What Is a Backdoor Roth IRA?


Want to contribute to a tax-free Roth IRA but exceed the income limits?
While you may not be allowed to make a Roth IRA contribution, you may be able to fund your account by way of what’s called a backdoor Roth conversion.
To help you determine whether this strategy is right for you, today we’re answering the question, “What is a backdoor Roth IRA?”
We’ll also be looking at how to do a backdoor Roth IRA conversion and important tax considerations, along with various considerations for initiating a Roth conversion. So let’s dive in.
Once your earnings exceed the income limits set by the IRS (more on those in below), the only way to add funds to a Roth IRA account is through a backdoor Roth. Also called a Roth conversion, a backdoor Roth IRA involves transferring funds from a tax-deferred retirement account—typically a traditional 401(k) or IRA—to a tax-free Roth IRA.
Typically, this involves paying a one-time tax on the amount to be converted. Because the transfer is considered income on that year’s taxes, some investors will do a series of backdoor Roth conversions over several years to avoid the additional income pushing them into a higher tax bracket.
However, it’s also possible to contribute money to a traditional IRA and then, within the same tax year, convert that money to a Roth IRA without paying taxes on the conversion. In this case, you just wouldn’t write off the contribution to the traditional IRA on your tax return.
In any event, the backdoor Roth IRA conversion deadline under either scenario is December 31 of each tax year.
Unlike traditional IRAs and 401(k)s, Roth retirement accounts are funded with after-tax funds. The trade-off is that Roth distributions are completely tax-free upon reaching 59 ½ years of age (so long as you’ve had an open Roth account for at least five years). Traditional IRA and 401(k) contributions, on the other hand, are tax-deductible while distributions are subject to income taxes.
Considering taxes are historically low, it’s easy to see how a Roth IRA could pay off big. Especially if you expect to earn more at the time of withdrawal or believe taxes will be higher in the future. And with many of the provisions in the 2017 tax cuts set to expire in 2025—not to mention that the US national debt is at an all-time high—it’s not crazy to think that taxes may be higher in the future.
There’s also another reason you might want to consider a backdoor Roth conversion: Portfolio diversification. If all of your investment funds are allocated to traditional assets like stocks and bonds, you might want to consider allocating a portion of your funds to alternative investments.
Alternatives are assets that exist outside the public markets, and can include private credit, venture capital, real estate, and even fine art. Due to the fact that they exist outside traditional markets, alternatives tend to be less correlated with public equities, meaning they can help hedge against market volatility. Some, like investments in pre-IPO startups, may even offer the potential for outsized returns.
Historically, these investments have been unavailable for most retirement investors. Fortunately, investors today have more opportunities to diversify their portfolios via what’s called a self-directed IRA, making them a prime candidate for a backdoor conversion.
However, not everyone is eligible to contribute to a Roth directly.
In 2023, the maximum yearly IRA contribution is $6,500, with those over 50 allowed to contribute up to $7,500 per year. However, whether you’re eligible to contribute to a Roth IRA depends on your modified adjusted gross income (MAGI):
Beyond these respective amounts, you cannot contribute to a Roth IRA. However, even if you can’t make regular contributions, it is still possible to add funds via a backdoor Roth.
Read more: Am I Eligible for a Roth IRA?
A backdoor Roth IRA gives you all the same benefits of a Roth IRA. Namely, as long as you’re eligible to take distributions, you’ll never pay taxes on gains or distributions.
There are other benefits to a Roth conversion, though.
Unlike with a traditional IRA, Roth IRA holders are not required to begin taking distributions at age 73. In fact, you don’t even have to take distributions during your lifetime, meaning you can leave your Roth IRA to your heirs. No wonder The Motley Fool calls Roth IRAs a “generational wealth secret.”
Still, just because distributions are tax-free does not mean that this strategy is right for you.
If you’re investing your IRA in alternative assets that you expect to yield big returns or which require a substantial investment minimum, or you anticipate that your taxable income will be higher in the future, it might make sense to take the one-time tax hit and convert your tax-deductible retirement funds into a Roth IRA. However, the same isn’t true for everyone.
Keep in mind that a backdoor Roth conversion:
Let’s say you want to convert your current balance of $5,000 from your traditional IRA into a backdoor Roth. Should you convert the entire amount in a single tax year, you will show $5,000 of additional income on your taxes for the year.
Assuming you are single or married but file separately with a salary of $42,000, the backdoor IRA conversion will push your total income to $47,000—just above the $44,725 maximum for your tax bracket (as of 2023). As a result, your income tax rate will increase from 12% to 22% for the year.
Because of these and other considerations, it’s always a good idea to consult with a trusted financial or tax advisor to determine the best strategy for you.
Whether you’re looking for a way to increase your Roth IRA investment funds, have a traditional IRA that you’d like to switch to a Roth, or are looking for a savvy way to use your 401(k) from a previous job, a backdoor Roth conversion could be a worthwhile strategy for you.
If you’re looking to invest your converted funds into non-stock assets like startups, cryptocurrency, venture capital, and real estate, Alto can help you convert your traditional IRA or 401(k) to a Roth IRA or Roth CryptoIRA.
To start investing in alternative assets using an IRA, open an Alto IRA or CryptoIRA.
Originally published October 12, 2021
Did you or your spouse get a raise? It could affect your eligibility to contribute to a Roth IRA. Here's how to calculate your MAGI to determine whether you're eligible.
Tax savings, quick and easy tax reporting, and portfolio diversification are 3 of the top reasons to consider investing in a Roth Crypto IRA.
If recently resigned from a job, you may be wondering what to do with your old 401(k). Today, we'll discuss rollovers and other ways to contribute to an IRA.