Roth conversion or backdoor Roth? Understanding the difference

Roth IRAs are one of the most valuable retirement planning tools available, but there is often confusion around two strategies that sound very similar: Roth conversions and backdoor Roth IRA contributions. Both can result in money ending up in a Roth IRA, but they work very differently and are designed to solve different planning problems.

Understanding the distinction is important because the tax consequences, eligibility requirements and planning opportunities are not the same.

A Roth conversion moves existing retirement assets

A Roth conversion generally involves taking money that is already held in a Traditional IRA, SEP IRA, SIMPLE IRA or other eligible retirement account and converting it to a Roth IRA. The amount converted is generally included in taxable income in the year of the conversion, to the extent it represents pre-tax dollars.

For example, suppose you have $200,000 in a Traditional IRA and decide to convert $50,000 to a Roth IRA. Assuming the entire $50,000 consists of pre-tax money, that $50,000 would generally be added to your taxable income for the year. After the conversion, the money is held in the Roth IRA and qualified future withdrawals can generally be made tax free.

The appeal of a Roth conversion is that you are voluntarily paying income tax today in exchange for moving assets into an account that can provide tax-free growth and tax-free qualified withdrawals in the future. A conversion can be particularly attractive when someone expects to be in a higher tax bracket later, has a temporary period of lower income or wants to reduce the size of future required minimum distributions from traditional retirement accounts.

A Roth conversion does not have an income limit. Someone with very high income can generally convert money from a Traditional IRA to a Roth IRA. The question is not whether you are eligible to convert but whether paying the tax today makes sense given your broader financial situation.

A backdoor Roth starts with a contribution

A backdoor Roth IRA strategy is different. It is generally used by individuals whose income is too high to make a direct Roth IRA contribution.

Instead of contributing directly to a Roth IRA, the individual makes a contribution to a Traditional IRA. If the contribution is nondeductible, meaning no tax deduction is taken for the contribution, the individual can then convert those funds to a Roth IRA.

For example, imagine a high-income taxpayer who is not eligible to make a direct Roth IRA contribution. They could contribute $7,500 to a Traditional IRA, assuming they are eligible for that year's IRA contribution limit, and then convert the contribution to a Roth IRA. The contribution itself was made with after-tax dollars, so there may be little or no additional income tax attributable to the conversion if the funds are converted promptly and there are no other complicating IRA balances.

The backdoor Roth is therefore not primarily about moving existing retirement savings into a Roth. It is a way for certain taxpayers to get new money into a Roth IRA when their income prevents them from contributing directly.

The pro rata rule is critical

One of the most important considerations with a backdoor Roth is the IRS pro rata rule.

If you have other pre-tax money in Traditional, SEP or SIMPLE IRAs, you generally cannot simply choose to convert only the after-tax contribution and avoid taxation on the rest. The IRS generally looks at your IRA balances collectively when determining the taxable portion of a conversion.

For example, suppose you contribute $7,500 of nondeductible money to a Traditional IRA, but you also have $92,500 of pre-tax money in other Traditional IRAs. You now have $100,000 of IRA assets, of which only 7.5% represents after-tax basis. If you convert $7,500, the conversion would generally not be entirely tax free. A portion would be treated as taxable based on the ratio of after-tax basis to total IRA assets.

This is one reason the backdoor Roth strategy requires more planning than simply making a contribution and moving the money to a Roth IRA.

Which strategy is relevant?

The easiest way to think about the difference is to ask where the money is coming from.

If you already have money in a Traditional IRA or another eligible retirement account and want to move some of those assets into a Roth, you are considering a Roth conversion. The primary planning question is whether the current tax cost is justified by the future benefits of having more money in a Roth account.

If you are earning too much to contribute directly to a Roth IRA and want to make a new annual IRA contribution, you may be considering a backdoor Roth. The strategy generally involves making a nondeductible Traditional IRA contribution and then converting that contribution to a Roth IRA, while carefully considering the pro rata rule.

There can also be situations where both strategies make sense. A high-income individual might make a backdoor Roth contribution each year while separately converting a portion of an existing Traditional IRA as part of a broader retirement and tax planning strategy.

Roth planning is about more than this year's tax bill

One of the biggest mistakes investors can make is evaluating either strategy solely by asking, "How much tax will I pay today?" The more important question is how the decision fits into the individual's entire financial plan.

A Roth conversion, for example, can affect more than federal income taxes. It can influence future required minimum distributions, Medicare premiums through IRMAA, taxation of Social Security benefits, state income taxes and the amount of tax that may ultimately be paid by heirs. The right conversion amount may therefore be different from year to year.

A backdoor Roth generally involves much less taxable income when executed properly, but the pro rata rule and existing IRA balances need to be reviewed carefully. It is also important to distinguish a backdoor Roth from simply making a direct Roth contribution. The income limits that apply to direct Roth contributions are precisely why the backdoor strategy may be useful.

The bottom line

Roth conversions and backdoor Roth contributions both provide a path to building Roth assets, but they solve different problems. A Roth conversion generally moves existing pre-tax retirement assets into a Roth and creates a current tax liability. A backdoor Roth is generally a method of making a new Roth contribution when income is too high to contribute directly.

Neither strategy is automatically appropriate for everyone. The decision should consider current and future tax brackets, existing IRA balances, retirement income needs, required minimum distributions, Medicare premiums, estate planning goals and the opportunity cost of paying taxes today.

For many investors, the most valuable Roth strategy is not simply getting money into a Roth IRA. It is determining when, how much, and from which account that money should come. That is where thoughtful tax and retirement planning can make a meaningful difference.

Reid Schwartz is a columnist for The Item and Co-Founder of Creech Schwartz Wealth Management &Partners in Sumter, SC, where he works as a financial advisor helping individuals, families, businesses, and nonprofits plan for long-term financial success.

*Tax and accountancy services are not available through or provided by Creech Schwartz Wealth Management or &Partners, LLC.

This article is for educational purposes only and not to be interpreted as tax or legal advice. Any tax planning strategies discussed by Creech Schwartz Wealth Management will be in conjunction with your tax/legal professional.

Securities and investment advisory services offered through &Partners, LLC, a broker-dealer and investment adviser registered with the U.S. Securities and Exchange Commission and member FINRA, SIPC.