Saving for retirement is important for everyone. It’s difficult to live off Social Security benefits alone, so most people will need to supplement their retirement income with their own savings.
Many people have access to retirement plans like 401(k)s through their employers. If you don’t have access to a 401(k), or simply want to save more or have more control over your retirement savings, you might consider opening an Individual Retirement Account (IRA).
An IRA is a special type of account that is designed for retirement savings. You can open IRAs at many banks and with most brokerage companies. If you put money in an IRA, you can receive tax benefits, but you also restrict your ability to withdraw that money.
One drawback of traditional IRAs and Roth IRAs is that they limit the amount you can contribute and exclude some people from contributing based on their income. However, there are ways to get around these limits.
What Is a Roth IRA?
For Roth IRAs, you pay taxes as normal when you contribute money to the account. However, withdrawals from the account are completely tax-free. That means you don’t have to pay any tax on your investment gains or dividends you receive in the account.
This means that using a Roth account can save you a lot of money in taxes compared to investing in a taxable brokerage account, depending on the tax rate you pay.
For comparison, a traditional IRA lets you deduct your contributions from your income, reducing your income tax bill immediately. However, you have to pay income tax on all the money you withdraw, including earnings, meaning you are deferring your taxes to a later date.
Roth IRAs are designed for retirement savings, so there are rules about withdrawing from the account.
Because you’ve already paid taxes on the money you contribute to a Roth IRA, you can withdraw contributions without penalty or taxation. However, the earnings in the account — the gains from your investment activities — are subject to penalties if you withdraw them before you turn 59 ½.
If you’ve had the account open for fewer than five years, you have to pay a 10% penalty and income tax on any earnings you withdraw. If you’ve had the account open for at least five years, you may be able to avoid taxes but will have to pay the 10% penalty on early withdrawals.
In some situations, such as paying for a first-time home purchase or paying for medical expenses, you may be able to avoid these taxes and penalties.
Once you turn 59 ½, you can make withdrawals from the account freely as long as it has been open for at least five years.
Roth IRA Contribution and Income Limits
The government places limits on the amount of money that you can contribute to a Roth IRA each year. The limits are based on your age and your income. These rules are to prevent high-income people from avoiding too much tax.
In general, for 2021, you can contribute up to the lesser of your taxable income for the year or $6,000. If you are age 55 or older, you can contribute an additional $1,000.
If you have a high enough income, the amount that you can contribute will begin to decrease until it reaches $0. The income maximum varies depending on your filing status.
| Full Roth IRA Contribution Allowed | Partial Roth IRA Contribution Allowed | No Roth IRA Contribution Allowed | |
| Single or Head of Household tax filing status | Earned less than $125,000 | Earned $125,000 to $139,999 | Earned $140,000 or more |
| Married, filing separately tax filing status, did not live with spouse during the year | Earned less than $125,000 | Earned $125,000 to $139,999 | Earned $140,000 or more |
| Married, filing separately tax filing status, did live with spouse during the year | N/A | Earned $0 to $9,999 | Earned $10,000 or more |
| Married, filing jointly, or qualified widower tax filing statuses | Earned less than $198,000 | Earned $198,000 to $206,999 | Earned $207,000 or more |
These income limits use your modified adjusted gross income (MAGI), which is your gross income minus certain deductions such as contributions to employer retirement plans and student loan interest.
What Is a Backdoor Roth?
A backdoor Roth is a financial planning strategy high-income-earners use to get around the income limits on Roth IRA contributions. They can do this by contributing to a traditional IRA and then converting the balance to a Roth IRA.
Imagine that you’re fortunate enough to have an income of $150,000 as a single person. You probably have a good amount of money to invest for retirement, but the government won’t let you contribute to a Roth IRA.
Savers can use a backdoor Roth IRA conversion to get around Roth IRA income limits. Traditional IRA contributions, unlike Roth IRAs contributions, are not limited by your income.
That means that you can contribute money to a traditional IRA no matter how much you make, and then roll those funds into a Roth IRA.
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How to Make Backdoor Roth Contributions
Making a backdoor Roth contribution is relatively easy.
1. Contribute to a Traditional IRA
To start, contribute the amount that you want to put in your Roth IRA to a traditional IRA.
When you contribute money to a traditional IRA, you can usually deduct those contributions from your income when you file your tax return. However, like Roth IRAs, there are income maximums for deducting traditional IRA contributions.
If you make more than the maximum allowed, you can still contribute to a traditional IRA, but you cannot deduct that contribution from your income when filing your tax return.
Because you’re rolling your money into a Roth IRA anyway, you’ll have to pay taxes, meaning you don’t have to worry about making too much to take the deduction.
2. Roll Your Traditional IRA Into a Roth IRA
Once you’ve contributed to an IRA, you want to roll that money into a Roth IRA.
A rollover lets you convert some or all of your traditional IRA balance into a Roth IRA balance. In effect, you can completely dodge the income limit for Roth IRA contributions using this strategy. Your broker can typically help you with the rollover process, making it relatively easy.
When you roll your traditional IRA’s balance into a Roth IRA, you pay income taxes on the amount you roll over.
The Pro-Rata Rule
Before you make a backdoor Roth contribution, you need to keep in mind one rule surrounding traditional IRAs and rollovers: the pro-rata rule.
To understand the pro-rata rule, picture your traditional IRA as having two buckets. One bucket includes money you deducted from your income and thus haven’t paid taxes on yet. The other includes money you contributed that you could not deduct from your income, possibly because you made too much money that year.
You need to track the buckets separately because although you have to pay income tax on pre-tax contributions when you withdraw them, you don’t have to pay them on post-tax contributions. If you did, you’d be paying taxes on the same income twice.
The pro-rata rule states that you must roll a proportional amount of each bucket into a Roth IRA when performing a rollover, meaning you can’t choose which bucket of money to roll over. This can have significant tax implications depending on how much pre-tax money you already have invested.
Avoiding the Pro-Rata Rule
The only way to avoid the pro-rata rule is to roll over your entire traditional IRA balance. If you make too much to contribute to a Roth IRA in the first place, you’re in a high tax bracket, resulting in a large tax bill as part of the rollover if you already have funds in your traditional IRA.
Keep in mind, the pro-rata rule looks at all of your IRAs and other pre-tax accounts, even if you keep them at different brokerages. You can’t open accounts in different places to dodge the rule.
3. Pay the Taxes Owed
When you roll money from a traditional IRA, you have to pay income tax on the money you roll over, unless the rollover is entirely composed of nondeductible contributions. If you’re rolling a large amount, you’ll want to have some money set aside to cover this cost.
To keep costs low, it might be worth timing your rollover for a year where your income is low, which means you’ll be in a lower tax bracket when you owe the tax on the amount rolled from your traditional to your Roth IRA.
Ultimately, backdoor Roth IRA contributions work best if you have little or no money in your traditional IRA. Asking a tax professional or a financial planner is a good idea if you want help with the process.
Advantages of Backdoor Roth Contributions
There are a number of reasons to consider backdoor Roth contributions.
1. Avoid Income Limits
The obvious benefit of backdoor Roth contributions is that they let you get around the income limits imposed by the IRS.
If you make too much to contribute to a Roth IRA, you probably have some extra money to save for the future. A backdoor Roth lets you get all of the advantages of a Roth IRA despite the income limits.
2. Tax-Free Growth
Money in a Roth IRA grows tax-free. You don’t pay taxes when you take money out of the account and the money you earn from your investments isn’t taxed either.
If you’re planning to invest the money anyway, by putting it in a Roth IRA, you’re getting the benefit of tax-free growth and only losing the freedom to withdraw earnings before you turn 59 ½.
Disadvantages of Backdoor Roth Contributions
Before using a backdoor Roth, consider these drawbacks.
1. Complexity
Making backdoor Roth contributions involves a few steps. You have to put money into a traditional IRA, then initiate a rollover to a Roth IRA.
If you have your traditional and Roth IRAs at the same company, your brokerage can probably help with the process, but there are a few moving parts.
You also have to make sure you submit the correct forms when you file your taxes to indicate your contributions and rollovers.
2. Combining Pre- and Post-Tax Money Is Messy
The pro-rata rule for rollovers means that backdoor Roth contributions work best if you don’t have any money in a traditional IRA.
If you do have some funds in your traditional IRA and don’t want to move the full balance of the account to your Roth IRA, you’ll be rolling a combination of pre- and post-tax funds into your Roth and leaving a combination of both in your traditional IRA.
This means you have to be diligent with your recordkeeping to make sure you don’t pay taxes on your post-tax traditional IRA funds when you withdraw money from the account in retirement.
You also have to pay taxes on any money rolled from a traditional IRA to a Roth IRA in the year you perform the rollover, which you need to plan for.
The Mega Backdoor Roth
Related to the backdoor Roth IRA is the mega backdoor Roth IRA. In rare cases, people can use a quirk of their 401(k) plan to get past the Roth IRA contribution limit, putting tens of thousands of dollars into their Roth IRAs each year.
401(k) Contribution Limits
A 401(k) is a retirement plan provided by employers as a benefit for their employees. One of the advantages of 401(k)s is their much higher contribution limits compared to IRAs.
For 2021, the individual limit for a 401(k) is $19,500 when it comes to deducting contributions from your taxes.
However, the true limit for 401(k)s is triple that number, $58,500. This limit includes all contributions made by the individual and their employer. Employees can deduct the first $19,500 they contribute and employers can contribute another $39,000 without the employee paying taxes on those employer contributions.
A small number of employers allow their employees to make post-tax, non-Roth contributions to their 401(k)s. This is like making nondeductible contributions to a traditional IRA.
You put money into the 401(k) but still pay taxes on the contributions. If your employer allows these types of contributions, you can add your own post-tax money to the account up to the $58,500 limit.
Typically, when you leave an employer, you can roll the balance of your 401(k) into your IRA. Most employers don’t let you roll your 401(k) into an IRA or make withdrawals from the account while you’re still employed. However, a small number of employers do allow these in-service distributions.
Performing a Mega Backdoor Roth Rollover
If your employer lets you make both post-tax, non-Roth contributions and allows in-service distributions, you have access to the mega backdoor Roth IRA.
To make a mega backdoor Roth contribution, contribute post-tax, non-Roth funds to your 401(k), then perform an in-service rollover of that money from your 401(k) to your Roth IRA.
Using this strategy, you can put as much as $39,000 extra into your Roth IRA each year, increasing your tax-advantaged investments by a huge amount.
Unfortunately, 401(k) plans that allow both post-tax, non-Roth contributions, and in-service distributions are incredibly uncommon, meaning that most people won’t be able to use this strategy.
However, if you run your own business or are self-employed, there’s nothing stopping you from designing your retirement plan to offer these options.
Final Word
Roth IRAs are one of the best ways to save for retirement, but if you make too much money, the IRS won’t let you contribute to the account.
For those with incomes high enough that they can’t contribute to a Roth IRA but who want to save more toward retirement, a backdoor Roth IRA contribution can help get around the limits.
If you’d rather keep the money out of retirement accounts and easy to access, you can always consider opening a taxable brokerage account. If you’re a hands-off investor, you can also think about using a robo-advisor to manage your portfolio.
