The American tax system is complex but offers many opportunities to reduce the taxable income for the current year or future years. A family of tax savings is based on retirement accounts, both for IRA and 401(k) accounts (Traditional and Roth). The rules are different depending on your income, and we'll explain these in detail. But in short, above a certain income (greater than $206,000 for all families in 2021, but it can be much lower for some tax-filing status), it is not possible to take advantage of the tax benefits of the Traditional or Roth IRA accounts. The backdoor Roth is a way to contribute to a Roth IRA without being limited by the income level.
Traditional IRA
You can contribute to your Traditional IRA at most $6,000 per year in 2021 (and if you are over 50, you are allowed $1,000 of catchup contribution, making the maximum contribution $7,000 per year). Depending on your income, your tax-filing status, and if you have a retirement plan at work, you can fully deduct from your income the IRA contributions. The deduction can be progressively reduced, or completely disappear depending on your income level (range of income between $10,000 and $206,000 depending on the tax-filing status in 2021). In general, provided that you fulfill the requirements, you contribute pre-tax money to your IRA, and you pay taxes in later years on the contributions and growth during the distributions. The non-tax-deducted portion of your contributions will not be taxed again during the distribution. You usually contribute to a Traditional IRA if you expect a lower tax rate in retirement than when you contribute.
Roth IRA
Unlike the Traditional IRA, the Roth IRA is contributed with taxed money, contributions are not deducted from your income, but the contributions and growth are not taxed during the distributions. The yearly limits are the same as for the Traditional IRA: $6,000 per year, and $7,000 if you are over 50. You usually contribute to a Roth IRA if you expect to have a higher tax rate in retirement than when you contribute. Contribution can also be useful if you want to take the tax advantages of the Roth IRA, but you are not allowed deductions for the Traditional IRA.
However, there is also an income limit on the Roth IRA. Contrary to the Traditional IRA that only disallows the deduction of the contributions, in the case of Roth IRA, you are not eligible to contribute to a Roth IRA at all if your income is too high. These income limits can be pretty low in some cases (range from $10,000 to $206,000 depending on the tax-filing status in 2021).
As we can see, if your income is above $206,000 (which is common if you are an accredited investor), your contribution to a Traditional IRA will have no tax deductions, and the growth will be taxed during distributions. Also, you won't be able to contribute after-tax money to a Roth IRA to benefit from the tax-free growth and distributions. Thus, for the most part, you have no access to tax-advantaged IRA accounts for high incomes.
The Backdoor Roth
Here is where the concept of Backdoor Roth circumvents the income level limitation for contributions.
You are allowed to convert your account from a Traditional IRA to a Roth IRA at any time. However, you will be required to pay the taxes on pre-tax contributions and the growth of your account during the conversion. This is the price to pay to switch from pre-tax money of the Traditional IRA to post-tax money of the Roth IRA. If your income is too high, by contributing to a Traditional IRA, you will have no tax deduction as we explained earlier. However, by converting your Traditional IRA to a Roth IRA just after your contribution, you won't have to pay taxes on the contributions (as these contributions were made after taxes, to begin with, as the tax deductions were disabled), and very little on the growth as you do the conversion just after the contribution (so the amount on the account did not have time to profit much).
The Pro-Rata Rule
It is very important to note that for the backdoor Roth conversion to be effective, it means that you should have zero pre-tax contributions on any existing IRA, on the one you are converting, or any other ones. Your IRAs are separated from your spouse's IRAs, so your spouse's IRAs are not taken into account during the conversion. If you have already some pre-tax contributions in some IRA accounts or any account growth, you will need to pay the taxes on the conversion based on the pro-rata of your pre-tax contributions and growth, and with the post-tax contributions. All your Traditional IRA accounts will be considered as an aggregate during the conversion.
For example, let's say that you have an existing IRA with $20,000 of pre-tax money (previous pre-tax contributions and subsequent growth), and you contribute $6,000 of post-tax money this year on a new Traditional IRA. When you convert your newly created Traditional IRA to a new Roth IRA, out of the $6,000 converted, 23% will be considered post-tax ($6,000 divided by the total sum of $26,000) and 77% will be considered pre-tax ($20,000 divided by $26,000). It means that you will have to pay taxes on 77% of the converted amount. So in this example, $4,615 will be considered as an income to be taxed as part of the conversion, and you will need to pay Federal and State taxes on it. After the conversion, it also means that your initial Traditional IRA has now $4,615 post-tax contributions (that have not been converted) and $15,385 of pre-tax contributions from before. The calculation is not complex, but it is important to keep everything documented so you can keep track of the various operations and give explanations if needed.
The Mega Backdoor Roth
The strength of the backdoor Roth IRA is that you can repeat this process every year, for both spouses. Thus, making $12,000 (or more) per year of investment and growth in tax-advantaged accounts regardless of your income level. It is worth noting that Traditional and Roth 401(k) have a similar conversion method that allows you in some cases to move up to $64,500 to tax-advantaged accounts for each spouse per year. This is called the Mega Backdoor Roth.