How To Set Up a Backdoor Roth IRA: A Step-by-Step Guide

What Is a Backdoor Roth IRA?

A backdoor Roth IRA isn’t just a retirement account—it’s a legal loophole that lets high-income earners contribute to a Roth IRA despite IRS income limits. Instead of contributing directly to a Roth, high-income earners contribute to a traditional IRA and later convert it to a Roth. With a Roth IRA, future growth and retirement withdrawals are tax-free, offering significant benefits for those expecting to be in a higher tax bracket in retirement or those wanting to maximize long-term savings.

Key Takeaways

• A backdoor Roth IRA is a strategy for high-income earners to contribute to a Roth IRA despite income limits.
• The process involves opening a traditional IRA, making a nondeductible contribution, and converting it to a Roth IRA.
• Understanding the pro-rata rule and tax implications is crucial to avoid unexpected tax liabilities.
• The five-year rule affects when you can withdraw converted funds without penalties.
• Consulting with financial professionals can help navigate complex rules and ensure compliance.

How a Backdoor Roth IRA Works

The backdoor Roth IRA is an IRS-sanctioned strategy for individuals whose income exceeds Roth IRA limits to get the perks of tax-free growth and tax-free withdrawals in retirement. Additionally, unlike traditional IRAs, Roth IRAs do not have required minimum distributions (RMDs) during the investor’s lifetime, which can benefit anyone wanting to use retirement accounts as an estate planning tool.

The plan is simple: instead of contributing directly to a Roth IRA, high-income earners open and contribute to a traditional IRA with after-tax dollars and convert those funds to a Roth IRA. 

Eligibility and Contribution Limits

Roth IRA income restrictions depend on an investor’s modified adjusted gross income and tax filing status. The IRS publishes annual contributions and income limits, including phase-out ranges, which reduce the contribution amount as income increases. Investors exceeding income limits must use a backdoor Roth IRA strategy instead of contributing directly to a Roth. 

For 2025, investors can contribute directly to a Roth IRA if their earned income falls below these limits:

Step-by-Step Guide to Setting Up a Backdoor Roth IRA

Step 1: Open a Traditional IRA

Start by opening a traditional IRA account through any brokerage firm, financial institution, or even robo-advisor. Once open, you can contribute up to $7,000 for the year (or $8,000 for those 50 and older) to the account. This contribution is made with after-tax dollars and is non-deductible. You report these contributions on Part I of Form 8606 when you file your taxes.

Tip

In this step, you should also open a Roth IRA if you don’t already have one, so there is a place for the funds to go after conversion.

Step 2: Convert to a Roth IRA

After your contributions hit your traditional IRA, you can convert them to a Roth IRA. Converting is another word for moving money from the traditional retirement account to the Roth. When you file your taxes, you report your conversion on Part II of Form 8606.

You don’t have to convert your contributions right away, but converting them before you accrue any income saves you a tax headache in the future. If your traditional IRA earns income before the conversion, you’ll owe taxes at your ordinary tax rate on that growth when you convert to a Roth. Converting quickly before your contributions grow ensures that all future growth happens tax-free in the Roth to maximize your long-term tax savings. 

Step 3: Repeat Annually

If you consistently earn too much to contribute to a Roth IRA directly, consider repeating this process every year. By strategically using a backdoor IRA strategy, you can grow your tax-free retirement income year after year. 

Important Rules and Tax Implications

Pro-Rata Rule

The pro-rata rule is an IRS rule specifically regarding taxing IRA conversions when you have pre-tax and after-tax contributions in tax-advantaged accounts. In these instances, you can’t choose to roll over only after-tax dollars to a Roth; you must roll over amounts proportional to the pre-tax and after-tax dollars currently held across all tax-advantaged accounts. This could lead to a substantial taxable event because you must pay taxes on the pre-tax amounts converted. 

Tip

A workaround for the pro-rata rule involves rolling pre-tax contributions to your traditional IRA into your company-sponsored 401(k) before converting after-tax balances to a Roth.

Five-Year Rule

In direct contribution Roth IRAs, you may not make qualified withdrawals from your Roth IRA until five years after your first contribution. In Roth conversions, each conversion has its own five-year clock. Distributions before the five years have elapsed are subject to a 10% early withdrawal penalty, even if you’re over 59½.

Tax Implications

When utilizing the backdoor Roth IRA strategy, you must account for the nondeductible traditional IRA contribution and the Roth conversion on Form 8606. By accurately reporting this, you can ensure you’re not taxed on the same money twice by incorrectly reporting your non-deductible basis.  

Warning

Remember that if you have any earnings on your traditional IRA before the conversion, those earnings are subject to tax at your ordinary income rate.

When a Backdoor Roth IRA Might Not Be Suitable

A backdoor Roth IRA is an excellent tool for tax savings, but it’s not a one-size-fits-all strategy. A backdoor Roth may not be suitable if:

• You need access to the converted funds in less than five years.
• You have a large existing pre-tax traditional IRA balance (due to pro-rata rules)
• You’re not comfortable navigating the process without a tax professional’s guidance.

In these instances, you may be better off maximizing contributions to retirement plans or utilizing taxable brokerage accounts. Consider consulting a financial planner or CPA to stay current on the latest tax laws. 

What Are the Tax Benefits of a Backdoor Roth IRA Compared to a Traditional IRA?

Backdoor Roth IRAs and traditional IRAs provide investors with tax-advantaged savings opportunities. The difference between the two is when the investor benefits the most. Traditional IRAs offer savings upfront, allowing investors to deduct contributions from taxable income. Backdoor Roth IRAs provide no up-front tax benefits but offer tax-free growth and withdrawals in retirement. 

How Does the Pro-Rata Rule Affect My Existing IRA Accounts?

How the pro-rata rule affects your existing IRA account depends on what you want to do with it. The pro-rata rule only applies to conversions. If you convert an IRA that contains both pre-tax and after-tax contributions, the pro-rata rule will determine how much of the conversion is subject to tax.

Can I Set Up a Backdoor Roth IRA if I Already Have a Roth IRA?

Absolutely. Using a backdoor Roth IRA strategy means converting traditional IRA contributions to a Roth IRA. You do not have to open a new Roth account to do so. 

What Happens if I Withdraw Funds From a Backdoor Roth IRA Before the Five-Year Period?

Each backdoor Roth IRA conversion triggers a new five-year waiting period before withdrawals. If you withdraw funds before the five-year period elapses (even if you’re over the age of 59½), your withdrawal is subject to a 10% penalty.

Are There Any Penalties for Incorrectly Reporting a Backdoor Roth IRA Conversion?

Incorrectly reporting a backdoor Roth IRA conversion can result in IRS penalties and double taxation on after-tax traditional IRA contributions.

The Bottom Line

High-income earners who cannot otherwise directly contribute to a Roth IRA can enjoy the same long-term benefits of tax-free retirement growth and withdrawals by using a backdoor Roth IRA.

While the process is simple, the IRS rules and tax ramifications mean you must act carefully. It is important to get it right because improperly reported conversions can lead to tax consequences and penalties. 

If you think a backdoor Roth IRA conversion might be right for you, work with a tax professional or financial advisor to ensure you follow IRS guidance and make the most of your money moves.