Backdoor Roth IRAs: Advantages & Disadvantages
“If only I could contribute to a Roth IRA…”
This is a sentiment many high-income earners express. If you earn more income than the income limit, you cannot directly contribute to a Roth IRA.
However, there is a way around it. Even if your income exceeds the income limit, you can still contribute through what's known as a 'backdoor Roth IRA' contribution.
Understanding Roth IRAs
A Roth IRA is a powerful tool for retirement savings, offering tax-free growth and tax-free withdrawals. In contrast, a traditional IRA allows your investments to grow tax-deferred, but you’ll owe taxes when you take money out later. Due to these tax benefits, the IRS imposes certain rules for Roth IRAs, including limits on contributions and income.
For 2024, the contribution limit is $7,000 or $8,000, if you're 50 or older. The income limit for contributing to a Roth IRA is $161,000 for single filers and $240,000 for married couples filing jointly. This is based on your Modified Adjusted Gross Income (MAGI).
Be sure to verify the current annual limits at IRS.gov, as they may change each year.
What is a Backdoor Roth IRA?
A Backdoor Roth IRA is a legal workaround for high-income earners to make Roth IRA contributions.
If your adjusted income is more than the annual IRA income limit and you don’t have other savings held in a traditional IRA, it may be beneficial to contribute to a backdoor Roth IRA.
By doing so, your retirement savings can take advantage of the Roth IRA’s tax-free growth and tax-free eligible withdrawals.
Here is a look at the process, step-by-step:
- Step One: Make a nondeductible contribution to a traditional IRA. Unlike traditional contributions to traditional IRAs, this contribution will be considered nondeductible.
- Step Two: Convert the traditional IRA to a Roth IRA. If the conversion takes place immediately and you don’t have other funds in any other traditional IRAs, this conversion is not taxable.
- Step Three: File the IRS Form 8606. Don’t skip this step. It is important that you notify the IRS of your nondeductible IRA contribution, which is reported on this tax form. Filing Form 8606 is essential for tracking your basis in nondeductible IRA contributions and ensuring that you don't pay tax twice on the same money.
Benefits of a Backdoor Roth IRA
The primary benefit of a Roth IRA is its ability to offer long-term financial growth without tax implications. As previously mentioned, money invested in a Roth IRA grows tax-free, and qualified withdrawals are also tax-free. This can be particularly advantageous for retirees when managing their retirement income.
Additionally, unlike Traditional IRAs, Roth IRAs do not have required minimum distributions (RMDs).
Common Pitfalls of a Backdoor Roth IRA
When considering a Backdoor Roth IRA, it's crucial to be aware of the pro rata rule. This rule affects how your IRA funds are taxed when they are converted.
The pro rata rule states that when you convert part of a traditional IRA to a Roth IRA, the conversion includes both pre-tax and after-tax contributions, based on the proportion of each in your total IRA balance. If you’re not familiar with this rule, you could face an unexpected tax bill.
For example, let's look at a hypothetical client named Grant. Grant earns too much money to contribute directly to a Roth IRA, and he wants to do a backdoor Roth IRA. He already has $10,000 in a traditional IRA and adds a $5,000 non-deductible contribution before converting it to his Roth IRA. However, because of the pro rata rule, a portion of this conversion will be taxable.
Here is how the taxable amount is calculated:
First, we calculate the total balance in the Traditional IRA, including both the pre-existing funds and the new contribution.
Pre-existing Traditional IRA balance:** $10,000 (pre-tax)
New non-deductible contribution:** $5,000 (after-tax)
Total Traditional IRA Balance: $10,000 (pre-tax) + $5,000 (after-tax) = $15,000
Next, we breakdown the contributions into pre-tax and after-tax contributions.
After-tax contributions: $5,000 / $15,000 = ⅓ or ~33.33%
Pre-tax contributions: $10,000 / $15,000 = ⅔ or ~66.67%
Taxable Amount of Conversion: 66.67% of $5,000 = $3,333.33
Thus, the taxable amount is 66.67% of the conversion amount, which is $3,333.33 (66.67% x $5,000).
A second common pitfall that you will want to avoid is inaccurate record-keeping. This can be a headache for many, especially when the pro-rate rule was applied to your conversion. Keep in mind all future withdrawals will be pro rata as well.
If you don’t want to overpay in tax on part of your withdrawals, then you must keep accurate records. This applies to heirs who inherit your traditional IRA as well.
Is a Backdoor Roth IRA for You?
The best answer is it depends and that is because a backdoor Roth IRA doesn’t make sense for everyone. Your situation may be different than the next person’s and you’ll need to assess your unique circumstance and goals.
When evaluating a decision, you may want to consult with a financial advisor. An advisor can help you consider the benefits and risks of completing a Backdoor Roth IRA. It is important that your advice is tailored to your individual circumstance.
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This blog article is for informational and educational purposes only.
Sources:
Fidelity - 4 ways a Roth IRA may benefit your estate plan
IRS - Required Minimum Distributions FAQs
