Backdoor Roth IRAs: What to Know Before Stepping Through

Key Takeaways

• The backdoor Roth allows high-income savers who can’t make a direct Roth IRA contribution to nonetheless get some funds into a Roth IRA.
• High-income savers want to maximize contributions to their company retirement plans. In 2024, the contribution limit is $23,000 if you’re under 50 and $30,500 if you’re over 50.
• If you’re a very high-income earner, you may not have a sufficient income replacement rate in retirement by just maxing out all of these tax-sheltered vehicles. That’s a reason to potentially fund a taxable account.

Susan Dziubinski: Hi, I’m Susan Dziubinski with Morningstar. People who earn too much to contribute directly to a Roth IRA often pursue what’s called a backdoor Roth IRA. Joining me to discuss that and other top investment strategies for heavy savers is Christine Benz. She is Morningstar’s director of personal finance and retirement planning, and she is also the host of The Long View podcast.

Good to see you, Christine. Thanks for being here.

Christine Benz: Hi, Susan. It’s great to see you.

Who Should Be Doing a Backdoor Roth IRA?

Dziubinski: Let’s start by talking about the backdoor Roth, what it is, who should do it, and just as important maybe if there are people who should not be doing it.

Benz: The backdoor Roth is a mechanism that allows high-income people who can’t make a direct Roth IRA contribution to nonetheless get some funds into a Roth IRA. And the basic idea there is that you are making a traditional IRA contribution. It’s not deductible because if you earn too much to make a direct Roth IRA contribution, you also earn too much to deduct a traditional IRA contribution on your tax return. So, it’s not deductible, but you’re making that contribution. And then at some later date, and I wouldn’t let too much time elapse, some later date you are converting those funds to a Roth IRA. There are no income limits on the Roth IRA conversion. So, ideally, you would do that within short order of having made the contribution, but it is a way for high-income people who can’t make that direct Roth IRA contribution to get some money into the Roth column.

In terms of who shouldn’t do it or who should at least be careful and get some tax advice, I would say that the key category would be the person who has a lot of traditional IRA assets in their portfolio. Maybe you’ve rolled over a big 401(k) into an IRA. In most cases, that will consist of funds that have never been taxed so that you have your own pretax contributions that you’ve made. You maybe have the employer contributions that they’ve made on your behalf. You have the investment gain. None of that has been taxed in most instances. So, the key thing that you want to be careful about is that when you do your conversion of your little Roth IRA or when you’re doing this backdoor conversion, because of the complexion of your total IRA portfolio, it could cause some of that conversion to be taxable, which is why you want to get some tax advice before proceeding. Not necessarily a reason not to do it, but a reason to just make sure that you’re thinking through the tax implications first.

Backdoor Roth IRA Limits and Options for High-Income Savers

Dziubinski: Got it. Now, you point out that these are relatively small sums that people can put into an IRA. So, higher-income folks should actually think about other ways to save more. What are some of their top options?

Benz: Right. In 2024, we’re talking about $7,000 a year if you’re under 50 into an IRA or $8,000 if you’re over 50. So, you want to look down the line and look at what other opportunities you have available to you. Certainly, looking at your company retirement plan. For high-income savers, they’d want to be thinking about trying to maximize those contributions. So, in 2024, I think it’s $23,000 if you’re under 50 and $30,500 over 50. So that’s step one is seeing if you’re maxing out there. And then if you’re in a position to save even more, you’d want to be thinking about whether your company plan allows for what are called aftertax 401(k) contributions. So, there is a total 401(k) contribution limit that is higher than those numbers that I just outlined. It’s $69,000 in 2024 that you can get all in into your 401(k). That would consist of your own pretax or Roth contributions, your employer contributions, and what are called aftertax contributions. These are contributions of aftertax dollars that many plans now are allowing people to convert to Roth in-plan. So, it’s a really attractive feature.

401(k) Contributions

Dziubinski: Do all plans offer this aftertax 401(k) contribution on top of the regular 401(k) contribution, or is it plan by plan?

Benz: It’s plan by plan, and that’s such an important question, Susan. I just did a quick look at Vanguard’s How America Saves report where they look at all the features of 401(k) plans and about 20%, a little over 20% of plans are currently offering the aftertax feature. So, check to see. Generally speaking, it will be the larger employers that offer more of these bells and whistles. That’s where you’ll tend to see the greatest uptake. Do a little investigation. But this is a great opportunity for people who are heavy savers, especially if they have that in-plan conversion feature where you can just check a box and have each contribution automatically get converted in-plan, so the tax drag on those conversions is almost nothing. It’s really an attractive savings opportunity for high-income folks.

Health Savings Accounts

Dziubinski: Now we’ve talked about HSAs before, maybe not in a little while, but we have talked about them. Now you say that these two can be a great idea as a component of someone’s investment plan. Let’s go through that.

Benz: Absolutely. An HSA, a health savings account, is ostensibly there to provide your healthcare outlays, a fund that you can tap into. But the way that you might want to think about using it, if you can afford to do so, is if you’re covered by a high-deductible healthcare plan that qualifies for an HSA, you fund the HSA. Then as you have healthcare expenses, as you incur them, you’re using non-HSA assets to cover those healthcare costs. And then you’re investing that HSA in long-term securities. And the beauty of that is that when you eventually pull the money out for qualified healthcare expenses, ideally in retirement, you would leave the HSA undisturbed all the way up until retirement. But at some later date, whenever you use the HSA funds, those withdrawals are also tax-free, assuming they’re for qualified healthcare expenses. So, I guess a way to think about it is it’s kind of like a single-purpose Roth IRA. So, you’re getting that tax-free withdrawal treatment—very, very attractive—but you can only get that tax-free withdrawal treatment on qualified healthcare expenses. So, it’s just a really nice thing to add to your toolkit if you’re in a position to fund those healthcare outlays out of pocket and if you’re covered by that high-deductible healthcare plan.

Who Should Own Taxable Accounts?

Dziubinski: Finally, moving away from the tax-sheltered retirement savings vehicles, you also say that for this particular cohort of people, taxable accounts are a must-own. Why is that?

Benz: Well, one of the key reasons is if you’re a very high-income earner, you may not be able to have a sufficient income replacement rate in retirement by just maxing out all of these tax-sheltered vehicles. So that’s something to think about and a reason to potentially fund a taxable account. And then another consideration is just all the flexibility that you have with a taxable account. So, no limits on how much you put in, no limits on what you need to invest the money in, no strictures around withdrawals, so no specific ages or dates when you can withdraw the money, and you can also earn long-term capital gains treatment, which is pretty favorable relative to, say, the income tax treatment that you will face on 401(k) withdrawals. So, that is a chief benefit, just all of that flexibility. And then, finally, it’s just not that difficult to mimic some of the tax-saving features of these tax-sheltered accounts inside of a taxable account. You can think about for your equity exposure using exchange-traded funds or traditional index funds. If you’re a high-income earner, you probably want to think about municipal bonds for your fixed-income exposure. And with those two main tools in your toolkit, it’s a great way to limit the ongoing tax drag on that account.

Dziubinski: Well, Christine, thank you for your time today. These are some great strategies for high-income savers. We appreciate it.

Benz: Thank you so much, Susan.

Dziubinski: I’m Susan Dziubinski with Morningstar. Thanks for tuning in.

Watch “3 Mistakes to Avoid With Your Investment Portfolio in 2024″ for more from Christine Benz.