Do you know about the benefits of Backdoor Roth IRAs? Do you even know what a Backdoor Roth IRA is? Having heard the term, women facing new beginnings, other clients, and prospects often ask about Backdoor Roth IRAs. Many don’t know much about them.
When it comes to personal finance and retirement planning, the Backdoor Roth IRA represents an increasingly popular strategy for individuals looking to maximize their tax advantages and secure a more comfortable retirement. High-income earners can’t contribute directly to a Roth IRA. However, a tax loophole allows them to make indirect contributions. This financial maneuver allows individuals to contribute to a Roth IRA, even if their income exceeds the traditional limits set by the IRS. In this blog, we’ll delve into the basics of Backdoor Roth IRAs and explore the advantages they offer to savvy investors.
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Basics behind the use of Backdoor Roth IRAs.
1. Income Limitations On Roth IRAs:
Not everyone can fund a Roth IRA. They come with income eligibility restrictions. In 2023, individuals with modified adjusted growth income (MAGI) exceeding $153,000 (single and HOH filers) or $228,000 (married filing jointly) are ineligible to contribute directly to a Roth IRA. In 2024, these figures increase to $161,000 and $240,000, respectively. (Please note that figures for both 2023 and 2024 are presented because you can still fund a 2023 Backdoor Roth IRA until April 15, 2024.) These limits can present a roadblock for high-earning individuals who wish to benefit from a Roth IRA’s tax advantages.
2. Backdoor Roth IRA. A Solution to Income Limits:
The Backdoor Roth IRA serves as a workaround for these income limits. It starts with a non-deductible contribution to a Traditional IRA. Then you convert that contribution to a Roth IRA. This conversion is possible because there are no income restrictions on Roth conversions.
3. Limits on Contributions:
For 2024, you can contribute the lesser of your earned income or $7,000. ($6,500 in 2023) A working spouse can also make a contribution for a non-working (or low-earning) spouse, as long as both spouses’ combined contributions don’t exceed their combined incomes. Individuals who are 50 or older can make an extra $1,000 in annual catch-up contributions.
4. Beware of the Pro-Rata Rule:
If you have additional traditional IRA assets, then there’s a potential problem. The IRS won’t let you treat the conversion as coming solely from the current year’s contribution to a non-deductible IRA. Instead, you’ll have to include a portion of the conversion in your taxable income, based on the pro-rata value of your nondeductible and other traditional IRA assets. That’s generally not desirable. If you have extensive retirement assets in deductible traditional IRAs, you should think twice before trying to do a Backdoor Roth IRA. (We’ll work through an example of how this works a bit later.)
While the process sounds straightforward, it requires careful consideration to navigate the potential tax implications.
Benefits of Backdoor Roth IRAs.
1. Tax-Free Growth:
One of the primary advantages of a Roth IRA is tax-free growth. Investments within a Roth IRA can grow over time without incurring capital gains taxes. This can result in significant savings, especially over a long investment horizon.
2. Tax-Free Withdrawals in Retirement:
Unlike Traditional IRAs, your withdrawals from Roth IRAs in retirement are tax-free. For retirees, this can be a game-changer. Why? Tax-free income provides more flexibility in managing your overall tax liability during your retirement years. In addition, future tax rates may be higher than current rates. As a result, you may prefer to pay taxes on your retirement account contributions, as you do with a Roth, rather than on your distributions, as you do with a traditional IRA or 401(k). This leads to another benefit of Backdoor Roth IRAs. They can help you hedge your bets, too. How? They can allow you to have a position in accounts with both pre-tax and post-tax contributions.
3. No Required Minimum Distributions (RMDs):
If you have a Traditional IRA, you must start taking RMDs after reaching age 73 (if you were born in 1951 or later). Roth IRAs, including those created through a Backdoor Roth IRA strategy, do not have RMDs during the original account owner’s lifetime. This allows for greater flexibility in managing retirement income. It can also help you lower your lifetime tax bill.
4. Estate Planning Benefits:
Roth IRAs offer attractive estate planning advantages. Since RMDs aren’t required for the original account owner, the assets can continue growing tax-free, providing a potentially tax-efficient way to pass wealth to heirs. (See this blog for additional information.)
5. Easier Recordkeeping:
The lack of RMDs also simplifies recordkeeping. Plus, it makes tax preparation simpler. It will save you time and headaches in retirement when you’d rather be enjoying your free time and living your life plan.
Considerations and Caution.
While the benefits of Backdoor Roth IRAs can be significant, individuals should be aware of potential tax implications, including the pro-rata rule, which can impact the taxation of the conversion. It is also recommended that you consult with a tax professional or financial advisor to ensure proper execution and to consider individual circumstances.
Steps to Take to Realize the Benefits of Backdoor Roth IRAs.
1. Make a Nondeductible Contribution to a Traditional IRA:
The income and contribution limits are discussed above.
2. Immediately Convert Your Traditional IRA to a Roth IRA:
Taking this step immediately keeps the money in your traditional IRA from generating any earnings. If you have earnings, you will owe taxes on those earnings when you do the conversion. Please note that some harbor concerns about the IRS’s Step Transaction Doctrine. This rule says that if the sum of multiple legal steps is illegal, then the actions are unlawful. Since the Backdoor Roth IRA conversion skirts the legal limitations, this rule could apply. However, according to some, the IRS clarified in early 2018 that they do not require a waiting period before converting from a Traditional IRA to a Roth IRA. Plus, firms like Vanguard even mention the “backdoor” strategy on their website. Charles Schwab and Fidelity advertise the strategy as well:
3. Repeat the Process… If You Wish:
In any year you can’t fully contribute to a Roth IRA through the front door, you can still realize the benefits of Backdoor Roth IRAs.
4. Don’t Forget the Five-Year Rule:
If you are younger than 59 ½ you should not remove the converted funds from your Roth IRA for at least five years. If you remove them sooner, you will have to pay a 10% penalty unless you qualify for one of the limited exceptions.
5. File the Correct Tax Forms:
File IRS Form 8606, Nondeductible IRAs, when you file your tax return.
The Pro-Rata Rule.
The pro-rata rule is a tax regulation that applies to individuals attempting to perform a backdoor Roth IRA conversion. Its application can limit the benefits of a Backdoor Roth IRA.
The pro-rata rule comes into play when an individual has both pre-tax (deductible) and after-tax (non-deductible) money in a traditional IRA. According to the pro-rata rule, any conversion from a traditional IRA to a Roth IRA is considered to include a proportional amount of both pre-tax and after-tax contributions.
Here’s a simplified explanation of how the pro-rata rule works:
1. Pre-tax Contributions:
If you have made deductible contributions to a traditional IRA (pre-tax contributions), you cannot isolate the after-tax contributions for conversion. The pro-rata rule requires you to consider the entire balance in your traditional IRA when converting.
2. Proportional Conversion:
The pro-rata rule calculates the proportion of pre-tax and after-tax money in your traditional IRA. The percentage of after-tax contributions determines the tax-free portion of the conversion.
3. Tax Implications:
The pre-tax portion of the conversion is subject to income tax, while the after-tax portion is not. This means that if you have a significant amount of pre-tax contributions in your traditional IRA, the tax impact of the conversion can be substantial.
To navigate the pro-rata rule effectively, you may consider converting your pre-tax contributions to a Roth IRA when you have minimal or no pre-tax money in your traditional IRA. Alternatively, you may explore strategies like the “mega backdoor Roth” if your employer’s retirement plan allows it.
Important: Retirement funds held in a 401k/403b are not considered for purposes of applying the pro-rata rule.
It’s important to consult with a tax professional or financial advisor with a strong understanding of income taxes to fully understand the implications of the pro-rata rule and to determine the best approach for your specific financial situation.
The Pro-Rata Rule: An Example.
The pro-rata rule and its implications on the benefits of a Backdoor Roth IRA can be confusing. Hopefully, this example will make things clearer.
Assume you have an existing Traditional or Rollover IRA with a $100,000 year-end balance. This balance includes a current-year non-deductible contribution of $6,000. You completed a $6,000 Backdoor Roth conversion during the year. Being unaware of the pro-rata rule, you assume that the full conversion is tax-free. Unfortunately, that’s not the way it works. Here’s how the pro-rata rule would apply.
1. Calculate the Proportion:
- Pre-tax Proportion: $94,000/$100,000 = 0.94 or 94%
- After-tax Proportion: $6,000/$100,000 = 0.06 or 6%
2. Apply Proportions to Conversion Amount:
- Pre-tax Portion of Conversion: 94% of $6,000 = $5,640
- After-tax Portion of Conversion: 6% of $6,000 = $360
3. Resulting Roth IRA Contribution:
- $5,640 (pre-tax) + $360 (after-tax) = $6,000
4. Tax Implications:
- The $5,640 pre-tax portion of the conversion is subject to income tax at your current rate.
- The $360 after-tax portion is not subject to income tax since it has already been taxed.
In this example, you need to report $5,640 as taxable income for the year of the conversion. The after-tax portion contributes to your basis in the Roth IRA and is not subject to additional taxation upon conversion.
Keep in mind that this is a simplified example. Real-life scenarios can be more complex. Factors such as earnings within the IRA, other deductible contributions, and changes in the IRA balance over time can impact the pro-rata calculation. You may also want to consult with a tax professional or financial advisor with a strong understanding of income taxes for personalized advice based on your situation.
Summary of the Benefits of Backdoor Roth IRAs
The Backdoor Roth IRA is a powerful tool for individuals seeking to enhance their retirement savings and enjoy tax-free growth. By understanding the basics and carefully navigating the conversion process, investors can unlock the advantages of this strategy and build a more tax-efficient retirement portfolio. If you take advantage and maximize your retirement savings, you can save tens or even thousands of dollars on taxes over time.
Making a Backdoor Roth IRA contribution is more complicated than contributing the straightforward way. However, it’s your only option if your income exceeds IRS limits. It also allows you to realize the benefits of Backdoor Roth IRAs and provides tax benefits that you can’t realize from a Traditional IRA. As always, seeking professional advice tailored to individual financial situations is crucial to making informed decisions in the pursuit of financial freedom.
If you are interested in discussing whether the benefits of Backdoor Roth IRAs would add value to your financial plan, please contact us. We would be happy to discuss them with you.
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Phil Weiss founded Apprise Wealth Management. He started his financial services career in 1987 working as a tax professional for Deloitte & Touche. For the past 25+ years, he has worked extensively in the areas of financial planning and investment management. Phil is both a CFA charterholder and a CPA.
Located just north of Baltimore, Apprise works with clients face-to-face locally and can also work virtually regardless of location.
