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Retirement Account Tax Saving Series V – Backdoor Roth IRA

June 11, 2024

In our previous articles, we've covered various aspects of IRAs. This article introduces the Backdoor Roth IRA, highlighting its advantages and the strategy behind it.

What is the Backdoor Roth IRA?

The Backdoor Roth IRA offers a tax-saving opportunity for those whose income exceeds the limits for direct Roth IRA contributions. There are several methods to utilize this strategy, but we will focus on the most universally applicable method.

Traditional IRA to Roth IRA Conversion

When your income surpasses IRS limits, you cannot directly contribute to a Roth IRA. However, you can still contribute to a Traditional IRA. Remember, there are income limits for deducting contributions to a Traditional IRA. The key is distinguishing between contributing to a Traditional IRA and deducting those contributions.

The income limits for Traditional IRA contributions specifically apply to deductions. You can contribute to a Traditional IRA without claiming a deduction, using after-tax money, even with a high income.

Here’s the strategy: contribute after-tax money to a Traditional IRA and then transfer it to a Roth IRA, effectively "sneaking" $7,000 into a Roth IRA annually.

An Example

On January 1, 2024, you contribute $7,000 to your Traditional IRA. On January 2, 2024, you transfer this $7,000 to your Roth IRA. This maximizes the use of the Backdoor Roth strategy, making any gains on that $7,000 tax-free as long as they stay in the account and qualified withdrawals are tax-free.

Important Considerations

  • After-Tax Contributions: The $7,000 contributed to the Traditional IRA must be after-tax money without any tax deduction claims. If it’s pre-tax money, you will need to pay taxes when transferring.
  • Avoiding Gains: Avoid gains in the Traditional IRA before transferring to the Roth IRA. If there are gains, taxes will be due on those gains when transferring. Ideally, contribute and transfer immediately to minimize the time for any gains to accrue.
  • Pro-Rata Rule: This rule complicates the process slightly. The IRS prevents you from only converting after-tax contributions to a Roth IRA while leaving pre-tax contributions in the Traditional IRA. According to IRS Notice 2014-54, each distribution includes a proportionate share of both pre-tax and after-tax amounts.

Examples of the Pro-Rata Rule

Example 1: Suppose you have $100,000 in your Traditional IRA: $80,000 is pre-tax and $20,000 is after-tax. In 2024, you decide to transfer the $20,000 to your Roth IRA. You might think you owe no taxes since it’s after-tax money. However, due to the pro-rata rule, only $4,000 (one-fifth) is considered after-tax and $16,000 (four-fifths) is considered pre-tax, meaning taxes are due on the $16,000.

Example 2: Suppose you initially have $20,000 after-tax in your Traditional IRA and transfer this to your Roth IRA. Later, you contribute $5,000 pre-tax. The IRS calculates your IRA balances as of December 31. Thus, your $20,000 transfer would still include a taxable portion due to the $5,000 pre-tax contribution made later.

Summary of the Backdoor Roth Strategy

The Backdoor Roth is beneficial for those categorized as "wealthy" by IRS standards with income surpassing IRA limits.

  • Execute the strategy correctly to avoid triggering taxes.
  • Plan to manage the pro-rata rule effectively to minimize tax liabilities.
  • A Roth IRA offers tax deferral on any earnings in the account and qualified withdrawals of earnings from the account are tax-free.

The Backdoor Roth IRA is a powerful tool for middle-class individuals seeking to optimize their retirement savings and minimize taxes. By understanding and implementing this strategy correctly, you can significantly benefit from tax-free growth in your retirement accounts.

 

Disclosure:

This material is for general information only and is not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. LPL Financial and LPL representatives do not provide tax or legal advice.

Backdoor Roth: Although this strategy has existed since 2010, the IRS has not officially commented or provided formal guidance on whether it violates the step transaction rule. (When applied, this rule treats what are several different steps as if they were a single transaction for tax purposes.) Experts have mixed opinions on the likelihood of this happening, but the lack of a definitive ruling means there is some risk involved. If the IRS decides that the loophole is a violation, if restrictions do come into play at some point, they could require backdoor Roth converters to pay a penalty, or they might include a grandfather clause. There’s no guarantee the backdoor Roth IRA strategy will always be available. Congress recently considered legislation that would have eliminated the backdoor option. As of now, the backdoor Roth IRA is still around, but no one can predict its future. If you use this backdoor Roth strategy solely to sidestep the earnings limits on Roth, you need to be aware of the risks and seek the counsel and support of a tax professional.

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.

Contributions to a traditional IRA may be tax deductible in the contribution year, with current income tax due at withdrawal. Withdrawals prior to age 59 ½ may result in a 10% IRS penalty tax in addition to current income tax.