What is a Backdoor Roth IRA, and Why is it Legal?

Tyler Kert
Tamarack Wealth Management

A Backdoor Roth IRA is a strategy that helps high-income earners receive the benefits of a Roth IRA, even if they exceed the income limits for contributing to a normal Roth IRA. Roth IRAs are investment accounts that offer tax-free growth and withdrawals in retirement. They are an excellent tool for young investors because they allow individuals to contribute after-tax dollars while they are in a lower tax bracket that can be withdrawn tax-free in the future. However, there are income limits set on contributing to Roth IRAs. In 2024, individuals with incomes over $153,000 (or $228,000 for married couples) are not eligible to contribute directly. The backdoor Roth strategy allows people to sidestep this restriction by using a traditional IRA as a stepping stone.

Here’s how it works: First, you make a contribution to a traditional IRA, which has no income limits. If you contribute after-tax dollars (which are common for high earners whose contributions aren’t deductible), the amount won’t be taxed when it’s converted to a Roth. After funding the traditional IRA, you convert it to a Roth IRA. Any earnings in the account may be subject to taxes upon conversion, but careful timing—such as converting shortly after funding—can minimize these taxes. If you’re planning to do a backdoor Roth, you should convert your traditional contribution to a Roth immediately to avoid earnings and resulting tax liabilities. 

The strategy is perfectly legal. In 2010, Congress removed the income limits for Roth conversions, and the IRS has not placed restrictions on the process. This move by Congress was intentional. They were encouraging more people to take advantage of Roth IRAs for retirement savings, and the government benefits from the immediate tax revenue on any pre-tax amounts that are converted. Even though the backdoor Roth is essentially a loophole that takes advantage of the lack of restrictions between traditional and Roth IRA conversions, it still complies with IRS rules.

One of the biggest appeals of a Roth IRA is that all growth in the account is tax-free, and withdrawals are also tax-free in retirement, provided you are over age 59 ½. Additionally, Roth IRAs don’t have Required Minimum Distributions (RMDs), meaning you can leave the money in the account as long as you want. Many individuals are annoyed when they are required to take money out of their traditional IRA accounts in the form of RMDs. The government requires these distributions so they can collect the tax revenue from the withdrawals. Roth IRAs don’t require RMDs and allow the investor more control over when they want to take their withdrawals. This also makes the Roth especially useful for people who want to leave tax-free funds to their heirs.

However, there are some potential complications to consider. If you have other pre-tax IRA funds, you won’t be able to contribute to a back-door Roth without converting the traditional IRA funds to a Roth first. If you have pre-tax IRA funds and try to do a backdoor Roth, the conversion will trigger the pro-rata rule, which requires you to pay taxes on a portion of the converted amount based on the ratio of pre-tax to post-tax money across all your IRA accounts. This will make things get messy and you’ll run the risk of getting hit with an unexpected tax bill. As a best practice, you should only consider a backdoor Roth if you don’t have other large pre-tax IRA accounts.

While the backdoor Roth IRA offers clear benefits, it’s important to recognize that future legislation could close the loophole. Lawmakers have debated whether the strategy allows high earners to avoid the intended limits of Roth IRAs, but for now, the backdoor method remains a legal and effective way to build tax-free retirement wealth.

If you are looking to optimize your retirement savings and add future flexibility to your withdrawals, the backdoor Roth IRA is a powerful strategy, but it requires planning to execute correctly. Consulting with a tax-smart advisor is a wise move if you want to ensure that the strategy aligns with your goals and overall financial plan. With the potential for tax-free income in retirement, no RMDs, and tax-free inheritances for heirs, the backdoor Roth IRA can be a valuable tool - while the opportunity lasts.

Tyler Kert, a licensed financial advisor and CPA, provides financial planning and tax consulting services at Tamarack Wealth Management in Cashmere, WA.