Backdoor Roth IRA Planning: A Tax-free Financial Strategy

Roth IRAs are a great tool and a basic financial planning strategy. Roth IRAs have strong appeal due to the tax-free nature of its distributions and the fact that you don’t have required distributions during your lifetime. This offers the opportunity for a multi-generational compounding of earnings, so taxpayers can potentially leave significant wealth to their heirs. So, how can taxpayers utilize a Roth IRA long-term? Read on to learn about backdoor Roth planning: a simple tool to save you more in the long-term.

Tax Treatment of Roth IRAs

The tax treatment of a Roth IRA is almost the exact opposite of a traditional IRA. There are no income limitations when making a traditional IRA contribution, and contributions can be either deductible or nondeductible. Whereas annual Roth IRA contributions are made with after-tax money and are nondeductible. They are also subject to income limits and begin to phase-out when modified adjusted gross income (AGI) exceeds $138,000 in 2023 for single taxpayers and $218,000 for married filing jointly.

A problem arises from the limitations. Individuals whose income is too large to contribute to a Roth IRA will often be active participants in a retirement plan, and therefore, can only make nondeductible contributions to a traditional IRA.

As a result, a “backdoor strategy” is available to work around the Roth contribution income limits. This strategy is a two-step process, made up of a contribute-then-convert transaction.

How Does a Backdoor Roth Plan Work?

The backdoor Roth plan enables you to contribute to a regular IRA without the concern of income limitations. This contribution is also non-deductible. Then, you follow the contribution with a conversion to a Roth IRA. With this workaround, there is no income limitation on Roth conversions.

The strategy is fairly simple; however, there are a few considerations. A person must satisfy the requirements to be able to contribute to a regular IRA—this generally means having earned income. The maximum contribution to the IRA for 2023 is $6,500 and $7,000 for 2024. Individuals 50 years and above can make an additional $1,000 catch-up contribution. (Prior to 2020, there were age limits of 70 ½ to make a contribution, but those have been removed.)

Beyond this, a Roth conversion can be subject to tax as part of the pro-rata rule, which maintains that if a taxpayer has other traditional IRA funds, their Roth conversion is partially taxable. Ultimately, the IRS requires taxpayers to aggregate all of their IRAs, so in this situation, individuals must consider the totality of their IRA assets when calculating their taxes due upon conversion.

Another caveat to keep in mind is that if the original contribution isn’t converted quickly, it has the potential to accumulate earnings—and those earnings would then be taxable on the later conversion.

Additional Considerations for Backdoor Roth Planning

If an individual has no other traditional IRAs, then the strategy can be a simple procedure for high income taxpayers, who can’t otherwise invest in a Roth IRA directly. And making nondeductible contributions to traditional IRAs today can facilitate conversions in the future; for example, when income is lower.

Executing this plan for a married couple over a period of years can allow for a rapid accumulation of assets, including significant compounding of earnings over time, and resulting in a large account balance that is free from income. The lifetime Required Minimum Distribution (RMD) rules that apply to traditional IRAs do not apply to Roth IRAs.

It’s also important to note that if an individual is a participant in an eligible retirement plan that allows rollovers from IRAs, those IRA funds can be placed into the plan. This will eliminate the IRA balances and prevent the application of the pro rata rule.

Takeaways

Individuals and couples can use backdoor Roth planning for long-term, tax-free saving opportunities. The deadline to make contributions for 2023 is April 15, 2024. Please contact a Sikich Financial advisor for assistance with your retirement planning.

Sikich Financial does not provide tax or legal advice. The information presented here is not specific to any individual’s personal circumstances. To the extent that this material concerns tax matters, it is not intended or written to be used, and cannot be used, by a taxpayer for the purpose of avoiding penalties that may be imposed by law. Each taxpayer should seek independent advice from a tax professional based on his or her individual circumstances.

These materials are based upon publicly available information and are provided for general information and educational purposes only. The information contained herein has been compiled from data considered to be reliable.