Many high earners want to contribute to a Roth IRA for its tax-free growth and withdrawals, but income limits prevent direct contributions. However, the Backdoor Roth IRA offers a way to bypass these limits, allowing you to take advantage of the benefits of tax-free retirement savings. Following a simple two-step process, you can contribute to a Roth IRA even if you exceed the income thresholds.
What Is a Backdoor Roth IRA?
A Backdoor Roth IRA is not a special type of account but rather a strategy that allows individuals to contribute to a Roth IRA indirectly. It involves making a non-deductible contribution to a Traditional IRA and then converting that amount into a Roth IRA. Since Roth IRAs grow tax-free and allow for tax-free withdrawals in retirement, they are an attractive option for long-term savings.
Who Should Consider a Backdoor Roth IRA?
This strategy is ideal for individuals and couples whose income exceeds the Roth IRA contribution limits set by the IRS. For 2024 and 2025, these limits are:
2024 Single filers: Modified Adjusted Gross Income (MAGI) above $146,000 begins phase-out, with no direct contributions allowed above $161,000.
2024 Married filing jointly: MAGI phase-out starts at $230,000, with no direct contributions allowed above $240,000.
2025 Single filers: MAGI phase-out begins at $150,000, with no direct contributions allowed above $165,000.
2025 Married filing jointly: MAGI phase-out starts at $236,000, with no direct contributions allowed above $246,000.
If your income is above these thresholds, you must use the Backdoor Roth IRA process to contribute to a Roth.
Also, you have until April 15, 2025, to contribute for the 2024 tax year, giving you extra time to take advantage of this opportunity.
How to Complete a Backdoor Roth IRA Conversion
The Backdoor Roth IRA can be completed in two steps:
Step 1: Make a Non-Deductible Traditional IRA Contribution
Contribute to a Traditional IRA as a Non-Deductible Contribution: You can contribute up to the annual limit ($7,000 in 2024 and 2025 or $8,000 if you are 50 or older).
Keep The Contribution in Cash: Ensure the contribution is in cash and not invested immediately.
Step 2: Convert the Traditional IRA to a Roth IRA
Transfer the Funds to a Roth IRA: Convert the amount contributed from the Traditional IRA into a Roth IRA. This can typically be done online through your financial institution.
Timing the Conversion: While there is no IRS-mandated waiting period, some prefer to wait a few days before converting. The IRS clarified in 2018 that an immediate conversion is allowed.
Invest After Conversion: Once the funds are in the Roth IRA, you can invest them according to your long-term strategy.
How to Report a Backdoor Roth IRA on Your Taxes
To properly document the Backdoor Roth IRA, you will need the following forms:
Form 8606 (Nondeductible IRAs): This form reports the non-deductible IRA contribution and the conversion to a Roth IRA. It ensures that the IRS does not double-tax your contributions. This form is completed with your current year tax filing.
Form 1099-R (Issued by IRA Custodian): This form will arrive in January of the following year and reports the distribution from your Traditional IRA. The taxable amount should be zero if you have no pre-tax IRA money.
Form 5498 (Issued by IRA Custodian): This form, issued in May, confirms your IRA contributions. It is for informational purposes and does not need to be filed with your tax return.
Beware of the Pro-Rata Rule
The IRS requires that conversions consider the ratio of pre-tax and after-tax money across all your IRAs. If you have existing pre-tax balances in Traditional, SEP, or SIMPLE IRAs, a portion of your conversion may be taxable. To avoid this, consider rolling pre-tax IRA funds into an employer-sponsored 401(k) if your plan allows it, reducing the impact of the pro-rata rule.
Example of the Pro-Rata Rule in Action
Suppose you have $60,000 in a Traditional IRA from previous deductible contributions. In 2024, you contribute $7,000 as a non-deductible contribution and attempt a Backdoor Roth conversion. Since your total IRA balance is now $67,000, your conversion will not be entirely tax-free. The IRS determines the tax-free portion using the formula:
(After-tax contributions / Total IRA balance) × Conversion amount
(7,000 / 67,000) × 7,000 = $731 tax-free, while the remaining $6,269 is taxable income.
The Mega Backdoor Roth Strategy
For those with access to an employer-sponsored 401(k) plan that allows after-tax contributions and in-plan Roth conversions, the Mega Backdoor Roth provides an even greater opportunity for tax-free growth. This strategy allows you to contribute beyond traditional limits by making after-tax contributions to a 401(k) and then rolling those funds into a Roth IRA or Roth 401(k).
How It Works:
Make After-Tax Contributions to Your 401(k): Some 401(k) plans allow contributions beyond the standard elective deferral limit:
Convert to Roth: If your plan permits, roll the after-tax portion into a Roth IRA or convert within the plan to a Roth 401(k), enabling tax-free growth.
Monitor Contribution Limits: The total 401(k) contribution limit (employee + employer + after-tax):
2024: $69,000 or $76,500 if age 50+.
2025: $70,000 or $77,500 if age 50-59 or 64+. For ages 60-63, the maximum contribution is $81,250
The Mega Backdoor Roth is a great savings tool for those with high savings capacity and access to a flexible 401(k) plan. It offers the potential for significantly more tax-free savings.
Benefits of a Backdoor Roth IRA
Tax-Free Growth: Unlike traditional accounts, Roth IRAs grow tax-free, and withdrawals in retirement are tax-free if you follow IRS rules.
No Required Minimum Distributions (RMDs): Unlike Traditional IRAs, Roth IRAs do not require you to withdraw funds at a certain age, offering more flexibility in retirement planning.
Tax Diversification: A mix of taxable, tax-deferred, and tax-free accounts provides flexibility in managing tax liabilities in retirement.
Is a Backdoor Roth Right for You?
A Backdoor Roth IRA is an excellent strategy for high-income earners looking to maximize tax-advantaged retirement savings. However, navigating the pro-rata rule requires careful planning and avoiding unnecessary taxes. If you have significant pre-tax IRA balances, I can help optimize your strategy.
By leveraging this approach, you can build tax-free retirement savings and create greater financial flexibility in the future.
If you need help with your investment plan, schedule a call with me.
The information given herein is taken from sources that IFP Advisors, LLC, dba Independent Financial Partners (IFP), IFP Securities LLC, dba Independent Financial Partners (IFP), and its advisors believe to be reliable, but it is not guaranteed by us as to accuracy or completeness. This is for informational purposes only and in no event should be construed as an offer to sell or solicitation of an offer to buy any securities or products. Please consult your tax and/or legal advisor before implementing any tax and/or legal related strategies mentioned in this publication as IFP does not provide tax and/or legal advice. Opinions expressed are subject to change without notice and do not take into account the particular investment objectives, financial situation, or needs of individual investors. This report may not be reproduced, distributed, or published by any person for any purpose without IFP’s express prior written consent
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