How a Backdoor Roth IRA Works: Income Limits and Drawbacks

A wooden cutout of a piggy bank displays the words backdoor Roth IRA. — (Image credit: Getty Images)

Some high-profile personal finance commentators are big fans of the “backdoor Roth IRA.” I’m not — at least not for high earners — and here’s why: If you’re making enough money to be considering a backdoor Roth, there are likely higher-impact, less administration-intensive ways to minimize your tax burden.

A backdoor Roth is a loophole that avoids income limits to be eligible to contribute to a tax-free Roth IRA retirement account. The loophole: Taxpayers making more than the $161,000 limit in 2024 can’t contribute to a Roth IRA, but they can convert other forms of IRA accounts into Roth IRA accounts.

The tax-free accumulation is the obvious attraction. But it comes with a relatively high administrative burden: Each year’s contribution has to be created as a separate Roth IRA account, meaning that if you make contributions for the next 20 years, you’ll be juggling 20 separate Roth IRA accounts (for more on this, see the additional subhead below, “About those multiple accounts …”). There’s also a thicket of IRS conversion regulations that have to be followed carefully to avoid triggering additional tax liabilities.

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The popularity of the strategy is certainly assisted by the support of high-profile advisers like Dave Ramsey, who rightly note the tax-free investment earnings accumulation benefits. Sometimes, though, I get the sense that the allure of the strategy comes as much from the sense that investors are getting one over on the government, doing something clever and slightly clandestine (the “backdoor” name makes it sound like a speakeasy during Prohibition) as it does for the benefits.

Is a backdoor Roth IRA a worthy strategy?

There’s a more important question for high earners considering the strategy, and even more so for business owners (who have more tax minimization tools available to them through their business entity). And that is: Is this the best way for me to earn more and keep more for retirement?

It’s there that I depart from the conventional wisdom that the backdoor Roth IRA is a worthwhile strategy. If a client of mine is hell-bent on using it, I won’t try to stop them. But the core idea of allowing tax-free accumulation of wealth — and in some cases of reducing current taxable income as well — can be achieved by business owners in other ways.

For example, business owners can create deferred compensation plans that use life insurance policies as a vehicle to hold and accumulate value using deferred income. With proper structure, you can reduce current income and earn tax-deferred accumulation on those dollars.

Business owners can also create profit sharing plans for their company, which depending on the age demographics of their workforce can accrue significantly in the owner’s favor.

A risk that exists

But beyond the alternatives, there’s a significant and generally unstated risk that I see to Roth IRA accounts: The risk that Congress and the IRS simply won’t be able to keep their hands off those tax-free accumulations in an increasingly difficult fiscal environment for the federal government.

Think about it: Bills continue to be introduced to implement different forms of a national wealth tax — in effect a form of taxation that retracts an implicit deal between the government and taxpayers, which has been that you pay taxes on income when you receive it.

The notion of retroactivity — which is what a wealth tax would bring — continues to feel like the wolf at the door. With deficits at record levels, taxes labeled “billionaire wealth taxes” could easily and quickly expand into retroactive taxes on unrealized and untaxed Roth IRA accounts.

No one in elected office is currently proposing that kind of retirement account raid. Yet. But can you imagine a near-future Congress drooling over the bounty that Americans’ tax-shielded retirement accounts represent? I can.

Maybe that vulnerability will shrink when the U.S. Supreme Court rules in the spring on a case that has wealth tax implications. (You can read more about this in the article Will SCOTUS Uphold Wealth Taxes?) But in the meantime, any significant strategy that relies on accumulated wealth staying untaxed feels at least concerning.

Just the name could draw attention

I also think the very notion that this is openly called the “backdoor Roth IRA” makes it the kind of thing that can draw notice from politicians. The Build Back Better bill was going to kill these backdoor conversions. That deal died during negotiations with the GOP-controlled House of Representatives.

But there’s clearly a target on this loophole, and I simply wouldn’t put it past our politicians to take it a step further and raid tax accounts created under it.

So to summarize: The backdoor Roth IRA is something you probably should do if you’re a W-2 employee within narrow ranges of high income, and it’s also something you can use if it provides you a low-key, beat-the-tax-man thrill.

But if you do, be prepared for the possibility that the rules could change in the future. And be prepared for those sets of 20 statements to start accumulating.

Finally, if you’re a business owner with significant income and therefore significant tax obligations, my opinion is that you’re majoring in the minors with a backdoor Roth IRA and possibly taking your eye off a bigger, more important set of approaches and options to manage your tax burden and wealth accumulation.

About those multiple accounts …

Several readers have emailed me to say that a specific assertion I make in this piece is in error. Specifically, I say that each year’s backdoor Roth IRA contribution would require a separate Roth IRA account, and that the tracking, recordkeeping and audit risk involved makes the backdoor Roth IRA an undesirable option.

I also say that highly compensated W-2 workers and successful business owners have tax minimization strategies available to them that offer far larger tax savings with similar or lower administrative requirements and that, in the vernacular, the backdoor Roth IRA “juice is not worth the squeeze.”

Some readers have pointed out that one part of my assertion is technically incorrect. Separate Roth accounts would not be required by IRS regulations, they said.

And that is technically correct, but in our office, due to the nature of the transaction, our best practices would be to use a separate account every time. I apologize for the technical error, but I’ll tell you why what I said remains fundamentally true for our clients.

If the backdoor Roth conversion comes from a deductible contribution IRA account or your IRA had earnings before conversion, you would need to track the cost basis and earnings for each year’s contribution individually in order to document and pay the taxes due.

Given that a backdoor Roth still carries the strong whiff of loophole (which the Biden administration sought to close as part of the Build Back Better bill), I would strongly advise any client using one to use separate accounts for transparency and trackability each time they carry out a backdoor Roth transaction.

And for certain I’d tell them to maintain those separate accounts for at least the three-year lookback audit period after the transaction is made. We don’t want clients losing audits, and the IRS will see a Gordian knot of commingled assets as a weak point for attack. Can you document your way out of it? Maybe, but again, that’s even more of an administrative burden.

That’s why, for example, I had all my clients participating in the Paycheck Protection Program use a separate checking account for PPP receipts. Best practices in our office suggest not commingling funds when auditable transactions occur, and separate accounts accomplishes that.

If not following those best practices is a risk some readers want to take to establish a $6,500 investment account, that’s their option.

So I stand corrected. The regulations permit you to have just one account. I just wouldn’t advise it.

All this simply underscores the central point I make earlier in this article: For high-income taxpayers and business owners, there are dozens of tax-reduction strategies that can give you significant deferrals and savings with an acceptable and concomitant level of administrative burden and manageable audit risk.

But the backdoor Roth, as a limited small contribution investment account that carries significant recordkeeping burdens and that is under political attack as a loophole, isn’t one of them.

Disclaimer

This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. You can check adviser records with the SEC or with FINRA.

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Bruce Willey has been working with small to midsize businesses across the country for more than a decade, helping them navigate business and tax law in a variety of situations. His services include assisting with business start-ups, operations, growth, asset protection, exit planning and estate planning.