Back-Door Roth IRA Contribution

Roth IRA Contribution when you earn too much

A Roth IRA grows tax-free and provides tax-free distributions. These features make a Roth IRA a powerful tax shelter.

Because of these unique benefits, the desire to get money into a Roth IRA is high. However, income thresholds limit access to Roth IRAs.

Therefore, certain earners are unable to gain direct access to a Roth IRA. If their employer does not provide a Roth 401(k) then access to any Roth account requires a new strategy.

This strategy is known as a back-door Roth IRA conversion.

While the strategy is very common, there are a few obstacles along the way to consider before executing this strategy.

Mechanics of the back-door Roth IRA Contribution

At a certain level of earnings, you are no longer able to contribute directly to a Roth IRA. At similar income levels, you are also unable to make a deductible contribution to a Traditional IRA.

Once you exceed the earnings threshold to contribute to a Roth IRA, you not allowed to contribute to the account. However, when you exceed the earnings threshold for a Traditional IRA you are able to contribute to the account, but it is not a deductible contribution.

Because the amount you contribute is non-deductible, it is also tax-free when you take the money out.

The tax-free nature of the withdrawal might sound like it is another version of a Roth IRA. The difference is that any growth on that original contribution acts like a deductible Traditional IRA.

Growth on the account is a taxable withdrawal.

Since the contribution and the growth in the account are different, the IRS requires you to track the contributions to a non-deductible Traditional IRA. To track these contributions you use Form 8606, which attaches to your individual tax return (Form 1040).

Now that we know the original non-deductible contribution is tax-free upon withdrawal, it is desirable to convert that money to a Roth IRA so that growth on the account is tax-free upon withdrawal. This desire is where the back door Roth IRA contribution was born.

The step of converting Traditional IRA funds (deductible or non-deductible) to a Roth IRA is a Roth Conversion.

A Roth IRA conversion is a taxable event. However, the non-deductible nature of the original contribution means you are converting tax-free money. What is subject to income tax is any growth on the account.

Here is an illustration:

Joe earns above the earnings threshold for a direct Roth IRA or deductible IRA contribution. Knowing about the back-door Roth IRA rules, he decides to contribute $5,500 to a Traditional IRA and doesn’t receive a deduction. The contribution is invested in an account that earns him $100 of growth. Joe then converts the full $5,600 to a Roth IRA. The full $5,600 is a taxable event, but only $100 is subject to tax.

Beware of the IRA Aggregation Rules

One potential roadblock in the transaction is the IRA Aggregation Rule (IRC Section 408(d)(2)).

The IRA aggregation rule stipulates that all IRAs are one IRA even if you have separate accounts. This means any other “deductible Traditional IRAs” or “IRA Rollovers” from a former employer is one big IRA.

In addition to the view that all IRAs are one, all distributions from these IRAs are viewed as pro-rata distributions.

The presence of deductible and non-deductible Traditional IRA balances means you cannot simply convert the non-deductible portion of the Traditional IRA.

Here is another illustration:

Joe has $16,500 in an IRA Rollover from his former employer. He decides to make a non-deductible Traditional IRA contribution, and opens up a new account as shown here:

  • $16,500 IRA Rollover
  • $5,500 Non-deductible IRA

Joe now has $22,000 in total IRAs. Joe would love this money to go to a Roth IRA, so he does a Roth Conversion of $5,500. The IRA Aggregation rules state that Joe 25% of Joe’s IRA balances (i.e. 5,500/22,000) are non-deductible. Therefore, 25% of his Roth Conversion ($1,375) is tax-free while the other 75% is taxable ($4,125).

One way to avoid the IRA Aggregation rules is to leave your money in your employer 401(k) or to roll your money into the 401(k). IRA Aggregation rules only apply IRAs, so the presence of 401(k) money protects you from these rules.

Unfortunately, not all 401(k) plans allow roll-in contributions, which may eliminate this opportunity.

Bonus Tip: If you have or started a sole proprietorship, you could create an individual 401(k) that accepts roll-ins from your IRAs to execute this strategy.

The Step Transaction Doctrine

The Step Transaction Doctrine rule stipulates that the tax court can look at what are formally separate steps of a transaction that has no substantial purpose to be separate, and conclude that they are actually a single, integrated tax event.

Enforcement of the Step Transaction Doctrine rule makes  everything the in the middle irrelevant. For this transaction that means, you would have made a direct Roth IRA contribution.

If you make an ineligible Roth IRA contribution, then you must recharacterize the transaction by the time you file your tax return. If you do not recharacterize the contribution then you are subject to a 6% excise tax on the contribution.

Assessment of the 6% excise tax could accrue forever since there is no statute of limitations that apply to the transaction. A $5,500 ineligible contribution could be accruing a 6% tax for years and years!

There is no hard and fast rule to avoid the Step Transaction Doctrine.

Expert opinions vary from holding the money in the account one day to one year.

One thing I am certain of is that you should not document that your intention is to do a “back-door Roth IRA contribution” anywhere in your records. This alone supports your intent to bypass the Roth IRA contributions rules.

When it comes to an IRS audit… intent is one of the biggest factors in any auditor’s decision!

Should you use a back-door Roth IRA Contribution?

Whether you make a back-door Roth IRA contribution is based on your personal wealth strategy.

Beyond determining whether it is the right decision you need to follow the following checklist to ensure you do it accurately:

Verify there are no other pre-tax IRAs

  1. If there are, roll over existing pre-tax IRAs to a 401(k) (if available) to avoid the IRA aggregation rule
  2. Contribute to non-deductible Traditional IRA (if eligible)
  3. Invest funds in the non-deductible Traditional IRA
  4. Keep invested for one day to one year (up to you and your desire to be aggressive)
  5. Convert to Roth IRA
  6. Repeat steps 2-5 annually as desired
  7. Do not at any point along the way note that you are doing a “back-door Roth contribution”!

If you don’t have any questions along that checklist, you are on your path to execute a back-door Roth IRA contribution.


Do you want to understand how to make your money work for you and keep more of what you have earned? 

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Disclaimer: This article is provided for general information and illustration purposes only. Nothing contained in the material constitutes tax advice, a recommendation for purchase or sale of any security, or investment advisory services. I encourage you to consult a financial planner, accountant, and/or legal counsel for advice specific to your situation. Reproduction of this material is prohibited without written permission from Nate Byers a Madison, WI CPA Financial Advisor,  and all rights are reserved. Read the full Disclaimer in the footer below.