What is the Backdoor Roth IRA and Why You Might Need It
The Backdoor Roth IRA sounds super sketchy, but is totally legal and could be your new investing friend.
Put simply, the Backdoor Roth IRA is your loophole to invest in a Roth IRA if you’re considered a high earner and are over the income limit (more on this later!).
Let’s go over who could benefit from the Backdoor IRA, how to do a Backdoor Roth IRA, my most frequently asked questions regarding this type of account, and some things I recommend watching out for when going this route. You will notice I often refer back to working with a CPA, and I truly think that a good accountant is one of those things that costs you money, but makes you richer!
What is a Backdoor IRA?
The Backdoor Roth IRA is a strategy that allows you to maneuver around the IRS’ income limits for the Roth IRA while still taking advantage of tax free growth. It is not a new type of account that you would need to open, but rather it’s a strategy for high income earners to take advantage of the tax free growth the Roth IRA offers.
Basically, think of the Roth IRA as a final destination and you have two ways of getting there: if you are under the income limit, you take a coup ,get in through the drivers door, and drive straight to the Roth IRA exit. If you are over the income limit, you take a sedan and get in through the backdoor, crawl up to the driver’s seat, make a pit stop at the Traditional IRA and then drive to the Roth IRA exit. Super thrilling, very legal, and you still get to drive (woo hoo!).
The Backdoor Roth IRA is for those who:
🤑 Make over the limit for the Roth IRA
🤑 Want tax-free growth on investments
🤑 Think their taxes will be higher in retirement
…but still want to invest in an IRA.
So maybe you read my post about why the Roth IRA is my favorite and realized you were over the income limit, and were like, “Amanda, this is not fair!” I feel you, friend. Luckily maybe you can sneak in the backdoor and still get all of that tax advantaged goodness.
How to Do a Backdoor Roth IRA
To do a Backdoor Roth IRA requires some kinda funky steps. It gets established differently than the Traditional IRA or the Roth IRA.
Here’s how to do a Backdoor Roth IRA:
🏦 Step 1: Open Traditional IRA AND Roth IRA
NOTE: There are a few additional things you’ll need to do if you already have a Traditional IRA with money in it, so if that’s you, please consult with your CPA BFF before trying this at home.
🏦 Step 2: Once you’ve opened your accounts, you need to contribute up to $7,000* a year into the Traditional IRA
With the Backdoor Roth IRA, patience is a virtue. Only deposit your money, DO NOT INVEST.
Just hang tight!
I know this goes against everything I’ve talked about with the Roth IRA, but the reason you can’t invest that money right away is because you have to let your $$$ settle (this usually only takes a couple of days, so you won’t have to wait long!).
*income limit for 2024
🏦 Step 3: Convert your money
So once your cash has settled, you’ll see a message that shows you the cash you have available, and that’s how you’ll know it’s settled and ready to be converted so you can invest. If it says $0 available, that means it hasn’t settled yet, so keep on waitin’. It’s still traveling through the matrix.
When the money has settled, there will be a button that says something like “Convert to a Roth IRA” or “Transfer to Roth IRA” (diff firms use diff verbiage). DO IT!
🏦 Step 4: NOW you can invest your money!
🏦 Step 5: Repeat these steps until you’ve hit the maximum contribution limit!
You don’t need to do $7,000 all at once. You can do these steps as you have the money. I know that seems like a lot of steps, and you’re probably asking why you have to do allllll those extra things. Why do I have to do the extra step of putting the money into the Traditional IRA?! That seems like a waste of time!
I didn’t make the rules, I just know we have to play by them. In order to take advantage of this legal loophole, we have to as Britney Jean Spears said and “Work B*tch”.
What to Watch Out For
There are a few things that you’ll want to pay attention to when using the Backdoor Roth IRA method to avoid tax penalties.
One thing is you don’t want to leave money in the Traditional IRA for too long because it will accrue interest and that just complicates things a bit.
You won’t want to do the Backdoor Roth IRA if you have a Traditional IRA (even if it only has $10 in it). This is due to the pro rata rule (TL;DR you won’t go to investment jail, but you won’t reap the same benefits).
Now, there are some ways around this and some options if you still want to use the Backdoor Roth IRA method, but they’re very specific to your unique set of circumstances and depend on specific dollar amounts, so if this is you, call up that CPA!
Backdoor Roth IRA FAQs
💵 Can I just convert my existing Traditional IRA to a Roth IRA?
It depends.
If you have a lot of money in there you won’t want to as you’ll have to pay all the taxes at once (because you haven’t yet paid taxes on that money).
If you have a small amount, you are probably fine to do so (IE $100 is way different than $100,000). But remember, you should always contact a CPA for those nitty gritty specific questions.
💵 What if I’ve been contributing to a Roth IRA all year and end up making too much by year end?
You need to back that money outta there or you’ll have to pay a penalty each year that it’s left in there. Call your brokerage firm and your BFF aka your CPA ASAP.
💵 What’s considered a high earner?
Remember that the tax table and income limits can change from year to year. You can find the current MAGI threshold for this tax year on the IRS’ website.
💵 Do I have to invest $7,000 at once?
You do not have to invest the full $7,000 at once! You can invest however much you have each month and use the backdoor strategy multiple times throughout the year.
💵 I’m married. My spouse is above the income limit, but I am not. Do I need to do a Backdoor Roth IRA?
If your combined income is above it, yes. The government looks at your earnings together. However, if you’re married and filing single, the income limit changes to $10k (no, that’s not a typo 🤡).
Is the Backdoor Roth IRA for you?
The Backdoor Roth IRA does have a super sketchy name, but is completely legal! In the good ‘ol United States of America, taxes are one of our biggest expenses in life. The Roth IRA is not only the ultimate wealth hack for you, but also the ultimate wealth transfer vehicle since there are no required minimum distributions (RMDs). If you are over the income limit and can’t walk through the front door of the Roth IRA, you may consider the backdoor😎
Wrapping Up
While the Backdoor Roth IRA isn’t difficult to execute, there are a lot of rules you’ll want to make sure you are following when you do it. You definitely want to take advantage of every possible tax loophole that you can, but it’s important to have all of your lil duckies in a row. I know I’ve said it about 50 times in this post, but it’s so, so important to hire a good CPA who can help you if you have questions!
Looking for more tips and tricks to prepare your $$$ for the future?
Check out my Investing and Retirement course!
