When it comes to financial goals, two of the most common are: save more for retirement, and pay less in taxes. For many, a Roth IRA is a great option to achieve those goals, but for high-income earners, there are income limits prohibiting them from taking advantage of the benefits presented by a traditional Roth IRA directly. That's where the Backdoor Roth contribution strategy comes into play.
A backdoor Roth strategy allows you to bypass the IRS' income limitations on Roth contributions to save an additional $6,500 annually ($7,500 if over age 50) above what you're saving in your 401(k) using the pre-tax, Roth, or after-tax sources. To yield these benefits, the Backdoor Roth IRA contribution strategy marries a contribution to a non-deductible IRA with a conversion to a Roth IRA.
When contributing to a traditional IRA, there are phase-out limits for those exceeding certain income thresholds to write off these contributions on their tax returns. The tax deductibility phase-out limit in 2023 for a traditional IRA ranges from $138,000-$153,000 for Single or Head of Household filers or from $218,000 - $228,000 for those who are Married Filing Jointly assuming the filer in either category is covered by a plan at work. When making any contributions to an IRA after these thresholds, the contributions will be designated as non-deductible after-tax contributions. There are no income limits for making after-tax contributions to a traditional IRA.
The income limits for married couples filing jointly to contribute to a Roth IRA (during the 2022 tax year) is $228,000, and for Single or Head of Household, the income limit for contributing to a Roth is $153,000. While these income limits prevent contributing to a Roth directly, there are no income limits for converting traditional IRA assets to a Roth IRA.
The backdoor Roth contribution utilizes two accounts— a traditional IRA and a Roth IRA. If you are a high-income earner, you probably already know that you can’t contribute directly to a Roth IRA. The backdoor Roth contribution strategy is a way to get around the income limitation and still save money in a Roth IRA.
A simplified way of looking at the backdoor Roth process is:
This strategy allows you to save up to $6,500 annually per person (including spouses), over and above what you are already contributing to your employer’s 401(k). Many investors can contribute $6,500 for the 2023 tax year (as long as the contribution is made before filing the 2023 tax return) in addition to contributing for the 2022 tax year. If you are married and under 50, that means $13,000 in additional retirement plan savings for 2023 and an additional $13,000 for 2022, for a total of $26,000 in additional retirement savings that will grow tax-free for life and are tax-free upon withdrawal.
If you’re age 50 or over, you can contribute $7,500 per person (including spouses) each year, so, if both you and your spouse max out this savings strategy in both 2022 and 2023, you’ll have a total of $30,000 in tax-efficient savings to draw from in retirement tax-free.
While the backdoor Roth may seem simple at a glance, there are important stipulations and rules that can have a significant tax impact if the strategy is performed incorrectly. Among the most important stipulations if you have pre-tax money in any of your traditional IRAs is the pro-rata rule which states that all IRAs are treated as one IRA. So, how can the pro-rata rule affect the outcome of using a Backdoor Roth IRA strategy? Let’s walk through an example of the consequences one may face upon completing a Backdoor Roth IRA contribution without proper planning:
Max has an IRA at Vanguard that contains $93,000 of pre-tax funds. He decides he wants to do a Backdoor Roth IRA contribution, so he opens an IRA at Fidelity. Max contributes $7,000 of non-deductible money and immediately proceeds to convert the money to his Roth IRA at Fidelity. Max thinks that he will not owe any taxes on the conversion because he converted money from his Fidelity IRA to his Fidelity Roth IRA. However, he did not understand the pro-rata rule before making this financial decision.
The pro-rata rule says that all IRAs are treated as one IRA for the purposes of Roth Conversions. So, in reality, Max has $7,000 of non-deductible money across his IRAs and $93,000 of pre-tax money. In other words, 7% of the funds in Max’s IRAs are non-deductible, and the other 93% of the funds are pre-tax. So, of the $7,000 Roth conversion 7% is tax-free; the other 93% is taxable at ordinary income rates!
You may be saying to yourself, “I have pre-tax money in IRAs, does this mean that I cannot utilize the Backdoor Roth IRA contribution strategy without incurring negative tax consequences?" For the majority of our clients with a current 401(k) plan, the answer is yes, with some preliminary clean-up.
At Willis Johnson & Associates, many of our clients are corporate executives and professionals who are still working in corporate America and have a 401(k) plan with their employer. Employer plans are not considered part of the pro-rata rule. Typically, it can be beneficial to consolidate accounts before applying the Backdoor Roth IRA Contribution strategy to your financial plan to ensure the lowest possible tax impact.
So, if Max were our client, we may decide to consolidate his pre-tax IRAs to his company’s 401(k) plan. After we consolidated the $93,000 of pre-tax money into Max's company’s 401(k), then we could assist him in making a Backdoor Roth IRA Contribution because he no longer has any pre-tax IRA money.
When considering your financial goals and the strategies it takes to reach them, the backdoor Roth strategy can be a highly beneficial strategy for high-income earners to take advantage of. It's important to discuss the backdoor Roth strategy with a financial professional early to take advantage of the compounded growth and future tax savings it offers. To get a better idea of how you could leverage the backdoor Roth IRA in your financial plan, get in touch with one of our advisors who can offer guidance and additional recommendations to help you achieve your financial goals.