Backdoor Roth IRA: What It Is and How It Works

A Roth IRA offers tax-free growth and tax-free qualified withdrawals in retirement - an unusually attractive combination. But the IRS phases out direct Roth contributions above certain income levels. For workers above the phase-out, the "backdoor Roth" strategy uses a legal two-step (contribute to a nondeductible Traditional IRA, then convert to Roth) to reach the same outcome.

The strategy is straightforward but has one important complication - the pro-rata rule - that trips up many first-time users.

Why the backdoor exists

The IRS caps direct Roth IRA contributions above certain income thresholds. However, there is no income limit on either nondeductible Traditional IRA contributions or on Roth conversions. Combining the two lets you effectively contribute to a Roth without going through the front door.

Congress removed the income limit on Roth conversions in 2010 without adding one back. Backdoor Roth contributions have since become standard tax planning for high-income workers who want Roth exposure.

The mechanics

Step one: contribute after-tax dollars to a Traditional IRA (up to the annual IRA limit). Because your income is too high to deduct the contribution, it is a nondeductible contribution. Step two: convert the Traditional IRA balance to a Roth IRA. Because you have already paid tax on the contribution, only any earnings between contribution and conversion are taxable. If you convert soon after contributing, the tax owed is usually zero or trivial.

Report both steps on IRS Form 8606 when you file your taxes. Skipping this form is the most common backdoor Roth mistake and can lead to double taxation if not caught.

The pro-rata rule

The IRS treats all your Traditional IRA balances as one pool for conversion purposes. If you already have pre-tax money in any Traditional IRA (from prior deductible contributions or a 401(k) rollover), the pro-rata rule taxes the conversion based on the ratio of pre-tax to after-tax money across all your Traditional IRAs, not just the account you converted from.

Example: you have $95,000 in a rollover IRA from an old 401(k) (all pre-tax) and make a $5,000 nondeductible contribution. Your total IRA balance is $100,000, of which 95 percent is pre-tax. If you convert $5,000, the IRS considers 95 percent of the conversion ($4,750) taxable, even though the $5,000 you converted was after-tax. This is often a surprise.

Working around the pro-rata rule

The cleanest solution is to have no pre-tax Traditional IRA balance on December 31 of the year you do the conversion. Options include rolling any existing pre-tax Traditional IRA into your current employer 401(k) (if the plan accepts rollovers) or converting the entire pre-tax balance to Roth in one large event (and paying the tax bill). Either eliminates the pro-rata complication for future backdoor Roth contributions.

Is it worth the effort?

For a high-earning worker, a backdoor Roth adds $7,000 to $8,000 of tax-free retirement savings per year. Over a career, that compounds into significant tax-free wealth. Setting up the process cleanly the first year makes subsequent years a 10-minute annual routine.