Having a large nest egg in a Roth IRA means you can enjoy tax-free withdrawals from your account in retirement. Roth retirement accounts, like a Roth IRA, are funded with post-tax income (money you’ve already paid income taxes on), and in retirement, your withdrawals are completely tax-free.

Unfortunately, the Roth IRA has an income limit that restricts high-income individuals from contributing. If you make too much money, you can’t take advantage of the tax benefits that a Roth IRA gives you in retirement. The good news is that there’s a fairly simple workaround that’s actually more common than most people think: The backdoor Roth IRA.

You can do a backdoor Roth IRA conversion in Carry with just a few clicks and under 10 minutes. Learn more about Carry IRAs.

Table of contents

What is a backdoor Roth IRA and how does it work?

A backdoor Roth IRA is not a separate account but a strategy to contribute to a Roth IRA by first making contributions to a traditional IRA and then converting those funds to a Roth IRA, especially if your income exceeds the Roth IRA contribution limits. With a Roth IRA, you cannot make contributions if your income is too high.

Roth IRA income limits for 2023

  • If your income is $138,000 or less, you can contribute up to the maximum Roth IRA contribution limit of $6,500 ($7,500 if age 50+).
  • If your income is over $138,000 but less than $153,000, your contribution limit gets reduced.
  • If your income is over $153,000, you cannot contribute at all.

Roth IRA income limits for 2024

  • If your income is $146,000 or less, you can contribute up to the maximum Roth IRA contribution limit of $7,000 ($8,000 if age 50+).
  • If your income is over $146,000 but less than $161,000, your contribution limit gets reduced.
  • If your income is over $161,000, you cannot contribute at all.

Learn more about the Roth IRA income limits.

A backdoor Roth IRA involves making contributions to a traditional IRA first (which does not have income limits for contributions), and then immediately converting the funds to your Roth IRA. Since the Roth IRA’s income limits only applies to contributions, and not rollovers, this backdoor conversion allows high income earners to put money into their Roth IRAs, regardless of their income levels.

Convert to a self-directed Roth IRA

You can also do a backdoor Roth IRA conversion and choose to roll over the money into a self-directed Roth IRA instead of a traditional Roth IRA. A self-directed Roth IRA allows for a wider range of investments. This includes alternative assets like crypto, real estate, and private companies.

Will I have to pay taxes for a backdoor Roth IRA?

Another option for the backdoor Roth IRA is to contribute to a traditional IRA with non-deductible contributions, rather than taking a tax deduction for the contribution. A non-deductible IRA is a special type of traditional IRA where contributions are made with post-tax income. Since a Roth IRA is also funded with post-tax income, the conversion would not be a taxable event.

If doing a rollover from a traditional IRA to a Roth IRA

Yes, you will have to pay taxes since a traditional IRA and Roth IRA are funded differently.

  • A traditional IRA is funded with pre-tax dollars that you haven’t paid taxes on yet. Instead, the contribution amount gets deducted from your taxable income when you make a contribution.
  • A Roth IRA is funded with after-tax dollars that you already paid taxes on.

Therefore, when you convert funds from a traditional IRA into a Roth IRA, you’ll have to add the amount that gets converted to your taxable income for the year. For example, if you convert $5,000 from a traditional IRA to a Roth IRA, you’ll have to report the conversion and the $5,000 would be considered as taxable income on your next tax return.

If doing a rollover from a non-deductible IRA to a Roth IRA

The rollover from a non-deductible IRA to a Roth IRA is not a taxable event on its own since both accounts are funded with post-tax income. However, if you have any other IRAs that have both pre-tax and post-tax funds, there may be taxes involved due to the pro-rata rule.

Note: If you incur any profits from investments or interest generated in your non-deductible IRA before it gets rolled over to your Roth IRA, you may have to pay taxes on the gains during the conversion. As long as the conversion happens immediately, the taxes incurred will typically be a very small amount.

The pro-rata rule

When you rollover funds from an IRA into a Roth IRA, most people think that only the conversion amount gets taxed. But actually, there is one more tax consideration you need to take into account: the pro-rata rule.

If you have both pre-tax and post-tax funds in an IRA, you cannot just select only the post-tax portion when doing a backdoor Roth IRA conversion. The pro-rata rule is used to determine the ratio that should be used to determine how much should be a pre-tax conversion and how much should be a post-tax conversion.

Post-tax funds include any non-deductible IRA contributions, repaid reservist distributions, or rollovers of post-tax dollars from a qualified employer sponsored retirement plan (QRP) such as a 401k, 403b, or 457b.

Pro-rata rule formula

The pro-rata rule applies to all your traditional IRAs, including rollover IRAs. It calculates the proportion of taxable versus non-taxable funds in all your traditional IRAs when you make a conversion to a Roth IRA.

The formula looks something like this:

[non-deductible amount] / [total of all non-Roth IRA balances] = non-taxable percentage

[amount to be converted to Roth IRA] x [non-taxable percentage] = amount of post-tax funds converted to Roth IRA

To understand the pro-rata rule, let’s go through an example.

Let’s say that you earned $200,000 in income this year and want to contribute $6,000 into your Roth IRA. However, you are unable to contribute to your Roth IRA directly because you’re over the contribution income limit for 2023, which is $153,000. Therefore, you decide to do a backdoor Roth IRA conversion. You contribute the $6,000 into your traditional IRA and then immediately rollover the funds into your Roth IRA.

Because a traditional IRA is funded with pre-tax income and a Roth IRA is funded with post-tax income, you believe that you’ll just need to pay taxes on the $6,000 conversion amount and you’ll be good to go. However, that is not the case.

A traditional IRA has a tax deduction limit. While you can still make a contribution to your traditional IRA regardless of your income level, your contribution won’t be tax deductible if your income is over $83,000 for 2023. In other words, your contribution would be treated as a post-tax contribution.

The pro-rata rule dictates that if a traditional IRA contains both pre-tax and post-tax contributions, each dollar withdrawn from the account must contain a percentage of tax-free and taxable funds. And the ratio is based on the percentage of post-tax contributions made into the account versus pre-tax contributions.

For simplicity’s sake, let’s pretend that you had a balance of $94,000 in your traditional IRA (all pre-tax money) before your recent $6,000 post-tax contribution. After the $6,000 contribution, you now have a total balance of $100,000 in your traditional IRA – $94,000 in pre-tax money and $6,000 in post-tax money. The percentage of post-tax money in your account is 6%, and the percentage of pre-tax money is 94%.

Because of the pro-rata rule, you cannot just withdraw the $6,000 in post-tax money from your account and roll it over to your Roth IRA. You must split the withdrawal according to the pre-tax and post-tax ratio of your account balance:

Your $6,000 rollover will consist of 94% ($5,640) in pre-tax income, and 6% ($360) in post-tax income. The $5,640 gets taxed when rolled over into your Roth IRA. Instead of being able to roll over $6,000 in post-tax income, due to the pro-rata rule, only $360 in post-tax income was able to be rolled over, the rest being pre-tax income.

After the backdoor Roth IRA conversion, you now have:

  • $6,000 in post-tax income in your Roth IRA.
  • $94,000 in your traditional IRA which consists of $5,640 in post-tax income that still remains in your account.

How to avoid the pro-rata rule in a backdoor Roth IRA conversion

If you’re eligible for a solo 401k, one way to avoid the pro-rata rule is to first rollover all of your traditional IRA funds into your solo 401k first. Once your traditional IRA has a balance of zero, you can use it to make contributions for immediate rollover into your Roth IRA without having a mixed bag of pre-tax and post-tax funds.

Additionally, if you have a solo 401k, you can also decide to rollover the assets into a Roth solo 401k account rather than a Roth IRA. Rollovers don’t affect contribution limits; you’re allowed to rollover as much as you want from another retirement plan and you’ll still have the full solo 401k contribution limit to make contributions.

Solo 401k vs Roth IRA

  • A solo 401k lets you invest in any asset class (including alternative assets like crypto, real estate, and startups) while a Roth IRA is limited to traditional investments like stocks, bonds, mutual funds, and ETFs.
  • A solo 401k has 10x higher contribution limits than a Roth IRA. For 2024, you can contribute up to $69,000 into a solo 401k ($76,500 if age 50+) while you can only contribute $7,000 ($8,000 if age 50+) into a Roth IRA.
  • A solo 401k has no income limits. Any business owner or self-employed individual can make contributions as long as they have on full-time employees.
  • Some solo 401k plan providers will let you take out a solo 401k loan. If available, you can borrow up to 50% of your account balance up to a maximum of $50,000. There are no credit checks, and you’ll have 5 years to pay it back.

Rollover options

When performing the backdoor Roth IRA conversion, you have several different options to choose from when moving the funds from your traditional or non-deductible IRA to your Roth IRA.

  1. Same trustee transfer – If your plan provider for your traditional or non-deductible IRA and Roth IRA are the same, the simplest method is the “same trustee transfer”. Your plan provider will simply move the funds from your traditional or non-deductible IRA to your Roth IRA.
  2. Direct rollover – If your plan provider for your traditional or non-deductible IRA and Roth IRA are different, a direct rollover could be performed. Your traditional or non-deductible IRA plan provider will send the money directly to your Roth IRA plan provider.
  3. Indirect rollover – This is the least recommended method because it opens you up to penalties. In an indirect rollover, your IRA plan provider will send you the money first (withholding 10% of the funds). Once you receive the money, you’ll have 60 days to deposit the money in full to your Roth IRA. 10% of the funds get withheld, and you’ll have to come up with the withheld amount on your own from other sources in order to make the full deposit. This method is only recommended if you need a short-term loan by accessing your funds, since the IRS lets you do whatever you want with the money as long as it’s deposited within 60 days.

Also read: Transfer vs Rollover: Main Differences

How much can I put into my Roth IRA each year using a backdoor?

You can put in up to the IRA contribution limits for the year. A traditional and Roth IRA both have contribution limits of $6,000 for 2022 and $6,500 for 2023. If you’re at least 50 years of age, your limits are $7,000 for 2022 and $7,500 for 2023. Contribution limits are aggregated between all individual retirement accounts.

How do I set up a backdoor Roth IRA?

To implement the backdoor Roth IRA strategy, you’ll need to have both a traditional IRA (or a non-deductible IRA) and a Roth IRA. You can technically establish both accounts during the backdoor IRA process, but it can be simpler if you create them beforehand.

Once you have both accounts, here’s how it works.

  1. Make your contributions to a traditional IRA or non-deductible first. You can contribute up to $6,500 ($7,500 if age 50+) for 2023 and up to $7,000 ($8,000 if age 50+) for 2024.
  2. Immediately convert your contributions to your Roth IRA.
  3. If rolling over from a traditional IRA, prepare to pay taxes on the converted amount on your next tax return.
  4. You can now invest the money in your Roth IRA.

Once the money gets converted to your Roth IRA, you can start investing the money. All of your earnings are now tax-free, even when you make withdrawals in retirement.

When can I withdraw from a Roth IRA?

A Roth IRA typically lets you withdraw your contributions (not earnings) from your account at any time, without any penalties or taxes. You can withdraw earnings from your Roth IRA when you reach the age of 59½ and your Roth IRA is at least 5 years old (at least 5 years must have passed since you made your first contribution).

When can I withdraw my conversions?

Withdrawals of conversions or rollovers are treated differently from earnings or contributions, and follow a separate 5-year rule. Once your conversion is successful, the 5-year clock starts. Once the 5 year period is over, you can withdraw the amount of the conversion without penalties or taxes, but not the earnings.

Therefore, a backdoor Roth IRA could be a suitable option if you plan on withdrawing the funds after 5 years. Since a traditional IRA does not allow you to take any money out until after the age of 59½, making the same withdrawal from a traditional account would result in an early distribution penalty of 10% plus income taxes.

No RMD for a Roth IRA

Another benefit of doing a backdoor Roth IRA is that you have no required minimum distributions. With a traditional IRA, you’re required to start taking distributions each year once you turn 73 years old. You must take continue taking distributions every year until your account is emptied. With a Roth IRA, you do not have any RMD rules and can keep your money compounding tax-free as long as you’re alive.

Report the Contribution and Conversion on Your Taxes

Lastly, when performing a backdoor Roth IRA conversion, it’s crucial to accurately report both the non-deductible contribution to your Traditional IRA and the subsequent conversion to your Roth IRA. This process requires filing IRS Form 8606. Form 8606 is used to report non-deductible contributions to a Traditional IRA as well as conversions from a Traditional to a Roth IRA.Here’s what you need to know about reporting your backdoor Roth IRA:

  1. Form 8606: This form is essential for documenting both the non-deductible contribution and the conversion.
  2. Traditional IRA Contribution: Report your non-deductible contribution to the Traditional IRA in Part I of Form 8606.
  3. Roth IRA Conversion: Document the conversion from the Traditional IRA to the Roth IRA in Part II of Form 8606.
  4. Additional Documents: You may also need to provide other supporting documents, such as Form 1099-R (which reports the distribution from your Traditional IRA), and Form 5498 (which reports IRA contributions).
  5. Tax Implications: Be prepared to pay taxes on any earnings that occurred between the time you made the Traditional IRA contribution and when you converted it to a Roth IRA.

Working with a tax professional or using reputable tax-filing software can help ensure that Form 8606 is completed correctly and that both the contribution and conversion amounts are properly documented. This is particularly important as failing to report these transactions can result in penalties from the IRS.By accurately reporting your backdoor Roth IRA, you’ll avoid potential issues with the IRS and ensure that you’re able to take full advantage of the tax benefits offered by this strategy.

Start your backdoor IRA conversion

With Carry, backdoor IRA conversions can be done completely online in just a few clicks. And, you have the option to rollover your funds into a regular IRA for investing in traditional assets or a self-directed IRA for investing in alternative assets. Click here to learn more about Carry IRAs.