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:
- Contribute $6,500 to a traditional IRA as a non-deductible contribution.
- Immediately convert the $6,500 to a Roth IRA.
- 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:
- Contribute $6,500 to a traditional IRA as a non-deductible contribution. This contribution will not reduce your taxable income.
- Immediately, albeit without violating the “one step” rule, convert the $6,500 to a Roth IRA.
- 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.