Backdoor Roth IRA: How It Works and How to Set One Up

Roth IRAs have annual income limits, which means that not everyone is able to contribute to one. However, there is a way for high earners to sidestep this requirement.

A backdoor Roth IRA is a conversion strategy that allows high earners to open a Roth IRA despite IRS-imposed income limits. Completing the backdoor Roth IRA strategy begins with putting money in a traditional IRA, then converting the contributed funds into a Roth IRA, and finally paying taxes.

Once your money is in the backdoor Roth IRA, it grows tax-free — and that's a pretty sweet perk when it comes time to make withdrawals in retirement.

» Learn more: Roth IRA income limits and contribution limits

Here’s a step-by-step guide on how to do a backdoor Roth IRA conversion:

1. Put money in a traditional IRA. You might already have an account, or you might need to open one and fund it.

2. Convert your contribution to a Roth IRA. Your IRA administrator will give you the instructions and paperwork. If you don’t already have one, you’ll open a new Roth IRA during the conversion process. If you'd rather have someone take on this work for you, some financial advisors offer support in handling backdoor Roth conversions for their clients. When it comes to rolling over your money, you can choose to convert any amount you'd like — rollovers are not subject to the annual $7,000 limit.

3. Prepare to pay taxes. Only post-tax dollars go into Roth IRAs. So, if you deducted your traditional IRA contributions and then decide to convert your traditional IRA to a backdoor Roth, you’ll need to be prepared to pay income tax on the money you converted to a Roth. Read further for details on the pro rata rule, which plays a big part in determining your tax bill.

» See our list of the best IRA providers

Keep these rules in mind to avoid penalties:

Only certain types of transfers are allowed

The conversion needs to be one of the following:

• A rollover, where you receive the money from your traditional IRA and deposit it into the Roth IRA within 60 days.

• A trustee-to-trustee transfer, where the traditional IRA provider sends the money directly to your Roth IRA provider.

• A "same trustee transfer," where your money goes from the traditional IRA to the Roth at the same financial institution.

There's a pro rata rule for backdoor Roths

The IRS requires rollovers from traditional IRAs to Roth IRAs to be done pro rata. Here's how it works: When determining your tax bill on a conversion from a traditional IRA to a Roth IRA, the IRS is going to look at all of your traditional IRAs combined.

If all of your traditional IRAs combined consist of, say, 70% pretax money and 30% after-tax money, that ratio determines what percentage of the money you convert to a Roth is going to be taxable. In this example, no matter how much money you convert or which IRA you pull the money from, 70% of the amount you convert to the Roth will be taxable. You can't choose to convert only after-tax money; the IRS won't allow it^[0]

And a word about timing: the IRS applies the pro rata rule to your total IRA balance at year-end, not at the time of conversion.

Not always. A backdoor Roth IRA may not be a good idea if:

• The only way you can pay the taxes due is with money from your IRA withdrawal. Not only are you sacrificing any future investment growth on that money, but there's also the risk that, if you're under age 59 ½, you'll owe a 10% early withdrawal penalty on that money^[0]

  IRS. Retirement Topics - Exceptions to Tax on Early Distributions. Accessed Apr 8, 2022.

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• You'll need the money in five years or less. Money converted from an IRA to a Roth IRA falls under a Roth five-year rule: If you don't wait five years to withdraw it, you could owe taxes and a 10% penalty.

• The withdrawal from your IRA will push you into a higher income tax bracket. It's generally a good idea to convert just enough that you're not pushed into paying a higher tax rate that year.