If I use a Backdoor Roth conversion, does this mean money is taxed twice?

I would like to ask about the backdoor Roth IRA. Let’s say you exceed the income limit for Roth contributions, so you make a traditional contribution with no tax deduction and then make a backdoor Roth. Is that conversion taxable? Then you pay tax on that money twice, since you already paid tax on that income. I am confused.

– Jeff

The rules for backdoor Roth IRAs can seem confusing, and some scenarios are more complicated than others. Ideally, a non-deductible traditional IRA (after taxes) that converts to a Roth IRA would not be subject to any taxes so that the funds are not taxed twice. To be clear, converted funds are not double taxed, but some circumstances may result in a taxable transaction. That’s where the rules get more complicated. (And that’s why it’s a good idea to consult with one Financial Advisor when deciding whether a backdoor Roth makes sense for you.)

What is a backdoor Roth?

Let’s take a step back for a moment and look at the backdoor Roth. Because many people are not eligible to make Roth IRA contributions due to their liabilities income levelsthe backdoor Roth strategy helps circumvent these rules. And because Roth IRAs offer the opportunity for tax-free growth and withdrawals without the burden of… required minimum distributions (RMDs), this could be a very lucrative move.

For tax year 2023, you cannot contribute to a Roth IRA if you adjusted adjusted gross income (MAGI) is more than $153,000 for single filers or $228,000 for married couples filing jointly. Those limits will increase to $161,000 and $240,000 respectively for 2024.

Although you can no longer contribute to a Roth IRA if your income exceeds these limits, you can still contribute to a traditional IRA regardless of your income level. That’s the premise for your backdoor Roth.

The mechanisms for creating a backdoor Roth are simple (ignoring the tax issues for the moment). You contribute to one traditional IRA and then convert it to a Roth IRA. It’s so easy. (But if you need additional guidance regarding backdoor Roth conversions or other financial maneuvers, consider speaking with a Financial Advisor.)

When Does a Backdoor Roth Not Make Sense?

For many people, the long-term tax benefits of Roth conversions far outweigh the drawbacks. These benefits include:

• Tax-free growth

• Tax-free withdrawals upon retirement

• No RMD requirements, so you can grow your money for as long as you want

But in some cases the disadvantages outweigh the advantages. A backdoor Roth conversion may not make financial sense if:

• You have a lot of pre-tax money in traditional IRAs and could be subject to the pro-rata rule (more on that below)

• You’ll need to withdraw money from your retirement account to pay taxes on the conversion, which triggers a taxable event and possible IRS penalties for early withdrawal

• You’re going to have to use that money within five yearswhich could result in taxes and fines

• The conversion places you in a higher tax bracket and you will receive a tax bill that is larger than planned

The story continues

(A Financial Advisor can help you determine if a Roth conversion makes sense for you and how much you should convert for the most advantageous tax treatment.)

The pro rata rule

If your traditional IRA has a combination of deductible and non-deductible contributions, Roth conversions become more complicated and involve some IRS math. They don’t let you choose which part of the IRA you convert, meaning you can’t simply roll over the non-deductible (and therefore non-taxable) portion.

The pro rata rule calculates how to divide your Roth conversion into taxable and non-taxable segments. It starts with combining all of your traditional (non-Roth) IRAs to create a total basis. Then you calculate the percentage of non-taxable funds in that total. Finally, you apply that percentage to your Roth conversion to determine its non-taxable portion.

Here’s an example with numbers. Suppose Gina has traditional IRAs with a total balance of $100,000. She made $25,000 in non-deductible contributions, so her non-taxable percentage would be 25% ($25,000/$100,000). Now she wants to convert $25,000 into a Roth IRA. Using the pro-rata rule, the non-taxable portion of that conversion would be $6,250 (25% x $25,000), and the remainder would be added to her taxable income for that year. (Consider a match with a Financial Advisor if you have any questions about the pro-rata rule.)

Dealing with taxes

Most traditional IRAs are funded with pre-tax dollars, so converting them to Roth accounts typically increases an individual’s tax liability. Even with that tax burden, it can still be beneficial to make a Roth conversion and enjoy tax-free growth and tax-free withdrawals in retirement.

If you have a combination of deductible and non-deductible contributions in your IRA, the pro-rata rule comes into play and you’ll pay taxes on at least part of the conversion.

Ideally, to implement the backdoor Roth strategy, you would contribute to an empty traditional IRA – the only one you have – to avoid additional tax complications for the conversion. You don’t deduct traditional IRA contributions from your taxes, so you fund it with after-tax dollars – just as you would if you were making a direct Roth contribution. (Your traditional IRA contribution is treated as non-deductible if you file a completed application.) IRS Form 8606.)

The conversion can then take place tax-free. However, any investment income made between the date of contribution and conversion is subject to tax. So it makes sense to complete the conversion as quickly as possible. (This is why it may make sense to speak to one first Financial Advisor who specializes in taxes.)

In short

With a backdoor Roth, you won’t pay double tax, but you may end up paying some tax depending on your financial situation. Talk to your financial advisor before taking this step to minimize taxes and maximize retirement benefits.

Tax season tips

• If you converting a pre-tax IRA to a Roth accountConsider your tax bracket. Converting too large a balance can push you to the next one tax bracket and increase your marginal tax rate. Instead, consider converting just enough pre-tax money to “fill” your current tax bracket, but not exceed it.

• a Financial Advisor with tax expertise can help you optimize your tax strategy. Finding a financial advisor does not have to be difficult. SmartAsset’s free tool connects you with up to three vetted financial advisors serving your area, and you can have a free introductory meeting with your advisors to decide which one you think is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, start now.

• Have an emergency fund on hand in case you encounter unexpected expenses. An emergency fund should be liquid – in an account that is not at risk of significant fluctuations like the stock market. The trade-off is that the value of liquid cash can be eroded by inflation. But with a high-interest account, you can earn compound interest. Compare savings accounts from these banks.

Michele Cagan, CPA, is a financial planning columnist at SmartAsset, answering reader questions about personal finance and tax topics. Do you have a question that you would like answered? Email AskAnAdvisor@smartasset.com and your question may be answered in a future column. Reader-submitted questions may be edited for clarity or brevity.

Please note that Michele is not a participant in the SmartAsset AMP platform nor an employee of SmartAsset. She received compensation for this article.

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