Backdoor Roth IRAs: A Savings Strategy for High-Income Investors
By Scott Snider
key takeaways
Backdoor Roth IRAs can be an effective way for high-income earners to contribute to a Roth IRA without being completely phased out by the IRS’ income limits.
The IRA aggregation rules can make backdoor Roth IRAs a tax trap, especially if the traditional IRA balance(s) exceeds $100,000.
To perform a backdoor Roth IRA you must contribute to a nondeductible IRA, and then convert the contribution to a Roth IRA shortly after the nondeductible contribution is made.
If you don’t like paying more in taxes than you need to and you make a sizable income, then a backdoor Roth IRA is a strategy you may want to consider. However, before explaining how to unlock this financial planning tool to your advantage, it is important to know the boundaries we are working with.
Here are the 2023 Roth IRA phaseout limits set forth by the IRS:
Single = $138,000 - $153,000
Married = $218,000 - $228,000
IRA RULES and considerations
Why the Roth phaseout limits matter is that if you exceed those limits, contributing directly to a Roth IRA is off the table. At least it appears that way on the surface…
Something else to know is that if a person is an active participant in a company-sponsored retirement plan and their income exceeds the Roth phaseout limits listed above, then that person is disqualified from making deductible IRA contributions. Therefore, the only other tax-sheltered alternative is to contribute to a nondeductible IRA, which is funded with after-tax dollars.
Nondeductible IRAs will grow the contributions tax-deferred until the distribution phase begins, as early as the normal retirement age of 59 ½ and no later than age 73 when required minimum distributions (RMDs) begin. Of particular importance is that the growth portion within the IRA is taxable upon distribution and must be taken out before the nondeductible contributions can be taken out. This is otherwise referred to as last in first out (LIFO) tax treatment.
Backdoor ROTH IRA to the RESCUE
A Roth IRA, on the other hand, allows the owner to grow their after-tax contributions on a tax-deferred basis and take tax-free withdrawals at full retirement. Translation - a Roth IRA is always better than a nondeductible IRA.
You might be wondering how a backdoor Roth IRA fits in with all this financial mumbo jumbo. Think of the concept this way, the “backdoor” is a smarter entry point for a person who wants to sneak their way into the house of Roth without being hit with IRS penalties.
So how does one actually slip their way past the IRS’ Roth income limits? Their “backdoor way in” begins with contributing to a nondeductible IRA, and then converting those funds to a Roth IRA within the same calendar year.
The IRA Aggregation Rule
A word of caution to high-income earners with multiple pre-tax IRAs. All of your pre-tax IRAs are treated as one account when calculating the tax consequences of a Roth conversion. In other words, the IRS’ aggregation rule requires the owner of multiple IRAs to include a proportionate amount of any pre-tax IRA balances (traditional IRAs) with their after-tax IRA balances (nondeductible IRAs) whenever performing a Roth conversion.
Example. A successful attorney, Atticus Finch, is age 55 and is considering all of his options for tax sheltering as much money as he can. He currently earns $400,000 and exceeds the IRS’ Roth phaseout income limits. He is an active participant in his company 401(k) plan. Therefore, he is unable to contribute directly to a Roth IRA and does not get a tax deduction for contributing to a nondeductible IRA. Additionally, Atticus owns a Traditional IRA worth $100,000. Atticus is unsure whether or not he should convert his recent nondeductible IRA contribution of $7,000 to a Roth IRA.
Problem. Unfortunately for Atticus, his $7,000 nondeductible amount gets rolled in with the $100,000 of pre-tax IRA funds when he goes to complete the Roth conversion. Meaning only 6.5% ($7,000 / $107,000) of the conversion is sourced from the nondeductible IRA, and the other 93.5% gets converted from the traditional IRA. Because most of the conversion is from the traditional IRA, Atticus is paying taxes on $6,545. If he is single and his tax bracket is 35%, the backdoor Roth IRA strategy just cost him $2,291 in taxes. Needless to say, Atticus isn't happy the next year when the IRS says he has to cough up more in taxes. While it's technically not double taxation, most people who make this mistake feel that way.
Solution. The way that Atticus can prevent this problem is by rolling over all of his Traditional IRA funds to his law firm's 401(k) retirement plan. That is because 401(k), 403(b), and other employer-sponsored retirement plans are excluded from the IRA aggregation rule. The benefit of doing it this way is that Atticus doesn’t pay any taxes on the conversion and he gets the full benefits of a Roth IRA. It’s important to know that employer-sponsored SIMPLE IRAs and SEP IRAs fall within the IRA rules when considering a backdoor Roth conversion.
SUMMARY GUIDE TO PERFORMING A BACKDOOR ROTH
STEP 1 - Confirm there are no other pre-tax IRAs
STEP 2 - When there are pre-tax IRAs, rollover the funds to a 401(k)
STEP 3 - Contribute to a nondeductible IRA
STEP 4 - Convert to a Roth IRA in the same calendar year
IMPORTANT DISCLOSURE INFORMATION
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