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If you’ve been looking into saving for retirement, you're already probably familiar with the Roth IRA, which is one of the only tax-advantaged vehicles that provide a tax-free benefit. But for higher-income earners, accessing a Roth IRA can be challenging due to income limitations that restrict contributions.
So does this mean you can't have this account at all? Not only can you own one, but you can convert your pre-tax money into your post-tax funds whenever you'd like. This feature opens an interesting opportunity for high-earners to contribute to their Roth IRA while working around the rule. Let's dive into it.
With great tax-free power comes great restrictive responsibility. Specifically, there are income limits to make a direct contribution:
For 2024, these income limits are as follows:
If your income exceeds these limits, your ability to contribute directly to a Roth IRA is phased out, or you become entirely ineligible to contribute directly. This can feel like a dead end for those who want to take advantage of the Roth IRA’s benefits. However, one strategy makes it possible to work around this problem.
The Backdoor Roth IRA is a process that allows people to contribute to a Roth IRA with a couple of additional steps behind the scenes, moving funds from a Traditional IRA to a Roth IRA. The idea is simple: Put money inside a Traditional IRA and convert those funds into a Roth IRA with a Roth Conversion.
This allows people to put their money into a Roth IRA without making a "direct" contribution to the Traditional IRA. While tax law does not explicitly outline the strategy, it is a widely used and permissible method under current IRS regulations, provided all tax rules are followed correctly.
While putting money aside despite these limits is possible, the process must be done right. Failure to do so can make things complicated down the line and create unintentional tax consequences if not carried out correctly.
If there any existing Traditional IRA funds, these need to be moved in an account that is not a Traditional IRA, such as a 401(k), 403(b), to provent unwanted tax consequences. These Traditional IRAs also include SEP IRAs and SIMPLE IRAs, which are technically Traditional IRAs. We'll explain why you should go towards the end with the Pro Rata rule, but this ensures the process does not trigger taxes in the process with existing funds. This also means you need to determine if this process works for you should you want to keep your existing IRA funds as is or move them at all.
If you don’t already have one, you must open both a Traditional IRA and a Roth IRA. You will use the Traditional IRA as the initial account to deposit contributions.
Contribute your desired amount to the Traditional IRA. For 2024, the IRA contribution limit is $7,000 (or $8,000 if you’re over 50).
It’s essential to leave the funds uninvested while they are in the Traditional IRA. This is to avoid any potential gains before converting the funds into the Roth IRA, which could result in taxes when the conversion happens.
Give the funds a few days to settle in your Traditional IRA before initiating the conversion, as the cash will need to be ready before initiating.
Once the funds have settled, initiate a Roth conversion from the Traditional IRA to your Roth IRA. This step allows you to move the money into the Roth account, which will grow tax-free. Depending on the custodian you work with, they may require your signature on a form to fill out.
You’ll be asked if you want to withhold taxes during the conversion. Do not withhold taxes for the conversion, as the contribution to the Traditional IRA was non-deductible, and ideally, there should be no taxable event unless you had gains in the account before converting.
Once the conversion is complete, you can invest the funds in your Roth IRA as you see fit. Your investments can grow tax-free!
Finally, a tax form, Form 8606, must be filed to ensure the Traditional IRA contributions are non-deductible. This ensures that the IRS recognizes that you did not deduct your income from the contribution and, therefore, avoids double taxation.
I mentioned in Step 0 to bring Traditional IRA funds to zero before initiating the process. While the IRS allows a conversion from a Traditional IRA to a Roth IRA, the taxation of this conversion has one caveat. The rule called "Pro Rata" indicates that a Roth Conversion from a Traditional IRA must be treated as an even distribution across all Traditional IRAs for tax purposes, even if you aren't trying to convert funds in those other accounts.
Sounds confusing? To help understand this, let's give an example:
Suppose you had $28,000 in an existing Traditional IRA (pre-tax). You decide to open a Traditional IRA to use as part of the Backdoor Roth IRA and max it out for the year with $7,000 (non-deductible). The total Traditional IRAs are $35,000, with 80% pre-tax and 20% non-deductible.
So if a $7,000 conversion occurs? 80% of the conversion will be from the pre-tax funds and 20% will be from the non-deductible funds, which results in $5,600 of the funds taxed. This is why it's vital to move the existing pre-tax funds to an employer-sponsored plan (as mentioned in Step 0), so they won't be inadvertently converted as a result of the rule!
Given the steps needed to put funds in a Roth IRA this way, it's always a good idea to consult with a financial advisor or a tax professional before moving forward. Even if your income exceeds the limits for direct Roth IRA contributions, the Backdoor Roth IRA offers an opportunity to take advantage of tax-free growth. By following this simple process, you can ensure that you’re building a tax-free nest egg for the future, no matter what income limit!
You know how to make money, but you're not sure if you're making the right moves financially. That's why I started Pashman Financial.
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