Is It Worth Doing A Backdoor Roth IRA? Pros and Cons

I'm on record disliking a Roth IRA, especially for high income earners. The Roth IRA is a way for the government to tax citizens up front to pay for their bloated and wasteful spending. However, there is a backdoor Roth IRA to consider for those who make more than the maximum income to contribute.

I firmly believe that if you are in the 32% marginal federal tax bracket or higher, it is not ideal to pay taxes up front in order to contribute to a Roth IRA. You are much better off maxing out your 401(k) and IRA first. It is highly unlikely you will make more money in retirement than while working.

If you are in the 24% marginal federal income tax bracket, contributing to a Roth IRA or doing a backdoor Roth IRA will likely be a wash. We don't know exactly the future of tax rates. Below are the latest federal marginal income tax brackets for 2021 along with income levels.

2022 income tax rates

If you are in the 22% or under marginal federal income tax bracket, then you should contribute to a Roth IRA. Roth IRA money will grow tax-free, and you won't pay a penny in taxes when you withdraw the money, either. Roth is simply a designation for post-tax money that will never be taxed again.

But what if you make over the Roth IRA income limit? This is where the backdoor Roth, a two-step process, comes in handy.

Roth IRA Income And Contributions Limits 2022

For 2022, the modified adjusted gross income for singles must be under $144,000 to be eligible to contribute to a Roth IRA. If a single earns less than or equal to $129,000, they can contribute up to the maximum limit.

For married filing jointly, the MAGI must be less than $214,000, with phaseout starting at $204,000. In other words, married filing jointly can contribute the maximum Roth IRA limit if income is equal to or less than $204,000.

Once you're over $144,000 for singles and $214,000 for married couples, you can no longer contribute to a Roth IRA. Such income levels put you in the top 15% of income earners in America, so you shouldn't feel too bad, given you can still contribute to a 401(k).

But it's always nice to have the option to pay taxes up front to contribute to a Roth IRA. After all, nobody knows for sure what the tax situation will look like during retirement and how much money they need.

Roth IRA Income And Contribution Limits 2022

What is the Backdoor Roth IRA?

A backdoor Roth IRA is who you make too much money and still want to contribute to a Roth IRA, through the back doo.

Here are the steps to do a Backdoor Roth IRA:

  • Step 1: Make a non-deductible IRA contribution to a traditional IRA.
  • Step 2: Convert the non-deductible contribution to a new or existing Roth IRA.
  • Step 3: Report the transaction with IRS Form 8606.

Before Congress formally recognized backdoor Roths, folks suggested waiting a statement cycle between contribution and conversion. This is no longer necessary.

What is crucial is remembering to report the transaction on IRS Form 8606 to ensure you don't pay taxes on the conversion. Since you're making a non-deductible IRA contribution, you're already using post-tax money.

If you don't file this form, you could end up paying tax twice, defeating the purpose of the Roth IRA.

Tax benefits of a Traditional IRA and Roth IRA

Some Things To Know About The Backdoor Roth IRA

The current maximum is $6,000 per person per year in 2022. This level tends to go up about $500 every two years or so to keep up with inflation.

As a couple, each individual can put away $6,000 a year or $12,000 total, even if one spouse has no earned income because this is a benefit of a spousal IRA.

However, to contribute to an IRA either directly or indirectly via the backdoor, you must have earned income.

To make the conversion tax-free, it's important that you do not have any tax-deferred IRA money in your name.

That includes a traditional IRA with tax-deferred contributions, a SIMPLE IRA, or a SEP IRA. If you do, a portion of your conversion will be subject to income tax via the pro-rata rule.

Let's say you have a total of $100,000 in tax-deferred dollars between a traditional IRA and a SEP IRA. You attempt the backdoor Roth IRA and convert your new $6,000 non-deductible IRA contribution to Roth IRA.

Since your total IRA balance was $100,000, and 94% of those were tax-deferred dollars, you'll pay income tax on 94% of the conversion. In this case, 94% of the $6,000 will be reported as taxable income.

If you do have IRA dollars you need to deal with first, you can consider converting them all to a Roth IRA, but only if you are at a 22% federal marginal income tax bracket or below.

Is It Worth Doing A Backdoor Roth IRA?

My advice on a Backdoor Roth IRA remains the same as contributing to a regular Roth IRA. If you are in the 22% federal marginal income tax bracket or under, I encourage you to do a Roth IRA and diversify your retirement funds.

But once your federal income tax bracket hits 24%, you're at roughly a neutral state. If your federal income tax bracket is 32% or higher, doing a Backdoor Roth IRA is a terrible, terrible idea. It is highly unlikely you will be making more money, and thereby being in a higher tax bracket in retirement!

It's nice to have tax-free money you can withdraw from in retirement. Being able to diversify your retirement income sources is always a great thing. But don't fool yourself about how much you're going to make in retirement.

Example Of A Backdoor Roth IRA

Let's say you earn a healthy $100,000 a year while working. You're in the 24% marginal income tax bracket. At a 4% rate of return, you need to have a retirement nest egg of $2,500,000 to generate a $100,000 income and pay a similar income tax rate.

But the reality is, if you generate $100,000 of the income in the form of dividend income, your long-term capital gains tax rate is only 15%. Further, not many Americans are able to amass $2,500,000 in retirement in the first place!

The bottom line: You will likely not make more in retirement than while working. Therefore, your tax rate in retirement will likely be lower than while working. As a result, doing a Roth IRA conversion is probably not worth it.

Now, if you're thinking about opening a Roth IRA for your children, that's a no brainer. Children can earn up to $12,550 a year (standard deduction) tax-free. Therefore, earning up to the Roth IRA contribution limit of $6,000 is smart. Your children earn tax-free income, contribute to a Roth IRA tax free, get to compound tax-free, and withdraw tax-free!

Diversify Your Investments Through Real Estate

Doing a backdoor Roth IRA to hopefully save on taxes down the line is smart if you are under the 24% tax bracket. However, you should consider diversifying your investment portfolio with real estate as well. With a Roth IRA, you can generally only invest in stocks and bonds.

Real estate is my favorite way to build wealth because it is a tangible asset that is less volatile, provides utility, and generates income. In 2016, I started diversifying into heartland real estate to take advantage of lower valuations and higher cap rates. I did so by investing $810,000 with real estate crowdfunding platforms.

Take a look at my two favorite real estate crowdfunding platforms. Both are free to sign up and explore.

Fundrise: A way for accredited and non-accredited investors to diversify into real estate through private eFunds. Fundrise has been around since 2012 and has consistently generated steady returns, no matter what the stock market is doing. For most people, investing in a diversified eREIT is the way to go. 

CrowdStreet: A way for accredited investors to invest in individual real estate opportunities mostly in 18-hour cities. 18-hour cities are secondary cities with lower valuations, higher rental yields, and potentially higher growth due to job growth and demographic trends. If you have a lot more capital, you can build you own diversified real estate portfolio. 

Recommendation To Boost Your Retirement

The best way to boost your retirement is to diligent track your finances and make sure your investments are properly allocated. To do so, sign up for Personal Capital, the web’s #1 free wealth management tool

They've got a fantastic free Investment Checkup tool to see exactly how much you are paying in fees. I was paying $1,700 a year in fees I had no idea I was paying.

After you link all your accounts, use their Retirement Planning calculator that pulls your real data to give you as pure an estimation of your financial future as possible using Monte Carlo simulation algorithms.

There is no rewind button in life. Save and invest consistently over time. It's much better to end up with a little too much than a little too little when you're old and no longer have the desire to work.

Personal Capital Retirement Planning Calculation For Estate Tax Planning

About the Author: Sam worked in investing banking for 13 years. He received his undergraduate degree in Economics from The College of William & Mary and got his MBA from UC Berkeley. In 2012, Sam was able to retire at the age of 34 largely due to his investments that now generate roughly $250,000 a year in passive income. He spends time playing tennis and taking care of his family. Financial Samurai was started in 2009 and is one of the most trusted personal finance sites on the web with over 1.5 million pageviews a month.

Is It Worth Doing a Backdoor Roth IRA is a Financial Samurai original post.

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