The Roth IRA has been popular for quite a while now. You have heard about its tax-free benefits and you would like to open one. But, there is a problem - you make too much money.
Don't despair, the door isn't closed. Even though high-income individuals are prevented from contributing directly to a Roth IRA, you can still get in on this popular retirement account by using the backdoor.
While it sounds kind of like a spy novel, it is actually called the "Back Door Roth IRA" strategy. Let's jump in:
First, a Roth IRA Refresher
The Roth IRA is a tax-advantaged account to help you save for your retirement and is funded with after-tax money - so you get no upfront income tax deduction for your contributions.
That's the downside. The upside is that the growth inside the IRA is tax-free, and the income when withdrawn, is also tax-free as long as you meet IRS rules (just don't touch the money until you are 59 1/2 or for 5 years, whichever is longer, and you should be fine).
The 'no upfront tax deduction' is basically a trade-off for tax-free growth and tax-free income later in retirement. Contrast this to a traditional IRA which is tax deferred (i.e. you are putting Uncle Sam on hold until you pay taxes later on all growth).
Here's the challenge for higher income people: If your earned income is too high, you cannot contribute to a Roth IRA.
If you are single and earn more than $144,000 (for 2022), or married filing joint and earn more than $214,000 (for 2022) you cannot contribute to a Roth IRA.
How then can you get contributions into a Roth IRA? By using a Back Door Roth.
In Through the Back Door
You have heard of Roth conversions - this is taking funds from a pre-tax retirement account and "converting" them to an after-tax Roth account.
Just about anyone can do a conversion - there are no income limitations like there are on contributions. But there are taxes, so consult with a financial planner first.
An example of a conversion is when you take funds from a traditional IRA and "convert" them to a Roth IRA. You generally pay taxes on this conversion.
So if your income is too high to contribute to a Roth IRA, a way to get money into one is by conversion. You could make a non-deductible contribution to a traditional IRA. There are no income limitations on non-deductible contributions. You can then convert this over to a Roth IRA.
This can work well if you only have one traditional IRA and just use it for making non-deductible contributions to convert to a Roth IRA. There may be little or no tax on this conversion, as long as you have no other traditional IRAs.
5 Star Tip: If you do have other traditional IRAs (like from a 401k rollover) and attempt this strategy, you will pay taxes on the conversion because of something called the pro-rata rule. Not a deal breaker, but it can get a little tricky. Talk to a financial planner first if you are not sure.
I would recommend you research the pro-rata rule on IRAs before proceeding.
Back Door Steps
So, here is what the Back Door Roth conversion can look like:
Open a traditional and a Roth IRA at the same custodian.
Make a non-deductible contribution to the traditional IRA. There are no income limitations for a non-deductible contribution.
Wait a day or two and then convert the balance from the traditional IRA to the Roth.
Be sure and file form 8606 for non-deductible IRA contributions.
Final Thoughts
Please remember there can be taxes involved, so talk with a financial planner before using this process. Everyone's situation is a little different. I help people and employees from many companies with this planning strategy, so reach out to see if I can help!
John Piershale, CFP®, AEP®
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