It’s no secret that Roth IRA dollars can be incredibly powerful in retirement. However, there are a number of nuances to keep in mind if you’re a high earner who is looking to take advantage of the loophole known as “The Backdoor Roth.”
First, let’s explore what a Roth IRA is and the limitations on them. Roth IRAs are tax-deferred accounts that are funded with post-tax dollars (meaning you do not take an income tax deduction like with a Traditional IRA). The greatest feature about the Roth IRA is that those monies are allowed to grow tax-deferred, and then the distributions are tax-free as well (so long as you meet the necessary criteria we will discuss in a moment). So, what this means is that all the growth on the investments is never taxed – not at ordinary income tax rates and not at capital gain tax rates.
A distribution is considered “qualified” if the account is five years old and one of the following is applicable:
- It’s made on or after the date you turn 59.5.
- It’s taken due to a permanent disability.
- You die and the beneficiary inherits the account and takes a distribution.
- You use the dollars to buy a first home (up to a $10k max)
If this criteria is not met, a portion of your Roth IRA distribution may be taxable.
Now that we know what a Roth IRA is and the rules behind distributing from it, let’s discuss what a “Backdoor Roth” is. The IRS has put income limitations on who can contribute to a Roth. Any single filer in 2023 who earns over $153,000 (or married filers earning more than $228,000) is barred from contributing. However… there is a loophole. Here’s how it works:
You can circumvent the income limitations by making a non-deductible Traditional IRA contribution and then converting it into your Roth IRA. The most important element to know about this strategy is that if you have pre-tax dollars (dollars you DID take an income tax deduction on), the IRS will make sure those dollars are converted pro rata, and you will owe tax on those. If you’re in a high-income tax bracket, it may or may not make sense for you to do this; consulting a tax advisor would be beneficial prior to executing this.
There is one more scenario, though, if you’re a high-income earner who does NOT have a Traditional IRA at all. It works like this – first you’ll need to open an empty Traditional IRA account. Next, make your non-deductible contribution to this account (maximum annual contribution limits in 2023 are $6,500 for people under 50 and $7,000 for people over 50.). In one or two business days, convert those dollars to your Roth IRA. You can do this every year the exact same way and sock away a fair amount even if you’re over the income limitations. Please also note 401(k) accounts are viewed different from Traditional IRAs, so you can absolutely have a 401(k) account and the IRS will not take these dollars into consideration when assessing Roth conversions.
There is a very important piece to this last scenario that accountants and people filing their own taxes sometimes miss – you need to file a Form 8606. If it’s not filed, you will most likely be taxed on the conversion, which, in essence, would mean you’re being double-taxed since you never took an income-tax deduction on the dollars to begin with. Since Form 8606 is specifically for non-deductible IRA contributions, it will tell the IRS some important things – the most important being what the basis of the Traditional IRA contribution is. Since there was no deduction, the basis would be $6,500 (if you’re under 50). This important piece then tells the IRS there should be no taxation on this conversion since there are no pre-tax dollars in the account. I’ve seen this mistake made when taxes are filed, and it’s no fun to go back and amend a tax return or pay tax twice on the same dollars, so be careful when executing this strategy.
All in all, Roths are fantastic investment vehicles due to the nature of how distributions are taxed (again, no capital gains or ordinary income taxes will be assessed if the criteria are met). While this may not make sense for all high earners who have pre-tax Traditional IRA dollars, it makes sense for those high earners who do not have a Traditional IRA with pre-tax dollars. While we do not offer tax advice, the advisors at Baird Retirement Management are familiar with strategies such as these.