Backdoor Roth IRA Conversion

If you’re killing it income-wise this year and will be over the income limits for making a Roth IRA contribution, don’t fret. See if a backdoor Roth IRA conversion works for you.

Take the Backdoor

A backdoor Roth IRA conversion allows higher earning taxpayers, those over the Roth IRA income limits and prohibited from contributing, to funnel money into a Roth IRA anyway. I coined this maneuver the ‘ole Roth IRA switcheroo over a decade ago, but the name never caught on.

A backdoor Roth IRA conversion takes advantage of a loophole and funds your Roth IRA via a conversion rather than a direct contribution, thus the backdoor reference. Going through the backdoor has the same result as making direct contributions: Tax-free earnings in your Roth IRA.

Traditional IRAs

You’ll need both a Roth IRA and a traditional IRA to pull off a backdoor Roth IRA conversion. There are 2 types of contributions you can make to a traditional IRA:

  1. Deductible Contributions – Deductible on your yearly income tax return. Principle and earnings are taxable upon withdrawal at ordinary income tax rates. You might have a traditional IRA with these types of contributions from the rollover of a 401(k)-type plan from a previous employer or direct contributions.
  2. Non-Deductible Contributions – Unlike deductible contributions, there are no income limits for making non-deductible contributions. However, as the name implies, tax must be paid on the contribution in the year it’s made. Earnings grow tax deferred and are taxable upon withdrawal, not tax-free like in a Roth IRA. That’s why you want to convert them.

If you or your spouse are covered by an employer retirement plan like a 401(k)-type plan, non-deductible contributions are probably your only traditional IRA option because you make too much money to make a deductible contribution.

The IRS’ Pro-Rata Rule

A backdoor Roth IRA conversion doesn’t make much sense if you have existing deductible contributions in a traditional IRA. The pro-rata rule states you can’t cherry-pick which funds in your traditional IRA(s) you want to convert: You must convert a “pro-rata” portion of your non-deductible and deductible contributions.

For example, assume you’ve got $195,000 of deductible traditional contributions and earnings from your former employer’s 401(k)-type plan rolled over into a traditional IRA. Because you’re over the limits, this year you want to do a backdoor Roth IRA conversion to your Roth IRA with a $5,000 non-deductible traditional IRA contribution.

97.5% (195/200) of the $5,000 conversion, or $4,875, would be subject to ordinary income tax because of the pro-rata rule. More than likely, the last thing you want to do is generate more ordinary income because of your already high marginal tax bracket.

Executing a Backdoor Roth IRA Conversion

If you never had a traditional IRA or have one with no deductible contributions in it, you’re good to go as far as the conversion because there’s nothing to pro-rate. First, make non-deductible contributions to a new or existing traditional IRA, then immediately convert those contributions to your Roth IRA.

The idea is to convert it right away before any earnings are generated. If left to percolate in your traditional IRA, those earningswould be taxable at ordinary income rates upon conversion. It is better to have those earnings accrue in your Roth IRA, whereupon qualified withdrawal of interest, dividends, and capital gains will be 100% tax-free.

Unlike direct contributions to a Roth IRA, which are accessible at any time for any reason with no tax or penalty, converted money won’t be accessible tax and penalty-free until five years have passed since the conversion. Conversions made in different years all have distinct and separate five-year redemption windows. Of course, earnings must be left in your Roth IRA until you’re at least 59 1/2 to be tax and penalty-free upon withdrawal.

If you think the ‘ole switcheroo sounds a bit sneaky and underhanded, you’re not alone. You don’t want to make the IRS angry, right? Don’t worry about it. As of now, it’s 100% legal. Honest taxpayers have been performing backdoor Roth IRA conversions for over a decade with zero consequences.

Contribution Deadline

For 2024, you have until Tax Day, April 15, 2025, to make a 2024 IRA contribution. If you’re contributing between January 1, 2025, and April 15, 2025, be sure the custodian of your account knows the contribution is for 2024, not 2025. Assuming you haven’t already contributed for 2024, you’ll preserve your ability to contribute in 2025, up to the IRA contribution limits.

Choose Your Custodian

You need a traditional IRA and a Roth IRA to perform a backdoor Roth IRA conversion. It’s best to hold them at the same financial institution or custodian. That will reduce the time and hassle of converting from one custodian to another.

If you want to move to a new custodian, do it via a trustee-to-trustee transfer or rollover. Open an IRA at your new custodian and they’ll help you roll over the old one and ensure your tax benefits are not lost.

Be sure your custodian offers free trades and low-cost indexed mutual funds and EFTs (exchange-traded funds). I recommend opening an individual brokerage account that has no broker association. Control your own money. Execute your own trades.

You can keep it simple via my One Stop Shop Investment Plan. Or, if you have the time and interest, you can get more involved with more active investments.

I insist my financial planning clients open similar accounts, even though in the beginning I help them (if necessary) with rebalancing and trades. Eventually, they no longer need my help. Investing simply and for the longer term is not rocket science. Any learning curve is well worth it considering all the money you’ll save.

Besides allowing for zero impropriety, it’s the only way I can remain completely neutral when recommending a brokerage. I receive no compensation, perk, free service, or other benefit from any of my recommended custodians:

iShares®, Vanguard®, Schwab®

What’s a Low Expense Ratio?

There are other worthy custodians besides the ones on my shortlist. Look for the following:

  • free trades and exchanges
  • low expense ratios
  • no other charges except the expense ratios

What’s a low expense ratio? It should start with a “.0”, as in .04% or .08%. Don’t tolerate an expense ratio over .15% for an index fund or ETF.