By: Sean Gallagher, CFP®
As the April 15th tax filing deadline rapidly approaches, so does the 2023 Roth IRA contribution deadline. Roth IRAs are among the most efficient yet under-utilized retirement saving strategies. By saving after-tax money in a retirement account, individuals can enjoy tax-free investment growth and distributions in retirement.
One retirement saving strategy that often piques interest is the Backdoor Roth IRA contribution. This method allows high-income earners to bypass traditional Roth IRA contribution limits, offering a potential tax-efficient retirement savings avenue. However, it's not without its intricacies and commonly generates a list of questions. Let's explore the top frequently asked questions surrounding Backdoor Roth IRA contributions:
1. What Exactly Is a Backdoor Roth IRA Contribution?
A Backdoor Roth IRA contribution involves a series of steps that allow individuals to contribute to a Roth IRA, even if their income exceeds the limits set by the IRS for direct contributions. For the 2023 tax year, individuals making above $138,000 or married couples making above $218,000 may be partially or fully restricted from direct contributions to a Roth IRA*. However, using the backdoor method, individuals can make a non-deductible traditional IRA contribution and convert it into a Roth IRA, effectively sidestepping the income limitations.
2. Who Can Benefit from a Backdoor Roth IRA Contribution?
High-income earners who are ineligible for direct Roth IRA contributions due to income limits benefit most from the backdoor method. Additionally, individuals anticipating a higher tax bracket during retirement may find a Roth IRA's tax-free growth and withdrawals most appealing. However, consulting with a financial advisor or tax professional is essential to determine if this strategy aligns with your financial plan.
3. What Are the Steps Involved in Making a Backdoor Roth IRA Contribution?
The process of executing a Backdoor Roth IRA contribution involves several steps:
a) Contribute to a Traditional IRA
Start by making a non-deductible contribution to a traditional IRA. Since there are no income limits for contributing to a traditional IRA, this step is accessible to everyone. However, ensure this is a separate IRA account and that you do not commingle these contributions with any prior deductible contributions.
b) Convert Traditional IRA to Roth IRA
Once the contribution is made, promptly convert the traditional IRA funds into a Roth IRA. This conversion is crucial to ensure the funds grow tax-free.
c) Report the Conversion
When filing taxes, report the conversion on IRS Form 8606 to document the movement of funds from the traditional IRA to the Roth IRA.
4. Are There Any Potential Pitfalls or Considerations to Keep in Mind?
While the Backdoor Roth IRA strategy can offer significant benefits, there are several considerations to be aware of:
a) Pro-Rata Rule
The pro-rata rule can complicate matters, especially if you have existing traditional IRA accounts with pre-tax contributions. If you have any pre-tax IRA balances outside of the backdoor conversion amount, you may accidentally trigger an additional tax liability on the conversion. To be safe, you will want all traditional IRA balances to be $0 by December 31st of the year you completed the Roth conversion. A common strategy to avoid this issue is to roll over any traditional IRA assets to your employer-sponsored retirement plan, such as a 401(k) plan, assuming the employer-sponsored retirement plan permits rollovers into the plan.
b) Non-Qualified Withdrawals
While withdrawals of direct contribution amounts can be made from Roth IRAs tax and penalty-free at any time, converted funds do not receive the same treatment. Withdrawals of converted amounts before the account holder reaches age 59 ½ or before the account has been open for five years may be subject to taxes and penalties. Additionally, the converted funds must remain in the account for at least five years to avoid tax and withdrawal penalties.
c) Timing
Timing is crucial when executing a Backdoor Roth IRA contribution. Any gains between the traditional IRA contribution and the Roth IRA conversion could be subject to taxes. Thus, promptly converting the funds is advisable to minimize potential tax liabilities.
5. Is the Backdoor Roth IRA Contribution Legal?
Yes, the Backdoor Roth IRA contribution method is legal. However, following IRS guidelines and properly reporting the contribution and conversion on your tax return is crucial. Failing to do so could result in penalties or unintended tax consequences. Individuals can use this strategy to bolster their retirement savings if the process is executed correctly and complies with IRS regulations.
The Backdoor Roth IRA contribution strategy offers high-income earners a valuable tool for expanding their retirement savings options. By understanding the process and addressing common questions and concerns, individuals can confidently navigate this approach to enhance their long-term financial security. Consulting with a qualified financial advisor or tax professional is recommended to ensure that the Backdoor Roth IRA contribution aligns with your overall financial plan and goals.
*Roth IRA direct contribution income limits are based on Modified Adjusted Gross Income (MAGI) and tax filing status. For single tax filers in 2023, a MAGI between $138,000 - $153,000 will be phased out of the full direct contribution amount, while a MAGI above $153,000 will be fully excluded. For married filing jointly tax filers in 2023, a MAGI between $218,000 - $228,000 will be phased out of the full direct contribution amount, while a MAGI above $228,000 will be fully excluded.
Sean Gallagher is a CERTIFIED FINANCIAL PLANNER™ at HIGHLAND Financial Advisors, a Fee-Only financial planning firm that offers comprehensive financial planning, retirement planning, and investment management. Sean graduated from Virginia Tech’s financial planning program in 2018 and successfully passed the CFP® national exam in 2019. As a Financial Planner at HIGHLAND Financial Advisors, Sean works on developing comprehensive financial plans and investment management for all clients.