Have You Considered a Backdoor Roth IRA Conversion?

02 December 2024

Traditional IRAs are a well-known, tax-deferred retirement saving vehicle. But they come with a major downside: You're taxed on withdrawals. Roth IRAs eliminate this downside. You can take federal-income-tax-free qualified withdrawals, but the trade-off is that contributions to Roth accounts don't reduce your current-year taxable income.

If you want to jump on the Roth IRA bandwagon, there are two ways to get money into a Roth account. First, you can make annual contributions. However, there are limitations on annual contributions, which leave many high earners in the cold. (See "Can You Make Annual Roth IRA Contributions for 2024 and 2025 Without Using the Backdoor Strategy?" below.)

The second way to get money into a Roth IRA is to convert a traditional IRA into a Roth IRA. This conversion option can be repeated annually with so-called "backdoor" Roth conversions.

Backdoor conversions have recently received considerable media attention, but they require careful consideration. Here's what you need to know before attempting this strategy.  

2 Key Advantages of Roth IRAs

The first step in deciding whether a backdoor Roth IRA conversion makes sense for your situation is understanding why Roth accounts are beneficial. There are two main tax advantages:

1. Tax-free treatment for qualified withdrawals. Unlike qualified traditional IRA withdrawals, qualified Roth IRA withdrawals are federal-income-tax-free. This is particularly advantageous if you expect to be in a higher tax bracket when you retire than you're in currently. A qualified Roth withdrawal is one taken after meeting two requirements:

• You've had at least one Roth IRA open for over five years, and
• You've reached age 59½, become disabled or died.

The five-year requirement begins the first day of the tax year during which you initially contribute to a Roth account. This can be a regular annual contribution or a contribution from converting a traditional IRA into a Roth account.

2. Exemption from the RMD rules. The original owners of Roth IRAs aren't required to take annual required minimum distributions (RMDs) from their accounts. In contrast, owners of traditional IRAs must take annual RMDs starting at age 73, and those RMDs will be at least partially taxable.

That means you can leave Roth accounts set up in your name untouched for as long as you live, making them valuable tools for transferring wealth to heirs. After you die, your Roth IRA beneficiary (or beneficiaries) must follow the same RMD rules that apply to inherited traditional IRAs.

Under those rules, if your surviving spouse is the sole beneficiary of the Roth IRA, he or she can treat the inherited account as his or her own Roth account. Thus, your surviving spouse can leave the account untouched for life, and it can continue earning tax-free income and gains while open.  

Under the RMD rules, if a nonspouse beneficiary inherits your Roth IRA, the beneficiary can keep the account open for up to 10 years. It can continue earning tax-free income and gains during that 10-year period. However, by the end of the tenth year following the account holder's death, most nonspousal beneficiaries must empty the inherited Roth IRA.

There are exceptions for certain "eligible designated beneficiaries," such as minors, disabled or chronically ill individuals, and beneficiaries not more than 10 years younger than the account holder. Contact your tax advisor for more details.  

How a Backdoor Roth IRA Conversion Works

Backdoor Roth IRA conversions become an option if you have enough earned income to make nondeductible contributions to a traditional IRA but your income is too high to make annual Roth IRA contributions. There are no income-based limitations on making annual nondeductible traditional IRA contributions.

For 2024 and 2025, you can make nondeductible contributions of up to $7,000 to a traditional IRA ($8,000 for people age 50 and older). The limits are doubled for married couples. For instance, if both spouses are age 50 or over at the end of the year, a combined total of up to $16,000 can be contributed ($8,000 to each spouse's account). However, you must have enough earned income to at least equal your nondeductible contributions. That earned income can come from either spouse or both.

After you make your nondeductible contribution to the traditional IRA, you can immediately convert your newly funded traditional IRA into a Roth IRA. Making a nondeductible contribution to a traditional IRA gives you a tax basis in the account equal to the nondeductible contribution amount. Therefore, the conversion won't trigger any taxable income.

But there's an important caveat: You can't have other traditional IRAs that were funded with deductible contributions or that have accumulated account earnings. In other words, if your only traditional IRA is the one you just funded with a nondeductible contribution, immediately converting that account into a Roth IRA will be a tax-free transaction.

Reality Check

You may have one or more traditional IRAs with balances from deductible contributions and/or accumulated account earnings. If so, converting the traditional IRA account that you just funded with a nondeductible contribution won't be a totally tax-free deal.

Important: You must count any SEP-IRAs or SIMPLE-IRAs set up in your name as traditional IRAs. If you have those types of accounts, their balances will include deductible contributions and almost certainly accumulated earnings.

Calculating the taxable income triggered by converting the traditional IRA that you just funded with a nondeductible contribution depends on the aggregate balance of the following:

• All your traditional IRAs (including any SEP-IRAs or SIMPLE IRAs) on the conversion date, and
• The aggregate amount of all nondeductible contributions to those accounts on that date.

Accounts set up in your spouse's name don't affect your calculation.

Hypothetical Example

Bob has two traditional IRAs:

1. IRA A has a $50,000 balance from deductible contributions and earnings, and
2. IRA B has a $50,000 balance consisting of $15,000 of nondeductible contributions and $35,000 of deductible contributions and earnings.

On December 15, 2024, Bob funds a new traditional IRA (IRA C) by making a $7,000 nondeductible contribution. He immediately converts that account into a Roth IRA. The conversion is treated as a distribution from traditional IRA C into a new Roth IRA. This is a backdoor Roth IRA conversion. But it's not tax-free even though traditional IRA C's entire balance was from a nondeductible contribution. Here's why.

Immediately before the backdoor conversion, Bob had three traditional IRAs with a combined balance of $107,000 ($50,000 plus $50,000 plus $7,000). The accounts have a combined tax basis of $22,000 ($15,000 from IRA B and $7,000 from IRA C). The remaining balance from deductible contributions and earnings is $85,000 ($107,000 minus $22,000).

The $7,000 deemed distribution from the backdoor conversion of traditional IRA C is 20.56% tax-free ($22,000 divided by $107,000). The remainder (79.44%) is taxable. So the backdoor conversion triggers $5,561 of taxable income (79.44% times $7,000).

However, if Bob had previously converted all his traditional IRAs into Roth accounts, his backdoor Roth IRA conversion would be tax-free. That's because his converted traditional IRA had a $7,000 tax basis from the nondeductible contribution.

What's Right for Your Situation?  

A backdoor Roth IRA conversion can be a tax-smart move for retirement planning and wealth management purposes. The rules are more complicated when you have certain tax-deferred retirement accounts that haven't yet been converted to Roth status — but it still might be a viable option, depending on your circumstances.

If you're interested in this strategy, contact your tax advisor to discuss the pros and cons. However, time is limited: The deadline for making a nondeductible traditional IRA contribution for the 2024 tax year is April 15, 2025. After making the contribution, you can implement the backdoor conversion strategy if that makes sense in your situation.

Can You Make Annual Roth IRA Contributions for 2024 and 2025 Without Using the Backdoor Strategy?

Annual contributions to Roth IRAs are subject to the same low annual contribution limit as traditional IRAs. The maximum annual contribution for both traditional and Roth IRAs is $7,000 for 2024 and 2025 ($8,000 for people age 50 and older). The limits are potentially doubled for married couples. For instance, if both spouses are age 50 or over as of year end, a combined total of up to $16,000 can potentially be contributed ($8,000 to each spouse's account).

There are several additional restrictions. First, you must have earned income, as defined, at least equal to the amount contributed for the year. If you're married, the requisite earned income can come from either spouse or both spouses. In other words, both spouses don't need to have earned income. They just need enough total earned income to equal or exceed their combined IRA contributions. 

Additionally, your annual Roth IRA contribution limit is reduced by any traditional IRA contributions you make for the year. Finally, the privilege of making annual Roth IRA contributions can be phased out depending on your adjusted gross income (AGI).

The annual Roth IRA contribution phaseout ranges for 2024 and 2025 are as follows:

Filing Status	2024 AGI Phaseout Range	2025 AGI Phaseout Range
Single and head of household	$146,000 – $161,000	$150,000 – $165,000
Married filing jointly	$230,000 – $240,000	$236,000 – $246,000
Married filing separately*	$0 – $10,000	$0 – $10,000

*For a married individual filing a separate return, the phaseout range isn't subject to an annual cost-of-living adjustment.

If you have substantial annual income, these AGI limits can eliminate your ability to make annual Roth IRA contributions — unless you use the backdoor conversion strategy. (See main article.) 

Important: The income limits for making annual deductible traditional IRA contributions are even lower than those for annual Roth IRA contributions.

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