Essential Insights
- High-income individuals who exceed certain income limits cannot directly contribute to a Roth IRA. They can use a workaround called a “backdoor Roth IRA” to indirectly contribute to a Roth IRA.
- The backdoor Roth IRA has tax consequences so you’ll want to ensure you understand them for your specific situation.
- If you don’t have access to a Roth 401(k) or if you already contribute the maximum to your 401(k), a backdoor Roth is worth considering.
Do You Earn Too Much to Contribute to a Roth IRA?
For the 2024 tax year, single filers earning $161,000 or more and married couples filing jointly earning $240,000 or more cannot directly contribute to a Roth IRA. There are many advantages to Roth IRAs so high-income earners sometimes use a workaround called a backdoor Roth IRA to indirectly contribute to a Roth IRA even when they’re above income limits.
The backdoor Roth IRA isn’t a distinct type of IRA. Rather, it’s a strategic maneuver to channel funds into a Roth IRA by contributing to a traditional IRA without claiming a tax deduction and then converting those funds into a Roth IRA. This process is different from a standard Roth conversion and may present unique tax implications.
A backdoor Roth IRA offers high earners the opportunity to enjoy the perks of Roth accounts. Once funds are in a Roth IRA, they grow tax-free, and qualified distributions in retirement are also exempt from tax. Roth IRAs, unlike traditional IRAs, are free from required minimum distributions (RMDs).
Implementing the Backdoor Roth Strategy
Initiating a backdoor Roth involves making a nondeductible contribution to a traditional IRA and subsequently converting it into a Roth IRA. This process has no income restrictions. The primary challenge depends on whether you already have other contributions in any traditional IRA. It’s wise to consult a tax professional to understand the nuances and tax implications of a backdoor Roth conversion.
Tax Implications of the Backdoor Roth IRA
Understanding the tax liabilities associated with a backdoor Roth IRA conversion can be complex, especially if you possess multiple traditional IRAs or if your IRAs contain anything other than nondeductible contributions. In short, if you already have assets in a Traditional IRA, you’ll want to make sure you understand the tax consequences before deciding if a backdoor Roth IRA is a good strategy.
Deductible contributions and earnings on all contributions are taxable as ordinary income during a Roth conversion. With multiple traditional IRAs, you’ll need to calculate the proportion of deductible and nondeductible contributions. The IRS utilizes the IRA aggregation rule, treating all your traditional IRAs as a single combined IRA for tax purposes.
For example, if you have $100,000 in total traditional IRA funds with 10% nondeductible contributions and 90% deductible contributions, converting $10,000 to a Roth IRA would mean that $9,000 (90%) of the conversion amount is taxable. You’ll also want to factor in state and local taxes.
Pros and Cons of Backdoor Roth IRAs
When assessing whether a backdoor Roth IRA aligns with your financial goals, some pros and cons include:
Pros:
- Tax-free earning growth and tax-free withdrawals in retirement.
- No RMDs for Roth IRAs
- More flexible retirement planning with tax-free Roth assets
Cons:
- Partial or full taxability of the converted amount depending on existing pre-tax Traditional IRAs.
- Potential to shift into a higher tax bracket for the conversion year.
It’s important to note that for tax-free distributions, the funds must remain in the new account for at least 5 years and the account holder must be at least 59½ years old. Different withdrawal restrictions apply to direct Roth IRA contributions and Roth conversions.
Setting Up a Backdoor Roth IRA
To implement a backdoor Roth IRA, the steps are relatively simple:
- Establish a traditional IRA and make after-tax contributions. Consider the impact of the IRA aggregation rule on the conversion.
- Set up a Roth IRA and transfer the after-tax contribution. Include Form 8606 in your tax return to track your basis.
- If needed, pay taxes on any converted earnings or deductible contributions. Consulting a tax professional is advisable to understand the tax impact.
Evaluating the Backdoor Roth IRA
A backdoor Roth IRA can be a great strategy for high earners seeking Roth benefits. For those who have access to a Roth 401(k) and who don’t make the maximum contribution to their 401(k), contributions to a Roth 401(k) may be a good alternative to a backdoor Roth IRA. Starting January 1, 2024, RMDs from Roth 401(k)s are no longer mandatory due to Secure Act 2.0.
Future of Backdoor Roth IRAs
While Congress has deliberated limitations on backdoor Roth conversions, current legislation emphasizes Roth contributions more than conversions. If considering a Roth conversion or backdoor Roth as part of your retirement strategy, stay informed about conversion rules and consult with a tax advisor on its financial implications.