How Do Roth IRAs and the Backdoor Roth IRAs Work?

Roth IRA con­tri­bu­tions are made with after-tax dol­lars or through a 529 rollover start­ing in 2024. Gen­er­al­ly, eli­gi­bil­i­ty of con­tribut­ing to a Roth IRA is based on your income and type of income.

Gen­er­al­ly, as a sin­gle per­son, your Mod­i­fied Adjust­ed Gross Income (MAGI) must be under $161,000 for the tax year in 2024. If you’re mar­ried and file joint­ly, your MAGI must be under $240,000 for the tax year in 2025, how­ev­er, using a ‘back­door Roth IRA” strat­e­gy may allow fund­ing even if your income lim­it does­n’t allow direct fund­ing. I address what and how a Back­door Roth IRA is below.

For most peo­ple, the Mod­i­fied Adjust­ed Gross Income is the same as your Adjust­ed Gross Income (AGI), which can be seen on your first page of your IRS Form 1040. You will like­ly want to speak with a tax pro­fes­sion­al if you feel your MAGI is dif­fer­ent, and by how much, than your AGI. Again, for most tax­pay­ers, it’s the same.

Your con­tri­bu­tion lim­its for tax year 2024 depend on your age (or age of spouse).  If you’re under age 50 at the end of the tax year, you’re gen­er­al­ly allowed to con­tribute up to $7,000, and if you’re over age 50 by the end of the tax year, you’re allowed to con­tribute up to $8,000 per person/spouse. For busi­ness own­ers, there are oth­er ways to con­tribute more of your income into a retire­ment account, includ­ing a Solo 401K, SEP, and oth­ers.

It is impor­tant to note that my clients hear me speak of real estate invest­ments as the best means to fund a retire­ment. Real estate tends to offer the great­est amount of cur­rent and future tax sav­ings based on cur­rent law. How­ev­er, most of my clients don’t have a desire to man­age and/or invest their retire­ment sav­ings into real estate, so for those, and maybe you, dis­cussing oth­er options is a need­ed require­ment.

What is a Roth IRA?

As stat­ed, a Roth IRA is a type of indi­vid­ual retire­ment account that allows indi­vid­u­als to save for retire­ment with after-tax dol­lars. Unlike a tra­di­tion­al IRA, where con­tri­bu­tions may be tax-deductible, con­tri­bu­tions to a Roth IRA are made with mon­ey that has already been taxed.

The key advan­tage is that qual­i­fied with­drawals in retire­ment, includ­ing both con­tri­bu­tions and earn­ings, are tax-free. Addi­tion­al­ly, tax­pay­ers can often with­draw some of the funds with­out incur­ring a tax­able event, albeit it’s impor­tant to speak with a tax pro­fes­sion­al first to deter­mine how much and what rules apply.

Roth IRAs are par­tic­u­lar­ly attrac­tive to indi­vid­u­als who antic­i­pate being in a high­er tax brack­et dur­ing retire­ment. By pay­ing tax­es now, they can enjoy tax-free income lat­er when their earn­ings and tax lia­bil­i­ties might be high­er. Many peo­ple incor­rect­ly believe because they won’t be work­ing in retire­ment that their income, or more impor­tant­ly, their tax­able income will be at a low­er tax rate.

How­ev­er, most suc­cess­ful peo­ple find they are in the high­est mar­gin­al tax rate dur­ing retire­ment, espe­cial­ly in the ear­ly stages and before they either trans­fer and/or spend their retire­ment nest-egg.

Addi­tion­al­ly, unlike a tra­di­tion­al IRA that is taxed as ordi­nary income, includ­ing what would oth­er­wise be tax-advan­taged cap­i­tal gains and div­i­dend income, Roth IRAs face no such tax­a­tion.

Key Features of Roth IRAs

1. Tax Advantages

• Con­tri­bu­tions are not tax-deductible, but qual­i­fied with­drawals are tax-free. The down­side is con­tribut­ing to a Roth IRA will not decrease your tax­able income for the year you con­tribute, unlike a tra­di­tion­al IRA, which gen­er­al­ly does decrease your tax­able income.
• Earn­ings with­in the Roth IRA account(s) grow tax-free, pro­vid­ed with­draw­al require­ments are met.

2. No Required Minimum Distributions (RMDs)

Unlike tra­di­tion­al IRAs, Roth IRAs do not require account hold­ers to take required min­i­mum dis­tri­b­u­tions at age 73 (or 75 start­ing in 2033). This allows funds to grow indef­i­nite­ly, mak­ing Roth IRAs an excel­lent estate plan­ning tool for many.

What is a Backdoor Roth Contribution?

A back­door Roth con­tri­bu­tion is a legal and IRS-sanc­tioned strat­e­gy that allows high-income earn­ers to bypass the Roth IRA income lim­its. The process involves mak­ing a non-deductible con­tri­bu­tion to a tra­di­tion­al IRA and then con­vert­ing those funds to a Roth IRA. Since con­tri­bu­tions to the tra­di­tion­al IRA were made with after-tax dol­lars, there is min­i­mal or no tax lia­bil­i­ty upon con­ver­sion.

This strat­e­gy is espe­cial­ly use­ful for indi­vid­u­als whose income exceeds the Roth IRA income lim­its but who still want to ben­e­fit from the tax-free growth and with­drawals offered by a Roth IRA.

How to Execute a Backdoor Roth Contribution

The back­door Roth con­tri­bu­tion strat­e­gy involves three key steps that must be per­formed cor­rect­ly to qual­i­fy:

Step 1: Contribute to a Traditional IRA

• Open a tra­di­tion­al IRA if you don’t already have one.
• Con­tribute up to the annu­al lim­it ($6,500 or $7,500 if you’re 50 or old­er for 2024).
• Ensure the con­tri­bu­tion is non-deductible by track­ing it on Form 8606 when you file your tax­es.

Step 2: Convert to a Roth IRA

• Once the funds are in the tra­di­tion­al IRA, ini­ti­ate a Roth IRA con­ver­sion.
• Noti­fy your finan­cial institution(s) to trans­fer the funds from the tra­di­tion­al IRA to the Roth IRA. You’re per­mit­ted to have one finan­cial insti­tu­tion for your IRA and a dif­fer­ent one for a Roth IRA, your accounts do not have to be with the same firm.
• If the con­tri­bu­tion was non-deductible and no earn­ings accrued in the tra­di­tion­al IRA, the con­ver­sion will have lit­tle or no tax con­se­quences. It is impor­tant to time the events very close­ly togeth­er to avoid tax­a­tion of income while your funds are in the IRA. Ide­al­ly, you want as short as peri­od between events to avoid tax­a­tion on growth, so plan­ning is impor­tant. HOWEVER, the events should not be con­sid­ered “one step” in the eyes of the IRS, or you may run afoul of IRS rules as dis­cussed below.

Step 3: Pay Taxes on Earnings (if any)

• If the funds earned inter­est or invest­ment income while in the tra­di­tion­al IRA, you will owe tax­es on the earn­ings at your cur­rent income tax rate dur­ing the con­ver­sion. Again, with prop­er plan­ning and tim­ing, this should be lit­tle or none invest­ment income.

Example of a Backdoor Roth Contribution

Scenario:

• Age: 45
• Income: $250,000 (above the Roth IRA income lim­its)
• Con­tri­bu­tion Lim­it: $6,500

Process:

1. Con­tribute $6,500 to a tra­di­tion­al IRA as a non-deductible con­tri­bu­tion.
2. Imme­di­ate­ly con­vert the $6,500 to a Roth IRA.
3. If no earn­ings occurred between the con­tri­bu­tion and con­ver­sion, there is no addi­tion­al tax lia­bil­i­ty.

By using this strat­e­gy, the indi­vid­ual has effec­tive­ly con­tributed to a Roth IRA despite exceed­ing the “nor­mal” income lim­its to con­tribute to a Roth IRA.

Example of a Backdoor Roth Contribution

Scenario:

• Age: 45
• Income: $250,000 (above the Roth IRA income lim­its)
• Con­tri­bu­tion Lim­it: $6,500

Process:

1. Con­tribute $6,500 to a tra­di­tion­al IRA as a non-deductible con­tri­bu­tion. This con­tri­bu­tion will not reduce your tax­able income.
2. Imme­di­ate­ly, albeit with­out vio­lat­ing the “one step” rule, con­vert the $6,500 to a Roth IRA.
3. If no earn­ings occurred between the con­tri­bu­tion and con­ver­sion, there is no addi­tion­al tax lia­bil­i­ty.

By using this strat­e­gy, the indi­vid­ual has effec­tive­ly con­tributed to a Roth IRA despite exceed­ing the income lim­its.

Potential Tax Pitfalls

While the back­door Roth con­tri­bu­tion is a straight­for­ward strat­e­gy, there are sev­er­al poten­tial pit­falls to be aware of:

1. Pro-Rata Rule

The IRS requires that all tra­di­tion­al IRA accounts be con­sid­ered togeth­er when deter­min­ing the tax­able por­tion of a con­ver­sion. This is known as the pro-rata rule.

How it Works:

If you have pre-tax and post-tax funds in any tra­di­tion­al IRAs, the con­ver­sion will be taxed pro­por­tion­al­ly. For exam­ple:

• You have $10,000 in a tra­di­tion­al IRA ($5,000 pre-tax and $5,000 post-tax).
• You con­vert $5,000 to a Roth IRA.
• Only 50% of the con­ver­sion will be tax-free, as half the total tra­di­tion­al IRA bal­ance con­sists of pre-tax funds.

Strategy to Avoid:

To min­i­mize the impact of the pro-rata rule, con­sid­er rolling over pre-tax IRA funds into an employ­er-spon­sored retire­ment plan (like a 401(k)) if your plan allows it. This iso­lates the non-deductible con­tri­bu­tions for a clean­er back­door Roth con­ver­sion.

2. Step Transaction Doctrine

The IRS might scru­ti­nize back­door Roth con­tri­bu­tions under the step trans­ac­tion doc­trine, which exam­ines whether a series of steps are essen­tial­ly a sin­gle action designed to achieve a result (i.e., bypass­ing income lim­its). To avoid issues:

• Doc­u­ment each step care­ful­ly.
• Leave a small time gap between the con­tri­bu­tion and con­ver­sion. You will want to speak with a tax pro­fes­sion­al so you remain in com­pli­ance.

3. State Tax Considerations

Some states may not con­form to fed­er­al tax rules regard­ing IRA con­ver­sions. Be sure to under­stand your state’s tax treat­ment of IRA con­tri­bu­tions and con­ver­sions. In oth­er words, you may not have an IRS tax­able event, albeit depend­ing on your state of res­i­dence at the time of trans­fer, your state may impose a tax.

Backdoor Tax on the Backdoor Roth IRA

One con­sid­er­a­tion that I speak of often is the pos­si­ble ‘back­door tax’ on Roth IRAs. To be sure, this phrase is mine, and you may not have heard of it, or the con­cept before, because, as stat­ed I made up this term. In a nut­shell, my fear is that Social Secu­ri­ty is in such poor finan­cial shape as of this arti­cle, that I fear Con­gress will aggres­sive­ly seek ways to ‘help’ the Social Secu­ri­ty fund man­age its oblig­a­tions, which present­ly, vast­ly exceed its abil­i­ty to pay. As of this writ­ing, it appears ben­e­fits need to be cut about 15% or more with cur­rent fund­ing, and this must hap­pen some­time pri­or to 2040, which is not very far away.

Options for Con­gress include reduc­ing ben­e­fits, which appear to be high­ly unlike­ly giv­en both major polit­i­cal par­ties strong­ly promise not to cut ben­e­fits, and/or rais­ing the tax on work­ers to help pay for retirees.

Anoth­er option is to ‘means test’ ben­e­fits, using per­son­al retire­ment assets, and to reduce Social Secu­ri­ty ben­e­fits by X per­cent­age based on the abil­i­ty of tax­pay­ers to off­set the lost ben­e­fits with their Roth IRA and oth­er retire­ment accounts. This option seems high­ly like­ly giv­en it fits well into the ‘tax the rich’ mantra so many are hap­py to see hap­pen, espe­cial­ly when it’s a choice of low­er eco­nom­ic tax­pay­ers tak­ing a cut or those that have greater eco­nom­ic wealth.

Do I know this will hap­pen, I do not. What I do know is that Con­gress will soon be faced with a prob­lem they will have to solve, as this can can only get kicked down the road for so long. It seems to me that means test­ing is cer­tain­ly on the table though. My best guess is that Con­gress will attempt to reduce increas­es, so the ben­e­fits do not quite match infla­tion, and do so in a way that isn’t too notice­able to the aver­age recip­i­ent.

Addi­tion­al­ly, because that won’t be near­ly enough of a ‘cut’ (or fail­ure to increase to be exact), and tax­es will increase, as well as the means test­ing I am dis­cussing here. The key point and take­away is I want my clients to know that while it looks great for many now, it may not be as good when it comes time to take advan­tage of your Roth IRA.

Benefits of a Backdoor Roth Contribution

1. Tax-Free Growth

Earn­ings with­in a Roth IRA grow tax-free, pro­vid­ing sig­nif­i­cant long-term ben­e­fits.

2. Tax-Free Withdrawals

Qual­i­fied with­drawals in retire­ment are entire­ly tax-free, which is a major advan­tage over tra­di­tion­al IRAs and 401(k)s.

3. No Income Limits

The back­door Roth strat­e­gy effec­tive­ly elim­i­nates the income restric­tions for con­tribut­ing to a Roth IRA.

4. Estate Planning Benefits

Roth IRAs are not sub­ject to required min­i­mum dis­tri­b­u­tions dur­ing the account holder’s life­time, allow­ing the funds to grow tax-free indef­i­nite­ly and pro­vid­ing a tax-effi­cient way to pass wealth to heirs. In fact, if the plan is fund­ed at least five years pri­or to gift­ing the fund to heirs, they can see sub­stan­tial tax sav­ings as well.

Frequently Asked Questions

Q: Can I perform a backdoor Roth contribution every year?

A: Yes, as long as you adhere to the annu­al con­tri­bu­tion lim­its and ensure prop­er report­ing on IRS Form 8606.

Q: What if I already have a traditional IRA with pre-tax funds?

A: The pro-rata rule will apply, and you may owe tax­es on a por­tion of the con­ver­sion. To avoid this, con­sid­er rolling pre-tax funds into an employ­er-spon­sored plan. You can gen­er­al­ly also roll your funds from an employ­er-spon­sored fund into a tra­di­tion­al IRA, albeit the type of employ­er fund, and the rules asso­ci­at­ed with the fund may pre­vent this while you’re still employed at that company/employer.

If this is some­thing you may have an inter­est in, you will want to find out ful­ly what your options are before mak­ing any trans­ac­tions to ensure every­thing goes as planned.

Q: Are there penalties for a backdoor Roth contribution?

A: No, if done cor­rect­ly. Ensure you fol­low IRS rules, report con­tri­bu­tions accu­rate­ly, and adhere to tax dead­lines.

Conclusion

The Roth IRA offers unpar­al­leled tax advan­tages for retire­ment sav­ings, and the back­door Roth con­tri­bu­tion strat­e­gy pro­vides a valu­able workaround for high-income earn­ers. By con­tribut­ing to a tra­di­tion­al IRA and con­vert­ing to a Roth IRA, you can poten­tial­ly secure tax-free growth and with­drawals, even if your income exceeds the Roth IRA lim­its.

How­ev­er, prop­er plan­ning and exe­cu­tion are cru­cial. Be mind­ful of the pro-rata rule, doc­u­ment your steps thor­ough­ly, and con­sult with a tax advi­sor to ensure com­pli­ance with IRS reg­u­la­tions. When imple­ment­ed cor­rect­ly, the back­door Roth con­tri­bu­tion is a pow­er­ful tool for build­ing tax-free wealth for retire­ment.

If you would like to dis­cuss your retire­ment, tax and finan­cial options fur­ther, please feel free to sched­ule a con­sul­ta­tion with me.