What Is a Backdoor Roth IRA?
Key Points – What Is a Backdoor Roth IRA?
- Explaining the Initial Misconception Behind Backdoor Roth IRAs
- 2024 Roth IRA Contribution Income Limits
- The Pro-Rata Rule
- Working with a CFP® Professional and CPA Together
- The Two Five-Year Rules
- 5 Minutes to Read
What Is a Backdoor Roth IRA?
We’ve talked a lot about Roth IRAs in 2023 and how they grow tax-free. Having a substantial amount of tax-free income can be a very good feeling. One thing we’ve touched on a few times but want to go more in-depth on are backdoor Roth IRAs.
Before we get into the nuances of what a backdoor Roth IRA is, we want to clear up a common misconception about it. While it might sound like it’s a type of IRA, a backdoor Roth IRA is actually a tax planning strategy. This strategy is utilized by people that eclipse the Roth IRA income limits to convert a traditional IRA to a Roth IRA.
2024 Roth IRA Contribution Income Limits
Let’s review the Roth IRA contribution income limits to see if a backdoor Roth IRA is a technique that you should consider. The Roth IRA contribution income limits, which are based on your Modified Gross Adjusted Income, are increasing in 2024. You must fall within income limits to make a full or partial contribution to a Roth IRA.
If you’re married and filing jointly, your MAGI needs to be lower than $230,000 to make a full contribution and lower than $240,000 to make a partial contribution to a Roth IRA. That $230,000-$240,000 income limit range will be a $2,000 increase from 2023. For single filers, that range is $138,000-$153,000 in 2023 and will increase to $146,000-$161,000 in 2024.
How the Backdoor Roth IRA Serves as a Loophole
If you exceed the Roth IRA income limits, you’re not out of luck thanks to the backdoor Roth IRA. The process of a backdoor Roth IRA starts by contributing funds that have already been taxed into a traditional IRA. These non-deductible contributions can be made to a newly opened IRA or one that you’ve already opened. However, if you’re contributing to an IRA that you’ve already funded, understand that the money you’ve already contributed to could impact your taxes. More on this in a bit.
Once you’ve made the non-deductible contribution to a traditional IRA, you’ll roll the funds over to a Roth IRA as a conversion. There aren’t income limits that come into play with traditional IRAs (and Roth conversions don’t have income limits), hence why the backdoor Roth IRA creates a loophole. It’s possible to convert all of your traditional IRA to a Roth IRA.
Understanding the Potential Tax Implications
When you convert money from a traditional IRA to a Roth IRA, it’s important to keep in mind that you’re required to pay tax on the conversion for any funds that have yet to be taxed. In 2024, you can make a maximum contribution of $7,000 between your IRAs and Roth IRAs. That jumps to $8,000 if you’re 50 or older and want to make a catch-up contribution.
So, let’s say that you contribute $8,000 to a traditional IRA in 2024, get no tax deduction from it, and then immediately convert the $8,000 to Roth. Since you already paid taxes on the contribution, there’s no tax on the conversion from the traditional IRA to the Roth IRA.
In-Plan Roth Conversions
You also have an opportunity to do a backdoor Roth IRA if your 401(k) plan allows for in-plan Roth conversions. (referred to in plan documents as an in-plan rollover). This allows you to roll your pre-tax 401(k) accounts and after-tax 401(k) contributions over to a designated Roth 401(k) account. Converting after-tax contributions in your 401(k) can result in much more money being added to Roth accounts each year than using individual IRA accounts, but you could do both to supersize your Roth accounts.
Before we review some of the tax implications of backdoor Roth IRAs, we’d be remiss if we didn’t share our Roth Conversion Case Studies white paper with you. In this white paper, we review two cases when a Roth conversion makes sense and one case when it doesn’t. Download a copy below to learn some of the key things to consider before doing Roth conversions.
The Pro-Rata Rule
While backdoor Roth IRAs can be an excellent tax planning opportunity for high-income earners, you still need to be careful and not fall into any tax traps. If you’re considering a backdoor Roth IRA, you need to have a good understanding of the pro-rata rule.
If you do a conversion of an after-tax contribution that is part of a traditional IRA, you need to file Form 8606 each year. That way you’re showing how much you’ve contributed to a traditional IRA that you haven’t deducted. With the pro-rata rule, if you convert any of your IRA, the pre-tax amount and after-tax amount both need to be taken into consideration.
For example, let’s say that you have $100,000 in an IRA and want to make a $8,000 contribution in 2024 and convert it via a backdoor Roth IRA. If you’re wanting to make that $8,000 non-deductible contribution and think you can convert it right away without being taxed, not so fast. That’s because you now have $108,000 in your IRA.
When you do the $8,000 conversion, only 7.4% of the conversion has already been taxed. The other 92.6% is going to be a taxable event when you do the conversion. So, to do that the backdoor Roth IRA, you need to make sure that you don’t have any other pre-tax money in an IRA. You can have as much money as you want in a traditional 401(k) or 403(b), but not in a traditional IRA that is pre-tax.
The Two Five-Year Rules
The rules surrounding IRA planning can be very tricky. It doesn’t help that there are two different five-year rules to follow regarding Roth IRAs. The first one we’ll discuss involves the earnings on Roth contributions. For Roth IRA earnings to be penalty-free and tax-free, the following criteria must be met.
- You must be 59½ or older at the time of the distribution.
- Roth IRAs need to be funded for five years before distributing any earnings generated within the account.
- Earnings that are taken prior to turning 59½ or a Roth IRA less than five years old are subject to a 10% penalty and taxed as ordinary income, unless you meet one of the specific exceptions for the 10% penalty.
Note: You always have access to your contributions income tax-and penalty-free, regardless of age.
The other five-year rule with Roth IRA involves Roth converted funds. The same basis and earnings components apply with Roth converted funds, but there’s one key difference. Roth converted funds need to be held for five years prior to accessing them without being assessed a 10% penalty for Roth IRA owners under age 59½. Each conversion has its own five-year clock. After the conversion has seasoned for five years, a Roth IRA owner under age 59½ has access to the converted amount without income tax or penalty.
Avoiding the 10% Early Withdrawal Penalty
Once you are 59½, you have access to all contributions, conversions, and earnings (earnings, if the owner has had a Roth IRA funded for five years). Any future contributions, conversions, and earnings are available immediately without income tax or penalty. If you want to do a backdoor Roth IRA every year, you’re required to wait five years for each distribution you’re converting to avoid that 10% early withdrawal penalty unless you have attained age 59½. However, there are several exceptions for how to avoid it that you can review here.
No Required Minimum Distributions
While age 59½ is at the front end of the age range to really hone in on IRA planning, age 73 is currently at the other end of the spectrum. Why? Because April 1 of the year following age 73 is the required beginning date for Required Minimum Distributions as of 2023. That moves up to 75 by 2033. Well, one of the biggest benefits of Roth IRAs is that they don’t have RMDs.
RMDs are the minimum annual amount that you’re required to take out of your retirement account or IRA. They exist so that people can’t build up their retirement accounts, delay taxes, and simply pass on their retirement funds as an inheritance. RMDs must be taken from traditional IRAs, SIMPLE IRAs, SEP IRAs. Employer retirement plan accounts have a special still working exception depending on whether you’re considered an owner of the business or not. You can learn more about the importance of planning for RMDs in our Understanding Required Minimum Distributions (RMDs) white paper.
Working with a CFP® Professional and CPA Together
Even if you think you’re an expert on the tax code, trying to navigate all the complex rules surrounding the backdoor Roth IRA isn’t advisable. That’s even asking too much of even the most knowledgeable financial advisor. And that’s one of many reasons why we have a team of financial professionals at Modern Wealth Management.
One unique aspect of our team is that we have CFP® Professional and in-house CPAs that work together to get the best net results for our clients. Our CPAs spend countless hours studying the tax code so that they understand the ins and outs of tax planning strategies like backdoor Roth IRAs. We want to make sure that our clients and prospective clients are aware of the tax planning opportunities that are available to them so that they’re paying as little tax as possible over their lifetime, not just in one year.
Do You Have Questions About Backdoor Roth IRAs?
If you’re looking into doing a backdoor Roth IRA and/or have questions about what we’ve covered, start a conversation with our team below.
We hope what we’ve discussed about backdoor Roth IRAs can help you make well-informed decisions. Please don’t hesitate to reach out if you have questions about backdoor Roth IRAs or other tax planning strategies.
Resources Mentioned in This Article
- Revisiting Roth vs. Traditional with Bud Kasper and Corey Hulstein, CPA
- How Does a Roth IRA Grow?
- Tax Planning Strategies with Marty James
- Converting to a Roth IRA: What Are the Pros and Cons?
- 2024 401(k) and IRA Contribution Limits
- Roth Conversion Decisions for 2023
- The Roth IRA Five-Year Rule
- RMD Age for 2023: What’s Your Required Beginning Date?
- RMD Questions: What Are Required Minimum Distributions?
- Understanding the SECURE Act 2.0 with Ed Slott
- Why You Need a Team of Financial Professionals
- The CFP® Professional and CPA Relationship with Logan DeGraeve, CFP® and Corey Hulstein, CPA
Investment advisory services offered through Modern Wealth Management, LLC, an SEC Registered Investment Adviser.
The views expressed represent the opinion of Modern Wealth Management an SEC Registered Investment Adviser. Information provided is for illustrative purposes only and does not constitute investment, tax, or legal advice. Modern Wealth Management does not accept any liability for the use of the information discussed. Consult with a qualified financial, legal, or tax professional prior to taking any action.