Tax Free Income with a Backdoor ROTH IRA

The Roth IRA is a way to earn tax-free income. Using Roth IRA accounts allows you to withdraw your investment gains completely tax-free in retirement. Before you get too excited, there are a few things to keep in mind. Uncle Sam has set some income limits for those who can join this tax-free party. But there is a workaround called the backdoor Roth IRA. It's a bit of a two-step dance, involving opening a traditional IRA with after-tax dollars and then converting it to a Roth IRA. Your backdoor conversion might be taxable, depending on your IRA's pre-tax versus after-tax makeup.

First, Some Background

Because the government designed this generous tax break for the middle class, the Roth has strict income limits for who can use it. In 2024, Roth IRA limits mean you cannot contribute directly to a Roth IRA if you're single and have a modified adjusted gross income of more than $161,000 or are married with joint modified AGI over $240,000. If your income is over these limits, you can still access these accounts indirectly through a backdoor Roth IRA. This strategy gives a workaround for the Roth IRA income restrictions. PLAY SOUND

A backdoor Roth IRA is a two-step process

First, you open a traditional IRA using after-tax dollars instead of the pre-tax money you usually fund these accounts with to get a deduction. Nondeductible contributions are not only simpler for the backdoor strategy but also circumvent the income limits for deductible traditional IRA contributions, which are even more restrictive than those for a Roth (if you have a retirement plan at work and either you or your employer contributed to it). 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, IN THEORY.

When the backdoor approach may be taxable

If you've contributed pre-tax money to a traditional IRA in the past, a tax law called the pro-rata rule complicates things. Under the pro-rata rule for Roth conversions, the IRS looks at the proportion of pre-tax versus after-tax dollars in your traditional IRA. This is the percentage that will be taxable when you make a backdoor Roth conversion. For example, let's say you have $95,000 of pre-tax funds in a traditional IRA and you contribute another $5,000 of nondeductible money. You might think that you could just convert the $5,000 of nondeductible money and avoid owing any additional taxes. Instead, thanks to the pro rata rule, the IRS considers 95% of each dollar you convert as taxable. Only $250 of your $5,000 conversion in this instance is tax-free while the rest is taxed as income.

Some more Backdoor Tips

For this reason, the backdoor Roth IRA strategy is most tax-effective for those who haven't already funded a traditional IRA with pre-tax dollars. The IRS looks at all your IRAs in aggregate. If you have your money in an old workplace plan, like a 401(k), moving over a large pre-tax retirement balance will hamper your ability to make tax-free transfers in the future for a backdoor Roth IRA. If you plan on using this strategy, leave the funds in your old workplace retirement plan, or if you're still working, transfer the balance to a new employer's retirement plan. Because of the rule, keep your nondeductible funds in cash in the traditional IRA and don't invest until after you've made the conversion. Otherwise, you'll owe income tax on the investment gains from the nondeductible funds when you convert to the Roth. We recommend making your backdoor Roth conversion all at once, putting the entire amount in your account in January and making the conversion right away.

Withdrawals and taxes After a conversion

With a Roth conversion, you must hold the account for at least five years or until age 59-½, whichever comes first, to avoid a 10% early withdrawal penalty that is applied to every dollar you convert, both contributions and gains. You also must wait five years for tax-free withdrawals of your gains, regardless of your age. This tax rule gets complicated when you make multiple backdoor conversions. Every conversion has its own five-year clock.

In Conclusion

The Roth IRA offers a tax-free income opportunity, especially beneficial in retirement. It's essential to understand some nuances to maximize the strategy's tax benefits effectively. As the landscape evolves, maintaining flexibility and seeking professional advice will be key in navigating the intricacies of retirement planning.