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Table of contents
Key Takeaways
- A backdoor Roth IRA is a legal way for high-income taxpayers to convert their traditional IRA into a Roth IRA.
- Tax may be owed on the conversion from traditional IRA to Roth IRA. However, future withdrawals can be made tax free as long as the requirements are met.
- Roth IRAs can be a source of significant tax savings over the course of a lifetime.
Roth IRAs allow individuals to put several thousand dollars towards retirement each year. They are a particularly good choice for those who expect to be in a higher tax bracket in the future. Due to eligibility rules though, not everyone is automatically able to have or contribute to a Roth IRA. These individuals who would not otherwise qualify have the option of doing a backdoor Roth IRA instead.
What is a Roth IRA?
A Roth IRA is an individual retirement account that you can contribute to with after-tax dollars. There is no current year benefit because Roth IRAs are funded by earnings that have already been taxed. However, contributions and the earnings on those contributions are able to grow tax-free and be withdrawn tax-free once you reach age 59 ½ as long as the account has been open for five years or more. High income earners cannot open or fund Roth IRAs, which is where a backdoor Roth comes into play.
What is a Backdoor Roth IRA?
A backdoor Roth IRA is a strategy that can be used by individuals who exceed Roth IRA income limits but want to convert their traditional IRA into a Roth IRA. When the assets of a traditional IRA are transferred to a Roth IRA, taxes are owed on any funds that have not already been taxed. The funds subject to tax include principal, earnings, and appreciation. If done correctly, no additional taxes should be owed upon making withdrawals just like with any Roth IRA.
How is a Traditional IRA Different from a Roth IRA?
With traditional IRAs, you can get a tax deduction for the amount of your contribution in the year you contribute. No taxes are owed until you start making withdrawals. At that point, taxes will be due on the funds contributed as well as earnings on the funds. There are also no restrictions on high-income earners participating.
Who are High-Income Individuals?
Individuals with a modified adjusted gross income (MAGI) over a certain threshold will have their Roth IRA contribution amount gradually reduced or eliminated entirely. For 2023, the MAGI limits are:
- Between $138,000 and $153,000 for single filers
- Between $218,000 and $228,000 for joint filers
Since there is no income ceiling on who can participate in a traditional IRA or who can convert a traditional IRA into a Roth IRA, the backdoor Roth IRA is a planning opportunity for high-income individuals.
How Do You Create a Backdoor Roth IRA
There are two different methods for creating a backdoor Roth IRA.
- Roll your company 401(k) account over into a Roth IRA (if allowed)
- Put money into an existing traditional IRA and then roll the funds over into a Roth IRA.
You can work with the bank or brokerage firm managing your IRA to accomplish this. If your retirement plan is managed by your employer, contact the financial services firm in charge of the plan to see if this is an available option.
What are the Tax Implications?
You should keep in mind that you must pay taxes on any funds in your traditional IRA that have not already been taxed. If all of your traditional IRA contributions were deductible, the entire amount converted into a Roth IRA will be taxed. For example, assume you contribute $6,000 to a traditional IRA and are able to deduct that amount on your tax return. When you convert that money to a Roth IRA, you will owe taxes on the $6,000.
You must also pay taxes on the earnings your traditional IRA contribution accumulates between the date of contribution and the date of conversion to a Roth IRA. You would not need to pay tax on any traditional IRA contributions that were not deductible upon transfer to a Roth IRA.
A Roth IRA conversion could put you in a higher tax bracket for that year if most or all of your traditional IRA contributions were deductible. This is especially true if you held the traditional IRA for a long time, allowing for greater earnings and appreciation on investments. It is good to be aware of, and prepared for, any additional taxable income you may have to report at the time of conversion.
Finally, money put into the Roth IRA are counted as converted funds rather than contributions. As a result, you need to wait five years to access funds from your backdoor Roth without penalty if you have not yet reached age 59 ½. This differs from regular Roth IRA contributions which you can withdraw at any point without having to pay taxes or penalties.
What are the Advantages of a Backdoor Roth IRA?
The most obvious advantage of a backdoor Roth IRA is the ability to get around the income limits. However, there are other benefits that can make the extra effort worthwhile.
The primary benefit is that you can pay taxes upfront on the converted funds, and then everything after is tax-free. This will be an especially attractive benefit if you think tax rates or your tax bracket will be higher in future years. This can lead to major tax savings over the years since Roth IRA distributions are not taxable.
Roth IRAs also do not have required minimum distributions (RMDs), so the balance in your account can generate tax-deferred growth for the entirety of your life. You can choose how much or how little you want to withdraw, and you can make these withdrawals whenever you choose. You may also decide to leave it all to your beneficiaries.
Roth IRA Contribution Limits
In 2023, you are able to contribute up to $6,500 annually (or $7,500 if you are age 50 or older). The contribution amount increases in 2024 so you can contribute up to $7,000 annually (or $8,000 if you are age 50 or older).
As always, at Easeify we are here to help. If you are looking to outsource your accounting to focus on other aspects of your business, contact us today.
