The Backdoor Roth IRA: A Tax-Smart Strategy for High Earners

If you're a high-income earner, you may feel like you're missing out on the benefits of a Roth IRA due to income restrictions. In 2024, the Roth IRA eligibility phaseout is $146,000 - $161,000 for Single tax filers and $230,000 - $240,000 for MFJ tax filers. However, there's a perfectly legal way to sidestep these limits: the backdoor Roth IRA conversion. Here's what you need to know.

What is a Backdoor Roth IRA?

A backdoor Roth IRA is not an official type of retirement account, but rather a strategy that involves converting a Traditional IRA into a Roth IRA. The process works like this:

1. Open and contribute to a nondeductible (after-tax) Traditional IRA. There are no income limits for this type of IRA.

2. Convert the nondeductible Traditional IRA to a Roth IRA. You'll only owe taxes on any earnings that have accumulated in the account, which should be minimal if you convert soon after contributing.

Beware of the Pro Rata Rule

Before you implement this strategy, it's crucial to understand the Pro Rata Rule. If you have any other pre-tax IRA funds (such as from a 401(k) rollover), the IRS requires you to prorate the portion you convert to a Roth IRA over all your IRA balances. This can result in a significant tax bill.

To avoid this, roll any pre-tax IRA funds into your current employer's 401(k) plan before executing the backdoor Roth conversion. Keep in mind that not all 401(k) plans accept incoming rollovers, so check with your plan administrator first.

Step-by-Step Guide to a Clean Backdoor Roth Conversion

1. Minimize pre-tax IRA balances by rolling them into your current 401(k), if possible.

2. Open and contribute to a nondeductible Traditional IRA. Be sure to file Form 8606 with your tax return to report the after-tax contribution.

3. Convert the entire balance of the nondeductible Traditional IRA to a Roth IRA.

It's important to note that you cannot open separate IRAs to segregate pre-tax and after-tax contributions. The IRS aggregates all of your Traditional, SEP, and SIMPLE IRA balances when applying the Pro Rata Rule.

The only way to completely isolate after-tax contributions to a Traditional IRA would be to roll any pre-tax money (which also includes earnings on after-tax contributions) into an employer-sponsored plan, such as a 401(k), 403(b), 457 governmental plan, of Thrift Savings Plan (TSP).

Is the Backdoor Roth IRA Right for You?

The backdoor Roth IRA conversion can be an excellent way for high earners to enjoy the tax-free growth and withdrawals that a Roth IRA offers. However, it's essential to understand the tax implications and navigate the Pro Rata Rule to avoid unexpected tax liabilities.

If you're considering this strategy, consult with a financial advisor or tax professional to ensure it aligns with your overall financial plan and to execute it properly. With careful planning, the backdoor Roth IRA can be a powerful tool in your retirement savings arsenal. Contact us for a complimentary consultation.