What is a backdoor Roth IRA?

A Roth IRA is a retirement account that allows individuals to contribute after-tax dollars. The contributions and earnings grow tax-free, and you can take tax-free distributions once certain requirements are met. However, not everyone is eligible to contribute directly to a Roth IRA.  Eligibility to contribute to a Roth IRA is based on your modified adjusted gross income (MAGI). For 2024, the maximum contribution starts to reduce at MAGI of $146,000 for single filers and $230,000 for joint filers.

However, there is a way around the income limitation for high-income taxpayers. A backdoor Roth IRA is a strategy that allows high-income taxpayers to contribute to a Roth IRA by converting funds from a traditional IRA. This is typically done by making your annual contribution to a traditional non-deductible IRA and then immediately converting this to a Roth IRA.  Doing this as soon as possible prevents earnings on your traditional IRA from being taxable on the conversion. Some financial advisors offer support in handling a backdoor Roth conversion for their clients – so reach out for help before starting the process of converting.

Nevertheless, before leaping to follow internet advice to contribute to a backdoor Roth IRA – you should consider these three things:

1.     Do you already have an IRA or Roth IRA account(s)?

2.     Does your current employer offer a 401(k) with a company match?

3.     What is your expected income for the year?

The IRS views all of your IRAs as a single account when determining the tax you owe on distributions, including Roth IRA conversions. If your traditional IRA accounts include both pre-tax (deductible, retirement plan rollovers) and after-tax (non-deducible) contributions, the pro-rata rule dictates that your Roth conversion will be taxed proportionate to your pre- and post-tax percentages.  You cannot dictate that your Roth conversion will only use after-tax funds.

For example, if you have an existing $100,000 traditional IRA and $7,000 came from non-deductible contributions, your non-taxable percentage would be 3% (or 7,000/100,000). This turns your IRA conversion of $7,000 into $6,510 of ordinary income on your tax return. Alternatively, if you do not have an existing traditional IRA or all your contributions were non-deductible, your pro-rata would be 0% and none of your IRA conversion would be considered taxable income on your return. Backdoor Roth IRAs can be valuable for the right taxpayer. However, it isn’t right for everyone.

In addition to the backdoor Roth IRAs, there are several other options to consider for retirement planning. 

401(k)s & Company Matches

A 401(k) is a retirement savings plan that allows taxpayers to make contributions through their employer to a defined contribution plan. The contribution limit for 401(k)s is $23,000 in 2024 or $30,500 for those over the age of fifty. Some employers will offer a company match – typically around 3% of the employee’s salary will be contributed to your account, up to a set limit. This is the biggest benefit of a 401(k), as it is essentially free money to the taxpayer. It’s also important to note that your employer’s contribution does not count toward the annual contribution limit.

When you open a 401(k) with your employer, you can usually decide for yourself between a traditional and/or a Roth account. The difference is primarily how they are taxed. A traditional 401(k) is when the employee contributes pre-tax dollars and thus reduces their taxable income in the current year. This is beneficial for high income taxpayers – who are currently paying a premium tax rate. When the taxpayer withdraws the retirement funds – they should be in a lower tax bracket, thus the tax on the withdrawal (money contributed + earnings) should be minimal.

On the other hand, a Roth 401(k) is when the employee contributes post-tax dollars. Thus, paying the tax on the income in the current year so that it can grow tax free in your retirement account. There is no tax deduction on this type of contribution, as you reap the benefits in the future. This type of account is beneficial for taxpayers who want to shield themselves from potential increases in tax rates in the future by paying the tax now. Moreover, it is important to note employer contributions can be made to both traditional and Roth 401(k) plans no matter what option you pick. 

If your employer doesn’t offer a company match, consider looking at other IRA or Roth IRA contributions. By going through a separate broker outside of your work plan, it will give you access to a larger selection of investments and help avoid administrative fees.

IRAs

Taxpayers are allowed to contribute a combined total of $7,000 to all Traditional and Roth IRA accounts in 2024, or $8,000 if you are over the age of 50. There is no employer match for contributions to either type of IRA.

Traditional IRA contributions are ideal for taxpayers who are seeking an immediate tax break, however if you are covered by an employer retirement plan, your deduction may be reduced or eliminated based on income levels. In 2024, single or head of household taxpayers who have an adjusted gross income of $87,000 or more (and are covered by a retirement through work) are not eligible for the deduction. Meanwhile, the phaseout from a full deduction to a partial deduction start at $77,001 for single or head of household. Similarly, married filing jointly taxpayers who have an adjusted gross income of $143,000 or more (and are covered by a retirement through work) – are not eligible for the deduction. The phaseout for married filing jointly starts at $123,001. However, you are still eligible to contribute to a non-deductible IRA even if your income is over the eligibility threshold.

Roth IRA contributions are ideal for taxpayers who are not eligible for the traditional IRA deduction and for those who expect to be in a higher tax bracket in the future. They are also ideal for younger investors with a long-time horizon until retirement who can really benefit from the tax-free growth. A taxpayer’s eligibility for a Roth IRA is not impacted by their 401(k) retirement through work. However, as mentioned above, there are income limitations to keep in mind.

When deciding between what savings vehicle you want to contribute to this tax year, it is important to weigh the tax advantages, eligibility and contribution limits beforehand. Talk with a financial advisor and/or your tax accountant about the best strategy to implement for your future today.