Backdoor Roth IRA

Some taxpayers saving for retirement prefer to fund a Roth IRA rather than a traditional IRA. Roth IRAs offer several advantages, including tax-free growth, required minimum distributions, and tax-free withdrawals in retirement. However, income limits restrict high earners from contributing to a Roth IRA. A backdoor Roth IRA provides a legal workaround for these income restrictions.

A backdoor Roth IRA allows high-income earners to contribute to a Roth IRA indirectly by making a nondeductible contribution to a traditional IRA account and then converting the amount in the traditional IRA to a Roth IRA.

Understanding this strategy's rules and potential tax implications is essential to implementing it.

As of the 2023 tax year, the maximum amount for any IRA contribution per taxpayer is $6,500 (or $7,500 if you are 50 or older). However, that contribution limit decreases as an individual's modified adjusted gross income (MAGI) increases, as shown in this chart:

Steps to Executing a Backdoor Roth IRA Strategy: 

• Open a traditional IRA. You can do this with your preferred financial advisor or tax professional.
• Contribute to your newly opened traditional IRA account. Ensure that this contribution is non-deductible, meaning you won’t get a tax deduction for it.
• Convert the traditional IRA account amount to a Roth IRA account. You can do this through your financial institution’s online platform or by contacting them directly.
• Convert your traditional IRA to a Roth IRA shortly after contributing to minimize tax implications. Otherwise, be prepared to pay taxes on earnings that occur between the time of contribution and the time of conversion. Note that the original contribution will not be taxed again because it was non-deductible.
• Report the nondeductible contribution on Form 8606 and the conversion on your tax return.
• Enjoy the benefits that come with having a Roth IRA account.

Pro-Rata Rule 

It is important to note that when converting a traditional IRA to a Roth IRA, the IRS looks at the ratio of your after-tax contributions (basis) to the total value of your traditional IRAs. This ratio determines the taxable portion of the conversion, known as the pro-rata rule. This rule considers your traditional IRAs (including SEP IRAs and or SIMPLE IRAs) as a single entity when calculating the taxable amount of the conversion to a Roth IRA.

Suppose your traditional IRAs have the following balances:

• $10,000 in after-tax contributions (basis)
• $40,000 in pre-tax contributions and earnings

The total value of your traditional IRAs is $50,000. If you convert $5,000 to a Roth IRA, the taxable portion is calculated as follows:

• After-tax contributions ratio: $10,000 / $50,000 = 20%
• Taxable portion: 80% of $5,000 = $4,000

In this scenario, $4,000 of the $5,000 conversion will be taxable.

The pro-rata rule ensures you cannot selectively convert only the after-tax contributions to avoid taxes.

In conclusion, the backdoor Roth IRA strategy allows high-income earners to bypass the income limits for Roth IRA contributions and benefit from the tax advantages of a Roth IRA. The process can be complex, especially if you have other traditional IRAs, which may require you to pay taxes during the conversion process to follow the pro-rata rule.

If a backdoor Roth IRA sounds like it may be right for you, consult with a financial advisor or tax professional to make sure that this strategy aligns with your financial goals and circumstances.