These days it's important to explore all avenues to maximize your retirement savings. One often-overlooked strategy is the Backdoor Roth Conversion. This financial maneuver allows higher-income earners to contribute to a Roth IRA regardless of income limits.
Understanding Roth IRAs
Let’s first review why Roth IRAs are so attractive. Contributions to Roth IRAs are made with after-tax dollars vs pre-tax dollars for traditional IRAs. Your Roth IRA investments grow tax-free. Unlike traditional IRAs, withdrawals from your Roth IRA in retirement are tax-free as well (if you are over age 59 1/2 and have owned a Roth for more than 5 years*). Additionally, Roth IRAs offer a more flexible approach to managing your investments, and unlike traditional IRAs there are no required minimum distributions after age 73.
* A separate 5 year rule applies to conversions.
The Income Limitation Rule
Roth IRAs are an excellent retirement savings vehicle, but there's a major catch besides the basic IRA contribution limits – income limits. In 2023, if your modified adjusted gross income (MAGI) exceeds $140,000 for single filers or $208,000 for married couples filing jointly, you are ineligible to make direct Roth IRA contributions. Enter the Backdoor Roth Conversion!
The Backdoor Roth Conversion: How It Works
The Backdoor Roth is a way for high-income earners to enjoy the benefits of a Roth IRA. Here's briefly how it works:
Traditional IRA: Start by opening a traditional IRA. There are no income limits for contributing to a traditional IRA, but you (or your spouse) must have earned income. Note, if you already have a traditional IRA, you'll need to do assess possible tax liability under the Pro-rata Rule. See below.
Pro-rata Rule: If you have a pre-tax balance in any traditional IRA, you fall under the Pro-rata Rule. This means a portion of your Backdoor Roth Conversion will be taxable. You want to avoid that. Ideally you should empty your traditional IRA before embarking on a Backdoor Roth Conversion strategy. The most popular way to accomplish that is to roll over any pre-tax funds in a traditional IRA into a 401(k). Consult a tax professional for guidance.
Make a Non-Deductible Contribution: Contribute cash to your traditional IRA. Since you are over the income limits, your contributions will be made with after-tax dollars. Don't over-contribute. The limits for an after-tax (non-deductible) traditional IRA contributions are the same as for a pre-tax contribution. For 2023, IRA contributions cannot exceed $6,500 ($7,500 if you are age 50 or older).
Convert to a Roth IRA: Convert all the funds immediately to a Roth IRA. There are no income limitations for this. The amount converted is considered a rollover and is not subject to early withdrawal penalties, and assuming there is no Pro-rata Rule in effect, the Backdoor Roth Conversion is a non-taxable event.
Rinse and Repeat: As long as you or your spouse has earned income (above the limit for a direct Roth IRA contribution), there's nothing stopping you from doing a Backdoor Roth Conversion every year.
The Backdoor Roth strategy can be a game-changer for high-income individuals. However, this is only a brief summary. There are a number of rules in play. It's highly recommended to consult with a financial advisor or tax professional.