How to Use a Backdoor Roth IRA (2024)

Christine Benz: Hi, I’m Christine Benz for Morningstar. With the tax deadline fast approaching, many investors are rushing to fund their IRAs. Joining me to discuss the perennially hot topic of backdoor Roth IRAs is tax and IRA expert, Ed Slott.

Ed, thank you so much for being here.

Ed Slott: Well, it’s great to be back with you, Christine. Thanks.

Benz: It’s great to have you here. I want to discuss backdoor Roth IRAs. It’s a perennially hot topic. People wonder whether this is an allowable maneuver. Maybe we can just start by you talking about who should consider it and what a backdoor Roth IRA means.

Slott: Well, first, it is allowable. It’s legal. The reason these questions come up every year because there were rumblings from Congress—“We’re going to stop that”—for years and years. In fact, there was somebody at the IRS that eventually said, “No, we’re OK with that. We just didn’t like the name. It sounded like a workaround.” And they actually said that publicly. So, yes, you can absolutely do it.

So, what is it, a backdoor Roth? You can’t look it up. I can tell you this, there’s nothing in the code, in the tax code that says section so and so, backdoor Roth. There’s nothing. Basically, with Roth IRA contributions, two kinds of Roths: Roth contributions, the annual limits, and Roth conversions, the big money. Roth conversions, where you convert an IRA to a Roth, there’s no income limits. You don’t even have to have earned income. Anybody could convert their IRA to a Roth. So, that’s not what we’re talking about. But if you want to make annual contributions to your Roth, there are income limitations. And they’re very high but still some people are over those limits. And I have the limits in front of me. For example, for 2024, although people might still be making at this point their 2023, but just to give a frame of reference, the ‘24 amount for married joint, like I said, it’s very high, for 2024 if your income is over $240,000 you cannot make a Roth IRA contribution, not conversion. And if you’re single, it’s $161,000, just as a frame of reference. So, if you’re over those limits, and you have earned income, a W-2, a job, self-employment income, you do not qualify for making a Roth IRA contribution. But there are no such limits, and it’s weird, there are no such income limits for making a traditional, not Roth, a traditional IRA contribution.

Now the minute I say this, people will say, “Oh yes, there are income limitations.” Only if you’re active in a company plan and want to deduct that traditional IRA contribution, but that’s not what we’re talking about here. We’re talking about opting for a nondeductible traditional IRA contribution, where you receive no deduction. And then converting those funds, because there’s no income limit for traditional IRA contributions or nondeductible IRA contributions. So, whatever your income is, if you have income, you still have to qualify by having earned income, you can contribute to a traditional nondeductible IRA and then convert those funds to a Roth IRA. So, they end up in the same place, back in the Roth IRA, but they go in as a conversion, not a contribution.

Benz: OK. So, if I go on my investment provider’s website, I’m not going to see a button that says, Backdoor Roth IRA. I need to actually take these two steps.

Slott: I don’t think that would ever pass compliance on anything. Could you imagine Fidelity [having that]? Who knows what the future might be, but I’ve never seen a button like that.

Benz: Right. So, I’m funding my traditional IRA and then I’m converting at some later date to a Roth. The question is, Ed, and I know this has been a little bit of a squishy one where there have been some differences of opinion, how long to wait between those two steps? Can you weigh in on that?

Slott: It’s a gray area. There’s no answer. Here’s my answer. Because originally years ago when this first started, some of the accountants said, “Oh, that’s a step transaction. You can’t do it in one step because you got to a place where you shouldn’t have been.” I don’t think anybody really cares about that anymore. But here’s what I do. To separate the two transactions, that’s the cleanest way that you know it showed up as a nondeductible IRA contribution in your IRA, and then convert it to a Roth rather than doing it in one step. So, here’s my practical advice. If you’re going to make the nondeductible contribution, make it and wait till the next month. And this is not a requirement, just a practical good advice item. Wait till it shows up on your statement for one month as a traditional IRA contribution. Because if you go in and out, who knows how it’s going to show up on the statement. And then once you can produce a month-end statement that had a contribution to a traditional IRA, then convert the next month. That’s it. And this way you have the transactions in two separate months, and you can show them on both monthly statements.

Benz: I want to discuss the tax impact because many people know that conversions oftentimes do lead to some sort of a tax bill. Can you talk about the tax impact of doing these backdoor Roth IRA contributions?

Slott: The tax impact is overrated, but you’re right. That question comes up all the time: “Well, won’t there be tax?” Well, it could be. It depends on how many other IRA funds you have. Because when you convert, you have to take into account all of your other IRAs. A lot of them may be already taxable. You use what they call a pro rata formula.

So, just to give you a simple idea of it, let’s say you have $100,000 in the total of all your IRAs. In other words—and this gets to that issue, too—people say, “Well, can I just convert this? I’ll put it in a separate, traditional, nondeductible, traditional IRA in a secret, undisclosed location, separate from everything, OK? Nobody will see it.” And then I just convert that and pay no tax. You can’t do that if you have other IRAs. Under the tax law, all your IRAs, including SEP and simple IRAs, are considered one IRA. So, let’s say the total of all your IRAs is $100,000, just to make an easy example, and there was basis or other nondeductible aftertax money of $10,000, just to make an easy example in there. So, $90,000 was pretax. So, if you converted the whole $100,000, you’d pay tax on $90,000 and tax-free $10,000. That’s your percentage. So, let’s say you made a contribution for 2024, and the maximum for 2024 is $7,000. Unless you’re 50 or over, you can add another $1,000 catch-up contribution, so $8,000.

So, let’s, say you’re 50 or over. You did $8,000 to a traditional nondeductible IRA. And then you convert the $8,000 to a Roth. Now you might think, well, there’s no tax. Well, if you had that percentage that I just talked about, 90% of it would be taxable, 10% tax-free. But again, you’re not talking about big dollars here because the most it could be is for the annual contribution limit. We’re not talking about a tax, and that’s why people get overwhelmed, “Will I pay hundreds of thousands in taxes?” No. It’s only to the limit, the $7,000 or $8,000. So even if all of it is taxable, that would have been taxable anyway at some point. So, I think it’s an overrated problem. But people should be aware of it because some people are told that it’s going to be tax-free. That would only be the case if you had no other IRAs.

Benz: OK, that’s helpful, Ed. One workaround I sometimes see posited for people in this situation who do have substantial rollover IRA assets is to roll in those funds into a 401(k) and that way they’re excluded from this pro rata calculation that you just walked us through. Does that strategy make sense to you?

Slott: It can, but it’s a lot of maneuvering to save the tax on only, like I said, the $7,000, for example. What you’re talking about is, I call it a reverse rollover. Going back, because most rollovers are 401(k) to an IRA, this would take your IRA and roll it back. Let’s say you have a company plan, a 401(k), and they accept rollovers in. Most do, but they don’t have to. It’s optional. So, let’s say they accept rollovers in. The good part about that is, as you said, it’s an exception to the pro rata rule. The only funds that can be rolled over to a company plan are pretaxed funds. So, if you rolled everything over in my $100,000 example, only $90,000, the taxable amount, would be eligible to be rolled over. That would, what we call, isolate the basis. You’d be left with only aftertax funds in your IRA, and then you could convert those funds tax-free. But it’s a lot of maneuvering, and then the funds that you move back to the 401(k) now, they’re under the regime, the rules of the 401(k). You don’t have the control you had because there could be more restrictions. So, I think it’s a little much just to accomplish that, but yes, it can be done.

Benz: I want to also touch on what’s called the mega backdoor Roth IRA, and I’m hoping you can talk about who should consider that.

Slott: That’s from a company plan where you can actually load up on the aftertax money in a 401(k), let’s say, in a separate 401(k) aftertax account, and convert just that to your Roth IRA and pay no tax. Yes, it can be done. You can bank lots of big money, but for most people, it doesn’t work—especially in big companies, maybe if you’re a smaller company and you have fewer employees—because you have to satisfy discrimination rules and testing rules. And the people that tend to want to do it are people at the high-income people at the company. The big executives want to do that, but they may not be able to—I’m giving you the reader’s digest version of the compensation tests—and it may be that they don’t qualify because not enough lower-income employees are doing it. It’s how many people are doing it. And remember, you have to have the disposable income to do it. A lot of the lower-paid employees can’t do it, so they don’t. And that only leaves the higher-paid people, so they fail the discrimination or the compensation tests.

Benz: And in any case, it sounds like maxing out the 401(k) up until the basic limits should be job one for most employees.

Slott: Oh, yeah, to get the matching and so forth. But the backdoor Roth is still alive, and it’s a great technique for lots of people. I’ll tell you one they miss. I found this every tax season. You have somebody that wants to do that. Let’s say, especially a lot of our viewers, you could have a married couple where one spouse is working and the other one is already retired. You can do the backdoor Roth for the nonworking spouse as long as you have enough income. Most people miss out on that.

So, for example, using the 2024 amounts, which are $7,000 and $1,000, or $8,000, you could put away for 2024—I know people right now might be working on their 2023, but just to give you an example—you could double that even if the nonworking spouse has no earnings as long as there’s enough earnings that you’ve made. And you could double that and put $16,000 away for both spouses. And to me, that’s a freebie. You’re just taking from one pocket taxable money and putting in tax-free for both spouses. Many people don’t realize that they have that ability.

Benz: And that can be a really great strategy for people who are, maybe one partner is already retired, for example.

Well, Ed, it’s great to see you. Always great to get your insights. Thank you so much for being here.

Slott: All right. Thanks.

Benz: Thanks so much for watching. I’m Christine Benz for Morningstar.