The Ins and Outs of Backdoor Roth IRA Contributions: A Guide to Tax-Savvy Retirement Planning

Retirement planning is a crucial aspect of securing your financial future, and the Roth IRA offers unique benefits for tax-free growth and withdrawals. However, high-income earners often find themselves restricted from contributing directly to a Roth IRA due to income limits. Enter the "Backdoor Roth IRA" strategy, a legal and tax-efficient way to bypass these limitations and maximize retirement savings. In this blog post, we'll delve into what backdoor Roth IRA contributions are, how they work, and the logistics of tax filing associated with this smart retirement planning strategy.

What is a Backdoor Roth IRA?

A Backdoor Roth IRA is a financial strategy that allows high-income individuals/families, who would typically be ineligible for direct Roth IRA contributions, to contribute to a Roth IRA indirectly. It involves two steps:

Step 1: Make a Non-Deductible Traditional IRA Contribution High-income earners start by contributing to a Traditional IRA without claiming a tax deduction. Since they exceed the income limits for a direct Roth IRA contribution, this is the first step towards the backdoor route. The table below (via Nerd Wallet) shows the phaseouts for direct Roth IRA contributions in 2023.

Step 2: Convert Traditional IRA to Roth IRA After making the non-deductible Traditional IRA contribution, the individual can convert the Traditional IRA funds into a Roth IRA. There are no income limits for Roth IRA conversions, making it a viable strategy for high earners. We typically do this for clients just a few days after the non-deductible Traditional IRA contribution. It's important to note that the Traditional IRA is never invested, we just leave it in cash. Since we are converting shortly after the contribution, you don't want to see any fluctuation in your balance and/or complicate matters.

Tax Considerations for Backdoor Roth IRA Contributions

Pro-Rata Rule: THIS IS HUGELY IMPORTANT

One essential tax consideration for backdoor Roth IRA contributions is the pro-rata rule. If you have other pre-tax IRA funds, such as a rollover IRA from a 401(k) or deductible Traditional IRA contributions, the IRS treats all Traditional IRA funds as a single entity when converting to a Roth IRA. This means you cannot cherry-pick the non-deductible contributions for conversion. The taxable portion of the conversion is calculated based on the ratio of non-deductible contributions to the total IRA balance.

Reporting the Conversion

When filing taxes for the year in which the conversion takes place, IRS Form 8606 must be filled out to report the non-deductible contribution and subsequent conversion. Failure to report this correctly can lead to penalties and unnecessary taxes. We often catch that this was done incorrectly and/or the non-deductible contribution was considered a taxable distribution on taxes. Make sure that you let your accountant know that it was a non-deductible contribution and conversion.

Benefits and Caveats of Backdoor Roth IRA Contributions

Benefits:

• Tax-Free Growth: Contributions grow tax-free in a Roth IRA, allowing for potentially substantial savings over time.
• Tax-Free Withdrawals: Qualified withdrawals in retirement are entirely tax-free, offering flexibility and financial security. This also creates flexibility. There is tremendous value in having accounts with different taxation types to draw from in retirement.
• No Required Minimum Distributions (RMDs): Roth IRAs are not subject to RMDs during the account holder's lifetime, providing more control over withdrawals in retirement. This can also be a substantially more impactful legacy to leave to your heirs, instead of them potentially being subject to the 10-year rule, which can (pun intended) be very taxing on  the gift you left them.

Caveats:

• Pro-Rata Rule: The presence of other pre-tax IRA funds can complicate the conversion process and lead to unexpected tax consequences. Planning opportunity: if you are able to rollover your Traditional IRA assets into your current workplace plan, you can often avoid this issue.
• Unsure if your income will be subject to the phaseout? If your income is trending close to the phaseout and you're unsure if you'll surpass it, we often ask clients to hold off on making the contributions until early the following year. Get your taxes ready to file but don't file yet. You can contribute to IRAs for the prior tax year up until the current year tax-filing deadline. (i.e. February 2024 you could decide to make a 2023 IRA contribution)
• Don't make monthly contributions. Technically, you could employ this strategy over several months but that would be a nightmare. I recommend doing it once per year, making it a much cleaner process.

Conclusion: The Ins and Outs of Backdoor Roth IRA Contributions: A Guide to Tax-Savvy Retirement Planning

Backdoor Roth IRA contributions are a fantastic way for high-income earners to take advantage of the tax benefits offered by Roth IRAs. As always, consult with a financial advisor or tax professional that is familiar with the steps needed to ensure that backdoor Roth IRA contributions will be executed successfully. With proper execution, this tax-savvy retirement planning strategy can enhance your financial future and can also be a big boost to your legacy planning.