biggest difference in Roth IRAs vs. traditional IRAs is the way they are taxed. When you convert money from a tax-deferred account to a Roth IRA, you must pay income taxes on the amount that you convert.
When you do a Roth IRA conversion, you’re required to pay taxes on the balance that you convert at your ordinary income tax rate for the year you do your conversion. These taxes can end up being greater than the taxes you would’ve paid if you’d contributed directly to a Roth IRA, which is why backdoor Roth IRA contributions are best used by people who aren’t eligible for Roth IRA contributions.
Backdoor Roth IRA Conversion Example
Let’s say you contribute $5,500 each year to a traditional IRA, and your account grows by about 6 percent per year. By contributing to a tax-deferred account, you would defer approximately $1,375 in taxes per year, depending on your individual income tax rate. In year 8, you could convert roughly $40,000 from your traditional IRA into a backdoor Roth IRA.
Under this example, you would be required to pay about $10,000 in taxes on the funds that you converted. This would actually be more than you had saved in taxes during the first 7 years because you would be taxed on both contributions and gains in your account. However, after your backdoor conversion, you would then have $40,000 in an account that would continue growing tax-free allow tax-free withdrawals during retirement.
Traditional IRA Example
Traditional IRAs and other tax-deferred accounts offer upfront tax benefits because they allow you to deduct any contributions from your taxable income for the year that you contribute. Once you contribute to a tax-deferred account, your account can grow tax-free until you start taking withdrawals during retirement.
When you take withdrawals from a tax-deferred account in retirement, those distributions are taxed as ordinary income. By using a tax-deferred account, you will have delayed your tax bill and used money that you would’ve paid in taxes to help your retirement account grow faster. However, these gains are still taxed when withdrawn from your account.
To learn more about how tax-deferred accounts work as well as their rules, contribution limits, and deadlines, be sure to check out our ultimate guide to traditional IRAs.
Roth IRA Example
Roth IRAs are different from tax-deferred accounts because backdoor Roth IRA contributions are not tax-deductible. Instead, when you contribute to a Roth IRA, you still have to pay income tax on any money that you contribute. However, once you contribute to a Roth, your account grows tax-free and you can withdraw money tax-free after you reach age 59 1/2.
In addition to tax-free withdrawals in retirement, Roth IRAs offer additional benefits that make them very beneficial for certain investors — especially high-earners. The biggest added benefit is that Roth IRAs are not subject to required minimum distributions, so you aren’t forced to withdraw money once you reach age 70 1/2. Instead, you can leave money in a Roth IRA as long as you want or even hand it down to heirs.
Roth IRAs have their own set of rules and restrictions that investors should understand before deciding to open an account. To learn more about their contribution limits rules, and eligibility requirements, check out our complete guide to Roth IRAs.
Backdoor Roth IRA Conversion Example
Using a backdoor Roth IRA conversion, account holders contribute to a tax-deferred account like a traditional, SEP or SIMPLE IRA. After they’ve contributed to a tax-deferred account, investors then use the Roth IRA conversion process to move all or part of their tax-deferred account into a Roth IRA account in one lump sum.
When an investor makes their initial contributions to a tax-deferred account, their contributions are tax-deductible. In order to complete a Roth IRA conversion, account holders have to pay income taxes on the amount that they convert from a tax-deferred account. They also have to report the conversion to the IRS.
While account holders must pay taxes when they convert funds from a tax-deferred account into a Roth IRA, they’d also have to pay taxes on their contributions if they contributed directly to a Roth IRA. However, once the conversion is complete, the account holder is left with a balance in a Roth IRA account that they would otherwise have been prohibited from using.
Backdoor Roth IRA Costs
The costs of establishing a backdoor Roth IRA are minimal. They’re usually limited to paying taxes on the amount that you convert to a Roth IRA. However, some providers may also charge account registration fees or trading commissions if your investments change as part of doing your backdoor Roth IRA conversion.
Some potential backdoor Roth IRA costs include:
- Taxes: 15 to 40 percent of amount converted
You’re required to pay taxes on whatever portion of a tax-deferred account you convert to a Roth IRA account
- Account registration fees: Up to $50
Some providers registration or custodial fees up to $50 for individual retirement accounts including backdoor Roth IRAs
- Trading commissions: $5 to $50 per trade
If you’re required to sell or change investments as part of your backdoor Roth IRA conversion, you may have to pay trading commissions on each trade.
The costs of a Roth IRA conversion are very minimal. Depending on the provider and investments that you use, your only costs may be the taxes required to convert your tax-deferred account to a Roth IRA. However, in order to avoid any additional taxes or penalties, it’s important to follow conversion rules and the conversion process carefully.
Backdoor Roth IRA Providers
A backdoor Roth IRA conversion is typically easiest if you work with your tax-deferred account provider. However, depending on the type of account that you’re converting it may be necessary to pick a new provider. If you’ve been thinking about changing account providers, a Roth IRA conversion can also be a good time to change.
Four of the top backdoor Roth IRA providers include:
Vanguard is the largest mutual fund company in the world. It offers a wide variety of low-cost, professionally managed mutual funds and exchange-traded funds (ETFs) that investors can use in a Backdoor Roth IRA. If you already have an account at Vanguard or want to focus on passive investing, Vanguard is a cost-effective provider worth considering.
Fidelity is one of the largest privately-owned financial services companies in the world. The company offers a wide range of retail banking, brokerage and investment advisory services. If you want an investment advisor to help you manage your account, Fidelity may be a good option.
Charles Schwab is a large and storied firm that offers a full menu of banking and financial services for individual clients and institutions. Charles Schwab is especially worth considering if you have additional banking needs or could benefit from financial services for your business.
TD Ameritrade is a large Canadian bank that has offices all across the United States. In addition to offering traditional banking services, TD Ameritrade also offers a wide range of financial services including investment management and securities brokerage. If you’re looking for a good online platform trade your backdoor Roth IRA, TD Ameritrade may be a good choice.
Backdoor Roth IRA Mistakes to Avoid
There are times when a Roth IRA conversion is especially beneficial. However, there are also ways to screw up the conversion process. If you’re contemplating a backdoor Roth IRA be sure to think carefully about the tax implications — present and future — and your fluctuating income before you do a conversion.
Five tips for using a backdoor Roth IRA are:
1. Be Sure Not to Finish a Roth IRA Conversion Late
Once you start a backdoor Roth IRA conversion, it’s important to complete your conversion on time. Otherwise, you may face penalties or unexpected taxes. If you don’t think that you can complete the process on time, wait until you’re confident in your ability to complete the conversion according to backdoor Roth IRA rules.
2. Don’t Do a Conversion in High-income Years
If you’re having a high-earning year, your tax rate may be higher than normal. In that case, it may not be a good time to do a backdoor Roth IRA conversion. If you’re thinking about doing a Roth IRA conversion, you may want to wait for a year when your tax rate won’t be so high.
3. Avoid Conversions Before You Understand the Tax Implications
Backdoor Roth IRAs are a great tool if your income normally exceeds Roth IRA income limits. However, a low-income year can be a particularly good time to do a Roth IRA conversion. When you do a conversion, you’ll be taxed on the balance that you convert to a Roth IRA, so it’s a good idea to do this in a year when you may be in a lower tax bracket.
“Anyone who has the resources to pay the taxes to do the backdoor Roth IRA should strongly consider it. The younger you are, the better due to longer tax-free growth, but even business owners that are nearing retirement should consider because it will eliminate these assets from any required minimum distribution calculations and can still grow tax-free if the 5-year hold requirements are met.”
— Michael W. Landsberg, CFP, CIMA, Principal & Chief Investment Officer, Landsberg Bennett Private Wealth Management
4. Don’t Forget Roth IRA Conversions in Estate Planning
Roth IRAs are not subject to required minimum distributions unlike tax-deferred accounts like traditional IRAs or 401(k)s. Instead, you can keep money in a Roth IRA as long as you’d like or even pass it on to your heirs. This makes Roth IRA conversions a great estate planning tool for passing on assets.
5. Never Try to Reverse a Roth IRA Conversion
Once you do a backdoor Roth IRA conversion, you can’t go back. You can still contribute to a tax-deferred account, but you won’t be able to move money back from a Roth IRA into a traditional IRA or other tax-deferred account. Be sure of your decision before you start the conversion process because there’s no going back.
“You need to pay tax on the fair market value of the conversion. Under the new Trump tax plan (Tax Cuts and Jobs Act of 2017), once a conversion is done, it can no longer be rescinded as was the case prior to the act. In other words, once you do a conversion, it is final. In the past, people have done Roth IRA conversions and, if the investment did not perform well, they would retract the conversion. The act stopped that strategy.”
— Adam Bergman, President, IRA Financial Group
Backdoor Roth IRA Frequently Asked Questions (FAQs)
If you still have questions about backdoor Roth IRAs after reading this article, here are some of the frequently asked questions about Roth IRA conversions. If you don’t see an answer to your question, be sure to post it in the comment section. You can also visit the FitSmallBusiness Forum and post it there.
Some backdoor Roth IRA frequently asked questions include:
Can You Have Multiple Roth IRAs?
There is no limit on the number of Roth IRAs that a person can have. Roth IRA contribution limits are the only restriction. No matter how many traditional or Roth IRAs you have, you can contribute a total of $5,500 per year, plus an extra $1,000 if you’re age 50 or older.
How Much Can You Convert to a Backdoor Roth IRA?
If you decide to do a backdoor Roth IRA conversion, there is no limit on the amount that you can convert, nor is there a limit on the number of conversions you can do. There used to be a Roth IRA conversion limit of $100,000, but that limit has been lifted.
Is There an Age Limit on Roth IRA Conversions?
There’s no age restriction on Roth IRA conversions. However, there’s a 10 percent penalty if you’re age 59 1/2 or younger and don’t complete a conversion. If you’re age 70 1/2 or older and have required minimum distributions, you can’t convert required distributions. Once you complete a conversion, you must hold your account for at least 5 years before taking distributions.
The Bottom Line
A backdoor Roth IRA is a valuable tool for investors who can’t contribute directly to a Roth IRA because their income exceeds Roth IRA income limits. By using a Roth IRA conversion, investors can move money from tax-deferred accounts into tax-advantaged Roth IRA accounts that allow tax-free growth and tax-free withdrawals in retirement.