Earn too much for a Roth IRA? Two considerations before you use the ‘backdoor’ Roth IRA.
The Roth IRA is now over 25 years old. Created in 1997, it allows individuals with earned income to invest after-tax money for retirement and avoid paying taxes on ALL the growth and income earned by those investments.
Too good to be true? If you are a high earner, maybe.
Eligibility starts to phase out if income is greater than $218,000 for married couples and at $138,000 for single filers. Here is the full table from the IRS. Those who earn more than these amounts may not even consider the Roth as an option. But there are still ways for high earners to fund Roth IRAs.
Enter the “backdoor” Roth, a method by which high-income individuals and families may still be able to take advantage of the Roth IRA.
Here are the basic “backdoor” steps, as well as a few things to consider before moving forward.
HOW TO USE THE BACKDOOR ROTH IRA
The strategy seems simple to execute:
Open a traditional IRA.
Make a non-deductible contribution to a traditional IRA with after-tax dollars. For 2023, the limit is $6,500 (or earned income, if less), or $7,500 for those 50 and older.
Open a Roth IRA.
Convert the traditional IRA to a Roth IRA.
That’s it. Four simple steps and you’ve completed the backdoor Roth conversion.
Anyone with earned income can make a non-deductible IRA contribution. Here is a link to the IRS table outlining IRA contribution deductibility for those who ARE covered by an employer sponsored retirement plan, and the table for those who ARE NOT covered by a work plan.
Of course, there are some strings attached. Here are a couple considerations and reasons why you may want to work with a competent financial professional to ensure you are executing appropriately and avoiding unintended consequences.
TWO CONSIDERATIONS BEFORE USING THE BACKDOOR STRATEGY
Do you already have an IRA?
Think twice before using the backdoor Roth if you already have a traditional IRA. Why? You could accidentally trigger an unexpected – and unwanted – tax bill. And create an accounting nightmare.
Pre-tax dollars and growth within traditional IRAs are taxed as ordinary income when withdrawn. Roth conversions (step 4 above) are considered withdrawals. You don’t get to be choosy when making Roth conversions by selecting which traditional IRA assets are being converted. With Roth conversions, the assets being converted are taken pro rata from all traditional IRA assets.
An example might help.
Imagine you have two traditional IRAs. One traditional IRA was created when you left your previous employer, and you rolled a 401(k) – which was all pre-tax money – into the IRA. The account has $100,000 in assets. The second IRA was just created with the intent to use the backdoor Roth, and you funded it with a $6,500 non-deductible contribution with after-tax money. You’ll owe ordinary income tax on the growth, but not the original contribution.
Total IRA assets are $106,500. IRA #1 with $100,000 accounts for 93.9% of those assets, and IRA #2 makes up the remaining 6.1%.
When you convert the new IRA to a Roth, the IRS will assume 93.9% of the converted dollars are pre-tax, regardless of which account was converted.
Multiply the $6,500 in converted assets by 93.9% from above and you just created $6,103 in unexpected ordinary income. If you earn enough money to be ineligible for Roth contributions, that means you are likely paying at least 24% in federal income tax, and perhaps as much as 37%, on those converted dollars. Pile state income tax on top of that…you get the idea. Not good.
Finally, you’ll need to track these conversions over time to properly account for pre-tax and after-tax monies inside the IRAs. This is a headache I’d prefer to avoid.
Side note: this is one of the primary reasons some individuals prefer to keep 401(k) assets in the plan or move them to a new employer’s plan. Rolling a 401(k) to an IRA can make sense in many situations but consider all your options first and consult a professional if you have questions.
Can you leave the money alone until age 60?
One of the caveats of tax-free Roth IRA withdrawals is age. These are intended to be retirement vehicles. Can you leave the money in the IRA until age 59½?
If you expect to need the money before then, perhaps an IRA is not the best answer. Early distributions from IRAs – both traditional and Roth – are assessed an additional 10% tax unless you qualify for an exception. You may be wise to consider an old-fashioned brokerage account for excess savings dollars. They give you tons of flexibility and can be managed in a very tax-efficient manner.
Roth IRAs do have another advantage over their traditional counterparts. Since the contributions are made with after-tax dollars, Roth IRA contributions may be withdrawn at any point, free from tax and penalty.
SUMMARY
The backdoor Roth IRA strategy can be an effective way for high-income individuals and families to save for retirement. Be careful to avoid common pitfalls that might create unexpected and unwanted taxes. Consider all your options and try to think holistically about retirement – few if any solutions are one-size-fits-all.
Interested in learning if a backdoor Roth IRA might be right for you? Email me at eric@divviwealth.com or set up time with the Divvi team to continue the conversations.
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