This is a question that is coming up more frequently, especially from those who wish to defer taking money from IRA accounts and want to potentially pass retirement funds along to their heirs. So, what should you consider before deciding whether this strategy is right for you? Read on for more.
The Basics
The difference between an IRA and a Roth IRA essentially comes down to when you pay the taxes. Generally, with a traditional IRA, you pay taxes on the withdrawals from the account, while with a Roth IRA, the withdrawals are tax-free because the tax was paid when the contribution is made. Given the power of compounding and tax deferral, the IRS has placed income restrictions on who can make deductions for contributions to an IRA, as well as on who may open and fund a Roth IRA. For 2024, the income limit for making a full contribution to a Roth IRA is $146,000 for single filers and $230,000 for married couples filing jointly. If you earn more than that, you can't contribute directly to a Roth IRA.
A backdoor IRA is a planning strategy that enables high-income earners to contribute to a Roth IRA, even if they exceed the income limits set by the IRS.
First: You make a non-deductible contribution to a traditional IRA, which has no income limit.
Second: You convert the traditional IRA to a Roth IRA, which also has no income limit.
By doing this, you effectively move money from a traditional IRA to a Roth IRA without paying any taxes on the conversion of those monies. If you have other pre-tax money in IRA accounts, the IRS will apply a ‘pro-rata rule’, and you will have to pay a conversion tax on that sum (more on this below). The benefits of converting to a Roth IRA include tax-free growth and withdrawals, as well as avoiding the required minimum distributions (RMDs) that apply to traditional IRAs after age 73.
What are the benefits of a Backdoor Roth?
A backdoor IRA can help you save more for retirement and reduce your tax burden in the future. Some of the benefits are:
You can contribute up to $7,000 per year to a Roth IRA and an additional $1,000 for those over age 50 (known as a catch-up contribution).
You can withdraw your contributions and earnings tax-free at any time after age 59.5 as long as you have held the Roth IRA for at least five years.
You can avoid RMDs, which are mandatory withdrawals from traditional IRAs that start at age 73 and are taxed as ordinary income. RMDs can increase your tax bracket and reduce your flexibility in retirement planning.
You can leave a tax-free legacy to your heirs, who can also benefit from the tax-free growth and withdrawals of the Roth IRA.
What are the drawbacks of a Backdoor Roth?
As is almost always the case, this is not a perfect solution for everyone and is based on the assumption that Congress won’t materially change the tax law on Roth withdrawals (after all, Social Security benefits where initially 100% tax-free, and then…).
Also, beyond potential changes in tax law, there are some drawbacks and risks that you should be aware of before implementing this strategy.
You have to pay taxes on any earnings in the traditional IRA before converting it to a Roth IRA.
You will have to follow the pro-rata rule, which means that if you have any other pre-tax money in any traditional IRA accounts, you have to pay taxes on a portion of the conversion, based on the ratio of pre-tax to after-tax money in all your IRAs. For example, if you have $100,000 in a traditional IRA, of which $10,000 is after-tax and $90,000 is pre-tax, and you convert $10,000 to a Roth IRA, you’ll have to pay taxes on 90% of the conversion, or $9,000.
Make sure to keep track of your non-deductible contributions to the traditional IRA, using Form 8606, to avoid paying taxes on them again when you convert them to a Roth IRA. You also have to report the conversion on your tax return using Form 1099-R.
Conclusion
Congress effectively blessed the idea of the Backdoor Roth in the commentary surrounding the passage of the Tax Cuts and Jobs Act of 2017. The IRS then agreed with Congress that there are no step transaction issues (for additional information on this, please click here). As a result, it's a best practice to convert the non-deductible contribution as soon as possible to:
Allow the dollars to be invested sooner
And avoid any additional tax on growth in the IRA.
For those looking to maximize retirement savings while minimizing future tax liabilities, a Roth IRA or Backdoor Roth may be a viable option. I encourage you to reach out to your financial advisor to further discuss this and to think about it as part of your holistic financial plan.
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