Backdoor Roth IRA Contributions: An Often Overlooked Opportunity for High Income Households
As a high income household , you might think that contributing to a Roth IRA is not an option for you due to income limits. In 2023, the ability to contribute to a Roth IRA in the regular manner is phased out at $153k MAGI (modified adjusted gross income) for single tax filers and phased out at $228k MAGI for those filing taxes under the married filing jointly status. However, there is a strategy known commonly as the “Backdoor Roth IRA” that allows high earners to take advantage of the benefits of investing via a Roth IRA.
What is a Backdoor Roth IRA?
A “Backdoor Roth IRA” is a strategy that allows individuals to contribute to a Roth IRA even if their income is above the limits set by the IRS. The process involves making a non-deductible contribution to a Traditional IRA, and then immediately converting contributed cash to a Roth IRA. Because the contribution was made with after-tax dollars, there is no tax owed on the conversion. This allows individuals to take advantage of the tax-free growth and withdrawals of a Roth IRA, regardless of their income level. This can be very attractive for high income households that have used up their ability to fund other tax advantaged accounts (max funded their 401k(s) for example), especially when the alternative is saving in a taxable brokerage account where dividends, interest, and capital gains are taxed currently to the account holder in the year they arise.
How does a Backdoor Roth IRA work?
The first step in implementing a Backdoor Roth IRA strategy is to make a non-deductible contribution to a traditional IRA. It is important to note that if you already have a traditional IRA with pre-tax dollars in it, you will need to factor in the pro-rata rule when making a non-deductible contribution. This rule requires that all of your traditional IRA accounts be considered together when calculating the tax consequences of a Roth conversion. Note: If you do have pre-tax dollars already in a traditional IRA, rolling this IRA into a current employer plan (assuming the plan allows for it) such as 401(k) can help you avoid the negative affects of pro rata rules on this strategy.
Once the non-deductible contribution has been made, you can then convert the funds to a Roth IRA. The conversion process is fairly straightforward and can typically be done online through your IRA provider. Because the contribution was made with after-tax dollars and there is no investment gain yet, there is no tax owed on the conversion (assuming no pro-rata rule issues). Following these simple steps enable you to get money into a Roth IRA through the “backdoor”.
What are the benefits of a Backdoor Roth IRA?
The biggest benefit of a Backdoor Roth IRA is the ability to take advantage of tax-free growth and withdrawals. Unlike traditional IRAs, Roth IRAs do not require individuals to take required minimum distributions (RMDs) in retirement. This means that the money can continue to grow tax-free for as long as you like during your lifetime. Additionally, qualified withdrawals from a Roth IRA are tax-free, which can be a significant benefit in retirement when taxes are often one of the biggest expenses. Additionally, having money in a Roth account can potentially help make your overall withdrawal strategy with your pre-tax and taxable accounts more tax efficient.
For 2023, the IRA contribution limits are $6,500 for those under age 50, and $7,500 for those age 50 or older. When done yearly, the impact these contributions into this tax advantaged account compound exponentially as the underlying portfolio holdings grow over time.
Conclusion
The backdoor Roth IRA strategy can be a powerful tool for high earners who want to take advantage of the benefits of a Roth IRA. By making a non-deductible contribution to a traditional IRA and immediately converting it to a Roth IRA, individuals can take advantage of tax-free growth and withdrawals. Additionally, a backdoor Roth IRA can provide a source of tax-free income in retirement and potentially be a useful estate planning tool. If you are a high earner who is interested in using this strategy, it is important to work with a financial advisor and/or tax professional who can help you navigate the process and ensure that it is done correctly.
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