Richer people can earn tax-free income with a backdoor Roth IRA. But how long will that back door remain open?.
The Roth IRA is that rare prize in the U. S. Tax code — a way to earn tax-free income. When they retire, savers who use Roth IRA accounts can take out all of their investment gains tax-free. However, there are tight income restrictions on who can use the Roth because the government created this advantageous tax break for the middle class. As of 2024, contributions to a Roth IRA will not be accepted directly if you are a single person with a modified adjusted gross income (MAGI) of more than $161,000 or a married couple with a joint MODI of more than $240,000.
“This method provides an escape from the income limitations on Roth IRAs,” says Rob Burnette, a tax preparer and financial advisor at Outlook Financial Center in Troy, Ohio.
The short answer is yes, you can technically do a backdoor Roth IRA every year. However, there are some important things to keep in mind before you decide to do this.
What is a Backdoor Roth IRA?
A backdoor Roth IRA is a strategy that allows high-income earners to contribute to a Roth IRA even though they are above the income limits for direct contributions. To do a backdoor Roth IRA, you first contribute to a traditional IRA and then convert that money to a Roth IRA.
Why Would You Do a Backdoor Roth IRA?
There are several reasons why you might want to do a backdoor Roth IRA. First, it allows you to contribute to a Roth IRA even if you are above the income limits. Second, it allows you to grow your retirement savings tax-free. And third, it allows you to withdraw your contributions from a Roth IRA tax-free and penalty-free at any time.
How to Do a Backdoor Roth IRA
To do a backdoor Roth IRA, you will need to follow these steps:
- Open a traditional IRA.
- Make a non-deductible contribution to the traditional IRA.
- Convert the traditional IRA to a Roth IRA.
Things to Keep in Mind
There are a few things to keep in mind before you do a backdoor Roth IRA.
- The pro-rata rule. If you have any pre-tax money in a traditional IRA, you will need to pay taxes on a portion of the money you convert to a Roth IRA. This is known as the pro-rata rule.
- The income limits. The income limits for Roth IRA contributions are adjusted annually. For 2024, the income limit for single filers is $161,000 and the income limit for married couples filing jointly is $240,000.
- The possibility of future changes. The IRS has not yet ruled out the possibility of changing the rules for backdoor Roth IRAs.
The backdoor Roth IRA is a valuable strategy for high-income earners who want to save for retirement in a tax-advantaged way. However, it is important to understand the rules and potential risks before you decide to do one.
Frequently Asked Questions
How much can I contribute to a backdoor Roth IRA?
The contribution limit for a backdoor Roth IRA is the same as the contribution limit for a traditional IRA, which is $7,000 for people under 50 and $8,000 for people 50 and older.
Do I have to pay taxes on the money I convert to a Roth IRA?
If you have any pre-tax money in a traditional IRA, you will need to pay taxes on a portion of the money you convert to a Roth IRA. This is known as the pro-rata rule.
What are the income limits for a backdoor Roth IRA?
The income limits for a backdoor Roth IRA are the same as the income limits for a traditional IRA. For 2024, the income limit for single filers is $161,000 and the income limit for married couples filing jointly is $240,000.
What are the risks of doing a backdoor Roth IRA?
The main risk of doing a backdoor Roth IRA is that the IRS could change the rules in the future. If this happens, you could be required to pay taxes on the money you have already converted to a Roth IRA.
Should I do a backdoor Roth IRA?
The decision of whether or not to do a backdoor Roth IRA is a personal one. You should consider your own financial situation and risk tolerance before making a decision.
Additional Resources
Disclaimer
I am an AI chatbot and cannot provide financial advice. The information provided above is for general knowledge and educational purposes only, and does not constitute professional financial advice. It is essential to consult with a qualified financial advisor for any specific questions or decisions.
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At least it does for now. Congress is now aware of this tactic due to reports that billionaires are funding Roths through the back door. Some Democratic lawmakers want to limit or outlaw the practice completely. Wade Pfau, a retirement income professor at The American College of Financial Services, notes that “the IRS has said theyre OK with this move short of new legislation formally blocking it.”
Additionally, the commotion has made upper-class families question whether backdoor Roths should be considered in their financial planning. Here’s what you need to know.
Beware of the pro-rata rule with backdoor Roth IRAs
A backdoor Roth IRA is a two-step process. To get a deduction, you first open a traditional IRA with after-tax funds rather than the pre-tax funds that are typically used to fund these accounts. In addition to making the backdoor strategy easier to implement, nondeductible contributions get around the income restrictions for deductible traditional IRA contributions—which are already more stringent than those for a Roth—if your employer or you have a workplace retirement plan.
Second, you convert the traditional IRA to a Roth, but because none of the contributions were deductible, no income tax is owed on the conversion. You report to the IRS that your contributions were nondeductible using Tax Form 8606 when you file your return.
Since there are no income restrictions on opening nondeductible IRAs or converting to a Roth, anyone can use the backdoor strategy. The 2024 back door contribution caps are the same as those for regular IRAs: $7,000 for individuals under 50 and $8,000 for those over 50, provided they have at least that amount in earned income. Every year, you can convert a backdoor Roth IRA, but if you’ve previously made pre-tax contributions to a traditional IRA, things get more complicated due to a tax law known as the pro-rata rule.
The IRS considers the percentage of pre-tax versus after-tax funds in your traditional IRA when determining the pro-rata rule for Roth conversions. This is the portion of your backdoor Roth conversion that is subject to taxes.
Let’s take an example where you have $95,000 in pre-tax funds in a traditional IRA and you make a $5,000 nondeductible contribution. You might believe that all you need to do to avoid paying any more taxes is to convert the $5,000 in nondeductible funds. Rather, as a result of the pro rata rule, the IRS regards 2095 percent of every dollar you convert as taxable (i.e., 95,000 out of 100,000). In this case, only $250 of your $5,000 conversion is tax-free; the remaining $5,000 is subject to income tax. The amount of the taxable conversion would also be added to your taxable income for the year.