Amidst the labyrinth of retirement planning, one beacon shines particularly bright: the Roth IRA. If you are looking for flexibility in withdrawing from a tax-free account in retirement or anticipate being in a higher tax bracket in the future, it might be worth looking at contributing your savings to this account. The Roth IRA offers the significant advantage of tax-free growth on investments, provided certain criteria are met, compared to a traditional IRA that grows tax-deferred, but incurs taxes on withdrawals. The obstacle that many individuals find with contributing to a Roth IRA is that they earn too much income. Fortunately, there’s a legitimate way to bypass this rule. You may have heard the term “backdoor Roth,” and it might sound dubious or complicated to you, but it’s perfectly legal and straightforward when executed correctly.
If you are already maxing out your employer’s retirement plan, earn too much money to directly contribute to a Roth, or your employer’s retirement plan doesn’t offer a Roth option, employing this strategy could be suitable for you. The income limits are based off one’s Modified Adjusted Gross Income (MAGI). For single individuals, if your MAGI is between $146,000 and $161,000 in 2024, you can directly contribute a portion of the maximum contribution limit. Anything over would disqualify you for directly contributing to a Roth IRA. For married couples, the range is $230,000 to $240,000 for partial contributions, and anything above $240,000 will disqualify you from direct contributions.
Now that we’ve established who can do a backdoor Roth, let’s dive into executing this method effectively. Overall, it’s a three-step process.
- Directly contribute to a traditional IRA. You can contribute up to the lesser of earned income or $7,000 per year for 2024. If you are age 50 or older, you can instead contribute up to $8,000. You can also contribute to your spouse’s IRA even if they are not working.
- Once the money has settled in the Traditional IRA, you will then need to make a Roth conversion, which is simply moving the money from the traditional IRA into the Roth IRA. Roth conversions are a taxable event, but regardless of whether you deduct the initial IRA contribution or not, the transaction should be a tax neutral event if done correctly.
- The final step, and arguably the most important one, is to make sure it gets recorded properly on your tax return. Tax professionals can make mistakes, so be sure to inform them of your backdoor Roth move and provide the proper forms. There are four tax forms you will need to be aware of:
- Traditional IRA 5498 – This will report the contribution made to the IRA.
- Traditional IRA 1099-R – This will show the distribution out of the IRA.
- Roth IRA 5498 – This will show the conversion amount made.
- Form 8606 – This is the form you or your tax professional will need to fill out to properly report the backdoor Roth IRA.
While this strategy appears simple, it can get complicated if there are existing funds in any of your IRAs (Traditional, SEP, SIMPLE). The IRS treats all IRAs as one account when dealing with distributions. If there are existing funds in an IRA and a Roth conversion is made, then a portion of that conversion will be subject to tax at one’s federal marginal tax rate. You can avoid this taxable event by rolling the money in the IRA(s) over to an employer retirement plan such as a 401(k), 403(b), or an Individual 401(k).
Recently, Congress has been debating on closing this loophole. In 2022, President Biden’s Build Back Better bill initially contained language eliminating the backdoor Roth IRA strategy, but ultimately the proposal was shut down and instead the Inflation Reduction Act was passed. As of late, the president introduced his budget proposal for 2025 which included reforming “tax-preferred retirement incentives to ensure that the ultrawealthy cannot use these incentives to amass tax-free fortunes.” While this proposal may alarm those who rely on the backdoor strategy, it has a long way to go before potentially becoming law. It would have to go through both houses of Congress, and factors such as the outcome of the upcoming election and other unforeseen variables may further delay progress in closing this loophole.
The Roth IRA is a powerful tool for obtaining tax diversification. With no required minimum distributions and tax-free withdrawals, the account provides valuable flexibility during retirement. In addition, historically we are in a period of low tax rates, and they are slated to revert back to their higher rates post-2025. On top of that, Congress may raise taxes to continue to fund Social Security & Medicare, so seizing the opportunity to secure lower tax rates is worth considering. Here at AFM, we are happy to discuss whether this strategy is right for you and can assist in the navigation and implementation of this strategy.
Presented by Lucas Campbell