Backdoor Roth: Not so “Hush-Hush”

February 02, 2024
  • If your Modified Adjusted Gross Income (MAGI) is too high to make direct Roth IRA contributions, backdoor Roth contributions can be made.
  • Be aware of pro-rata taxation of pre-tax IRA assets when implementing backdoor Roth.
  • Backdoor Roth contributions may be optimal once other retirement savings options (i.e. 401k’s and/or HSA’s) have been maximized.
  • Federal tax legislation has confirmed the legitimacy of backdoor Roth contributions.

Of all the ways to save for retirement, backdoor Roth is possibly one of the most misunderstood. Perhaps it is the terminology “backdoor,” which is associated with something that is secret, hush-hush, or downright improper. Who wants to consider making a “hush-hush” contribution? Let us dive into the details of this retirement savings option and explain why it may not be so “hush-hush” after all.

Put simply, a backdoor Roth contribution allows individuals to add funds to a Roth IRA if MAGI is too high to contribute directly to a Roth IRA. For 2024, individuals are phased out for direct Roth IRA contributions if MAGI is in excess of $161,000 (single filing) or $240,000 (married filing jointly). Roth IRA contributions are contributed post-tax but potentially grow tax-free.

Processing a backdoor Roth contribution is somewhat roundabout (thus the “backdoor” terminology). The process involves: 1) making a traditional non-deductible IRA contribution ($7,000 maximum contribution in 2024 [$8,000 if age 50+]; you must have earned income to be eligible to make an IRA contribution); 2) converting the contribution to Roth; and 3) reporting the backdoor Roth contribution properly on your tax return.

A backdoor Roth contribution is not taxable if you do not own pre-tax IRA assets, but if you do own pre-tax IRA assets, you may want to tread carefully. Pre-tax IRA assets include deductible traditional IRA contributions and earnings, SEP IRAs, and SIMPLE IRAs and are subject to a pro-rata taxation formula upon conversion (step three above). Here is an example of how the formula works:

  • $100,000 in pre-tax IRA assets and a $7,000 backdoor Roth contribution is made
  • $100,000 pre-tax IRA assets ÷ $107,000 total IRA assets = 93% pro-rata taxation
  • $6,510 is taxable as ordinary income ($7,000 Roth conversion x 93% pro-rata taxation)

Once an individual has maximized contributions to tax-advantaged retirement accounts such as a 401k and/or HSA, backdoor Roth may be the next best bet. A common way to avoid pro-rata taxation may be to first roll over pre-tax IRA assets to an employer retirement plan, but this may not be optimal as some plans do not accept incoming rollovers, have high fees, or a subpar menu of investment options.

As far as backdoor Roth contributions being “hush-hush,” 2017 federal tax legislation specifically cited the legitimacy of this maneuver. However, it is important to review your own specific situation before implementing backdoor Roth contributions. As always, please reach out to your valued advisor with any questions.

Securities offered through LPL Financial, Member FINRA/SIPC. Investment Advice offered through WCG Wealth Advisors, LLC, a Registered Investment Advisor. WCG Wealth Advisors, LLC and The Wealth Consulting Group are separate entities from LPL Financial. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. This information is not intended as authoritative guidance or tax advice. You should consult with your tax advisor for guidance on your specific situation. Traditional IRA account owners should consider the tax ramifications, age and income restrictions in regards to executing a conversion from a Traditional IRA to a Roth IRA. The converted amount is generally subject to income taxation. The Roth IRA offers tax deferral on any earnings in the account. Withdrawals from the account may be tax free, as long as they are considered qualified. Limitations and restrictions may apply. Withdrawals prior to age 59 ½ or prior to the account being opened for 5 years, whichever is later, may result in a 10% IRS penalty tax. Future tax laws can change at any time and may impact the benefits of Roth IRAs. Their tax treatment may change.