You've probably heard about the Roth IRA and how you should have one in your portfolio.
One of the primary reasons it's nice to have Roth money in your portfolio is because of the taxation of money in a Roth IRA. Specifically, qualified distributions from a Roth IRA are tax-free.
Money goes into the Roth IRA with after-tax dollars, and then when you pull the money out (assuming you meet certain requirements) the withdrawal, and all the earnings, is tax free.
But not just anyone can put money directly into a Roth IRA. The IRS has set income limits on who can put money into a Roth IRA.
The income limits for 2024 are:
Single Taxpayers $146,000
Married Filing Jointly Taxpayers $240,000
These income limits are indexed for inflation and usually increase each year. So if you make too much money you won't be able to put money directly into a Roth IRA.
So what can you do if you are above these income thresholds?
Are you just out of luck?
No, luckily there is a solution for you.
The Backdoor Roth
So what exactly is the backdoor Roth?
It is a tax strategy that allows higher income earners to get money into a Roth IRA. If you are above the income thresholds and you can't put money directly into a Roth IRA you have to come in through the "backdoor". Going in the backdoor involves using a Roth IRA and a Traditional IRA. You'll need both type of accounts opened to implement this strategy.
What you do is you a make a non-deductible contribution to a Traditional IRA and then convert it to your Roth IRA. When you make the non-deductible contribution to the Traditional IRA you are not getting a tax deduction for the contribution. This effectively makes the contribution and after-tax contribution, just like a Roth IRA contribution is made with after-tax dollars. This is important because when you go to convert the non-deductible contribution to your Roth IRA you won't pay any tax on the conversion.
*Normally you pay income tax on a Roth conversion (whatever you convert from a Traditional IRA to a Roth IRA).
Important things to be aware of
There are a couple of very important steps that you need to do be aware of though as you do the backdoor Roth IRA.
First, you need to be aware of IRS form 8606.
This form is where you report the non-deductible contribution that you made to your Traditional IRA. You will need to fill out and file this form in the year that you make the non-deductible contribution. It can be a confusing form, so make sure you work with a financial planner and tax professional to correctly complete and file this form.
Second, you will need to be aware of the Pro Rate rule. Because of this rule the backdoor Roth strategy really only works if you have no other money inside a Traditional IRA, SEP IRA or SIMPLE IRA. This is because if you have money in a Traditional IRA, and make a non-deductible contribution to that IRA you cannot just convert the same amount that you contributed and avoid paying income tax on that amount when you convert. When you do the backdoor Roth in this case part of the conversion will be taxable and part won't be.
For example, Let's say you have a Traditional IRA worth $100k and all of the money is pre-tax money. Then you make a $7k non-deductible IRA contribution into that IRA. You cannot convert $7k to your Roth without part of the conversion being taxable.
Instead, the IRS looks at it like this after you make the non-deductible contribution.
You have $100k in pre-tax funds and $7k in after tax funds with a total account value of $107k. Therefore, 6.5% of your account is tax-free money and 93.5% of the account is pre-tax funds ($7k/$107k=6.5%). The IRS applies this ratio to anything you convert. So, whatever you convert, 93.5% will be taxed and 6.5% will not be taxed. In this example, if you convert the $7k non-deductible contribution, $455 of the conversion would not be taxed and the remaining $6,545 would be taxed. This is the Pro Rata rule at work.
Don't overlook this very important pro rata rule. Because if you do, then you may be in for a surprise tax bill when you go to file your taxes.
Bottom Line
The backdoor Roth strategy is a great tool that is potentially available to higher income earners that are unable to directly contribute to a Roth IRA. However, there are some nuances associated with this strategy and therefore should be implemented with the involvement of a financial planner and tax professional.
At Didion Wealth Management, I'm both a financial planner and tax professional. If you'd like to learn more to see if this strategy can benefit you, feel free to reach out to me.
Cheers.
*Traditional IRA account owners have considerations to make before performing a Roth IRA conversion. These primarily include income tax consequences on the converted amount in the year of conversion, withdrawal limitations from a Roth IRA, and income limitations for future contributions to a Roth IRA. In addition, if you are required to take a required minimum distribution (RMD) in the year you convert, you must do so before converting to a Roth IRA.
*A Roth IRA offers tax deferral on any earnings in the account. Qualified withdrawals of earnings from the account are tax-free. Withdrawals of earnings prior to age 59 ½ or prior to the account being opened for 5 years, whichever is later, may result in a 10% IRS penalty tax. Limitations and restrictions may apply.
*This material was created to provide accurate and reliable information on the subjects covered but should not be regarded as a complete analysis of these subjects. It is not intended to provide specific legal, tax or other professional advice. The services of an appropriate professional should be sought regarding your individual situation.
*All investing involves risk including loss of principal. No strategy assures success or protects against loss in a declining market.
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