Let's Talk About Backdoor Roth IRAs

Let's Talk About Backdoor Roth IRAs

June 03, 2024

Hey there, Future Retiree!

Navigating the world of retirement savings can feel like solving a puzzle, especially if you're earning too much to fit into the neat categories set by the IRS for Roth IRA contributions. But don't worry, there is a savvy strategy: the Backdoor Roth IRA. Let's break down what it is, why it might be your retirement planning pal, and how to make it work for you.

So, What's a Backdoor Roth IRA Anyway?

Imagine this: you earn too much to contribute directly to a Roth IRA. Annoying, right? But here comes the "backdoor" part—a clever workaround. It’s not a different type of account, but a method that lets high earners fund a Roth IRA, even if their income is above the usual limit. It is also distinct from your work 401k plan, so even if you fully fund that, this strategy may still be feasible for you.

Why Should You Care About This?

Roth IRAs are awesome because you can pull money out tax-free when you retire, subject to certain rules. Plus, there’s no bothersome rule forcing you to withdraw money at a certain age. It's all yours, growing happily tax-free until you decide to use it. The Backdoor Roth IRA opens up this opportunity even if your paycheck is on the heftier side and even if you and or your spouse have 401k plans at work that you are fully funding.

Here’s How You Can Do It:

  1. Start With a Traditional IRA: First, you put the maximum after-tax money into a traditional IRA. There's no income limit here, which is great. But this contribution will not lower your tax bill this year—It’s a nondeductible contribution.
  2. Convert to a Roth IRA: Next, move that money from your traditional IRA to a Roth IRA. This process is usually as simple as filling out a form with your IRA provider.
  3. Deal With Taxes: Since the money you’re moving has already been taxed, the only tax you’ll pay now is on any gains that money might have earned while it was in the traditional IRA. If you do this quickly, those gains (and thus the taxes) will be minimal. You will want to consult your advisor and tax professional beforehand to ensure you follow these steps correctly.  

Watch Out for Pitfalls

While it sounds straightforward, there's a catch called the pro-rata rule. In Step 2 above, you are converting from your IRA account to your Roth IRA. With conversions, the IRS adds up all your IRA balances and qualified annuities to determine how much tax you owe on the conversion. This strategy is ineffective if the pre-tax balances are significant in these accounts. Ideally, you have zero pre-tax monies in IRAs & qualified annuities. If you have a work 401k plan, consider transferring your pre-tax IRA balances into the 401k. This may be a successful workaround because the IRS only cares about IRA balances (and not 401k balances).

Wrapping Up

A Backdoor Roth IRA could be a smart move if you're looking to boost your tax-free income in retirement—especially if you're earning too much to contribute to a Roth IRA the regular way. It’s like finding a secret passageway in an old castle—pretty cool, right? But because it can get a bit tricky, it would be wise to chat with a financial advisor to make sure this strategy fits perfectly with your overall financial landscape.

Contribution and Deductibility Thresholds for IRAs & Roth IRAs, 2024 

The content is developed from sources believed to provide accurate information. The information in this material is for educational purposes only and is not intended as tax, investment, or legal advice. It may not be used to avoid any federal tax penalties. Please consult legal, investment, or tax professionals for specific information regarding your situation. Mayfair Financial and FMG Suite developed and produced this material to provide information on a topic of interest. FMG is not affiliated with the named state-registered investment advisory firm. The opinions expressed and material provided are for general information and should not be considered a solicitation for the purchase or sale of any security.