Here’s how high earners can benefit from a Roth IRA via “the backdoor” despite IRS income limits. Plus, a forecast on the future of these retirement plans.
Matt Ruby
Jun 11, 2024June 11, 202418 min read18 minutes read
Coming in through the backdoor may sound like a sneaky move, but it’s actually a great fiscal solution for high earners looking to get the tax benefits of a Roth IRA. This article provides a deep dive into Backdoor Roth IRAs: what they are, why they matter, the pros and cons, how to get one, and their future.
Explanation of a Backdoor Roth IRA
The good news: You’re a high earner. The bad news: That means you aren’t allowed to open or fund a Roth IRA.
How come?
When your Modified Adjusted Gross Income (MAGI) exceeds regulatory ceilings, the IRS starts phasing out these options. For 2024, the maximum income is $161,000 for single filers and $240,000 for married couples filing jointly.
This is where the Backdoor Roth IRA enters the picture. This option allows high earners to sidestep these income limits by converting nondeductible traditional IRA contributions to a Roth IRA.
Is Backdoor Roth IRA Going Away in 2025?
There are potential complications in the world of backdoor Roth IRAs since there is a possibility they’ll be eliminated (or constrained) in the future.
While they seem safe for the rest of 2024, they remain a target of proposed legislation that could impact them in the future.
Legislators have already tried to limit Roth IRAs and/or change tax brackets and Required Minimum Distributions (RMDs) in the future.
Still, if these IRAs provide advantages, it’s probably better to act now than adopt a wait-and-see attitude. After all, each dConsidering the available benefits (e.g., the lack of required RMDs and relatively low tax rates), it’s still an appealing time to consider a Roth IRA conversion.
What is a Backdoor Roth IRA?
Definition and explanation of a Backdoor Roth IRA
A Backdoor Roth IRA is a strategy that allows high earners (i.e., folks who earn too much to contribute directly to a Roth IRA) to fund a Roth IRA by converting nondeductible contributions from a traditional IRA into a Roth IRA.
How does it work?
By opening a traditional IRA, making after-tax (or nondeductible) contributions, and then converting those funds to a Roth IRA at a later date.ay you miss means sacrificing potential tax-free growth on earnings.
However, note that the conversion process can trigger income tax on the appreciation of after-tax contributions. And, the pro-rata rule is also applicable if the traditional IRA contains both pre-tax and after-tax contributions. (The pro-rata rule is an IRS rule that determines the taxable portion of a distribution from a qualified retirement account that includes both pre-tax and after-tax dollars.)
How it differs from a traditional Roth IRA
Roth IRAs and traditional IRAs are similar in terms of their self-directed nature and contribution limits. However, they differ when it comes to their tax advantages.
With a Roth IRA, you contribute after-tax dollars and your money grows tax-free. After the age of 59 ½, you can generally make tax and penalty-free withdrawals.
Traditional IRAs, on the other hand, offer an immediate tax advantage by lowering your Adjusted Gross Income (AGI). With a traditional IRA, you contribute pre-tax dollars, which can provide a sense of reassurance about your current financial situation. Then, withdrawals are taxed as current income after age 59 ½, ensuring that you are prepared for any tax implications in the future.
Transforming the Traditional IRA: The Roth Conversion
About a decade after the creation of the Roth, changes introduced a backdoor method for investors to convert a traditional retirement account into a Roth IRA by paying a one-time tax.
The newfound flexibility significantly impacted retirement planning by allowing individuals to shift their retirement savings from a tax-deferred environment to a tax-free one.
It allowed any American to take money in less favorable traditional retirement accounts and, after paying a one-time tax, to shift them to a Roth where their money could grow untaxed, similar to having your own Bermuda-style tax haven right here in the U.S.
This process was a significant departure from previous restrictions that limited Roth conversions to individuals with lower income levels.
Before the change:
Individuals were limited in converting their traditional IRAs to Roth IRAs.
It expanded retirement planning options and gave individuals more flexibility in managing their retirement savings.
It also changed the tax code and allowed individuals to convert their traditional IRAs into Roth IRAs.
Removed the income limitation previously preventing high-income earners from converting their traditional IRAs into Roth IRAs.
Only individuals with a modified adjusted gross income (MAGI) of $100,000 or less were eligible to convert.
Now, regardless of income, anyone could convert their traditional IRAs into a Roth.
Eligibility requirements
Technically, high-income earners can’t open Roth-style accounts because of regulatory income caps. (In 2024, those caps are $161,000 for individuals and $240,000 for married couples.)
The Backdoor Roth IRA offers a workaround. Those over the cap can contribute to traditional IRAs and then perform Roth IRA conversions. That means you can continue to take advantage of tax-free growth.
Keep in mind that this is a totally legal loophole that lets you circumvent income limits. It can result in higher upfront tax payments, but you’ll then gain the future tax savings of a Roth account.
Limits of a Backdoor Roth IRA
Annual contribution limits
So, what are the annual contribution limits for a backdoor Roth IRA?
They’re the same as those for a traditional IRA and a Roth IRA. These are set by the IRS and subject to change annually.
For 2024, these are the limits:
Individuals under 50: $7,000
Individuals 50 and older: $8,000
Income limits for eligibility
There are also income requirements to contribute to a Roth IRA. For the 2024 tax year, married individuals filing jointly with a modified adjusted gross income (MAGI) of less than $240,000 can contribute to a Roth IRA (an uptick from the 2023 limit of $228,000). For single individuals, the max is $161,000.
A Backdoor Roth IRA strategy can provide an alternative if your income is above these limits. The limits don’t apply to backdoor Roth IRA conversions. You’ll need to contribute to a traditional IRA and then convert it to a Roth IRA.
Essentially, the Backdoor Roth technique is a solution for investors who wish to contribute to a Roth IRA but earn too much in a given tax year. The process is straightforward — you contribute to a traditional IRA and then convert it to a Roth IRA. However, it’s important to note that this conversion may trigger additional taxes, so it’s crucial to have cash on hand to cover these potential taxes.
Contribution limits for high-income earners
Your modified adjusted gross income (MAGI) must be below certain income limits to contribute to a Roth IRA.
As mentioned earlier: For the 2024 tax year, married individuals filing jointly with a modified adjusted gross income (MAGI) of less than $240,000 can contribute to a Roth IRA (an uptick from the 2023 limit of $228,000). For single individuals, the max is $161,000. A Backdoor Roth IRA conversion allows those with higher incomes who can’t contribute in the typical manner to still take advantage of a Roth IRA.
And again, these are the 2024 contribution limits as determined by the IRS:
Individuals under 50: $7,000
Individuals 50 and older: $8,000
NOTE: When an individual converts a traditional IRA to a Roth IRA, they are required to pay income tax on the converted amount in the year of conversion. This is because the funds in the traditional IRA were contributed pre-tax, and the government wants to collect the tax revenue it would have received upon withdrawal.
The decision to convert to a Roth IRA depends on several factors:
Future tax rates
The individual’s financial situation
Retirement goals
5 common mistakes to avoid with Backdoor Roth IRAs
Backdoor Roth IRA conversions can be complicated. Be careful to avoid the following mistakes. Also: Getting guidance from a financial advisor is recommended too.
Mistake 1: “I forgot about the pro-rata rule.”
If you have a large chunk of money in a traditional IRA which has never been taxed, the taxes owed on a backdoor conversion will be higher. This is because of the pro rata rule, which applies to retirement accounts that contain both pretax and after-tax contributions. This rule determines the ratio of pre-tax to after-tax dollars in an account and applies to distributions and conversions. Failing to note the implications of the pro-rata rule can lead to unexpected tax consequences.
Mistake 2: “I forgot about the five-year rule.”
The five-year rule: You have to wait five years after making an initial contribution to avoid taxes and/or penalties. Withdrawing funds before the five years are up (if you are under 59 ½) means you’ll face taxes and a 10% penalty on the withdrawal.
Mistake 3: “I overlooked the escape hatch.”
The escape hatch is a workaround to the pro-rata rule for people who can access effective company retirement plans that allow for roll-ins. This means you can transfer untaxed IRA dollars into your plan, bypassing the pro-rata rule. You should investigate the details of your 401k or company retirement plan options before proceeding with a Backdoor Roth IRA.
Mistake 4: “I only did it once.”
To get the most out of a Backdoor Roth IRA requires a serial conversion approach (i.e. contributing year after year). You’ll want to contribute the maximum allowed amount each year. Develop the habit of executing your Backdoor Roth IRA conversion annually (preferably early in the year).
Mistake 5: “I didn’t submit Form 8606.”
Don’t overlook Form 8606 on your tax returns. Otherwise, you’ll violate tax regulations and may wind up overpaying taxes. (Form 8606 is how you report non-deductible contributions to a traditional IRA to the IRS.)
News and Updates on Backdoor Roth IRAs
Recent changes or updates to Backdoor Roth IRA rules
The IRA sets contribution limits, which can change from year to year. For 2024, the IRA contribution limits are $7,000. It’s worth noting that individuals aged 50 or over can make an additional' catch-up contribution' of $ 1,000, a beneficial provision to boost retirement savings.
The income limitations for contributing to a Roth IRA account (the top reason people go for a Backdoor Roth IRA) are also important.
The future of Backdoor Roth IRAs is uncertain. Legislation has been proposed that could significantly impact retirement savings strategies. These changes could limit Roth IRAs, alter tax brackets, or modify RMDs in the future. Congress and the IRS may choose to target tax-free accumulations, particularly in the challenging fiscal environment of America. It’s crucial to stay informed and prepared for these potential changes.
President Joe Biden introduced his budget proposal for fiscal 2025, which included significant changes to retirement incentives. The proposal aims to ensure that the ultra-wealthy cannot use these incentives to amass tax-free fortunes, potentially affecting 'mega backdoor Roth conversions.'
This proposal would 'prevent excessive accumulations by high-income taxpayers in tax-favored retirement accounts and make other reforms.' As a high-income individual or retirement planner, understanding and adapting to these potential changes is key to maintaining financial control.
The administration wants to prevent people making more than $400,000 (or $450,000 for married couples) from making backdoor conversions into Roth IRAs. Biden’s proposed budget describes these conversions as a practice that “inappropriately sidesteps the income restrictions on contributions to Roth IRAs.”
Additionally, the budget proposes requiring high-income savers with an aggregate balance of $10 million or more in tax-preferred retirement accounts to withdraw half the difference between $10 million and their account balance annually.
A president’s budget is the first step, though. Congress will now develop its own budget/spending proposals for fiscal year 2025.
Some legislators have argued eliminating the Backdoor Roth would be a step toward a more efficient and effective retirement tax policy. The U.S. Supreme Court may also weigh in via a case with wealth tax implications.
Also, the fact that this approach is called a “Backdoor Roth IRA” may raise eyebrows, too, since it sounds slightly furtive. Moving forward, it’s a good idea to monitor these developments closely.
Impact of political or economic climate on Backdoor Roth IRAs
“While Congress has considered placing limits on backdoor Roth conversions, current retirement legislative efforts have focused on the benefits of contributing to a Roth, rather than conversions.”
But you should also be aware of the risks moving forward. To put it bluntly, Congress and the IRS may not be able to keep their hands off these tax-free accumulations considering the challenging fiscal environment faced by the federal government.
“To address the so-called ‘back-door’ Roth IRA strategy and a similar one for retirement plans, the proposal, among other things, would prohibit a rollover to a Roth IRA of an amount distributed from an account in an employer-sponsored eligible retirement plan that is not a designated Roth account (or of an amount distributed from an IRA other than a Roth IRA) for a high-income taxpayer. The provision would also prohibit rollovers or transfers of amounts that are not held within a designated Roth account into a designated Roth account for a high-income taxpayer.”
Bruce Willey, Founder of American Tax and Business Planning, warns,
“The notion of retroactivity — which is what a wealth tax would bring — continues to feel like the wolf at the door. With deficits at record levels, taxes labeled ‘billionaire wealth taxes’ could easily and quickly expand into retroactive taxes on unrealized and untaxed Roth IRA accounts.”
That said, no one in the elected office has proposed an attack on retirement accounts yet. As for the future, no one can say for sure.
Pros and Cons of a Backdoor Roth IRA
Advantages of a Backdoor Roth IRA
Tax-free growth and withdrawals
No required minimum distributions
Flexibility in contribution and withdrawal options
Let’s explore further…
The main benefit of a Backdoor Roth IRA (and it’s a big one): You can contribute to a Roth IRA even if your income is too high to contribute directly. Then, you can take withdrawals in retirement tax-free.
Later, you can withdraw money from a Roth IRA with no taxes or penalties (if you’ve met the five-year holding requirement). Roth IRAs can also help with your retirement planning since the money converted to a Roth is not subject to required minimum distributions (RMDs) after an account holder turns 73.
Note: In contrast, traditional IRA and 401k accounts require RMDs once an account holder reaches a certain age.
Also, having money in a Roth IRA provides tax diversification for account holders once they reach retirement. As long as you meet the five-year rule requirements and are at least 59 ½, there is no 10% early withdrawal penalty (thus, withdrawals will be tax-free).
A Roth can also help with estate planning. For example, spouses can roll an inherited Roth IRA into a Roth IRA in their own name and treat the assets like their own. If the original account was a Roth IRA and assets were in the account for over 5 years, distributions could be tax-free. There’s no time requirement on when you have to withdraw money either.
Disadvantages of a Backdoor Roth IRA
If you do a Backdoor Roth conversion, it could cause some of the conversion to be taxable. There may be federal, state, and local taxes on converted earnings and deductible contributions. And be prepared for the possibility that rules around this could change in the future.
Also, conversions could kick you into a higher tax bracket. Keep in mind the 5-year aging rule in order to be eligible for tax-free distributions too. Be sure to take your current year tax situation into account and note how any taxes incurred on the conversion impact your overall taxes for the year.
Plus, if you’re a high-earner, there may be bigger-impact ways to minimize your tax burden that don’t require so much administration on the backend. Bruce Willey writes, “Each year’s contribution has to be created as a separate Roth IRA account, meaning that if you make contributions for the next 20 years, you’ll be juggling 20 separate Roth IRA accounts. There’s also a thicket of IRS conversion regulations that have to be followed carefully to avoid triggering additional tax liabilities.”
Bottom line: It’s wise to get tax advice from an expert before proceeding.
Conversion to a Backdoor Roth IRA
Explanation of the conversion process
The three ways to create a Backdoor Roth IRA:
Fund a traditional IRA and roll over funds to a Roth
Convert an entire traditional IRA to a Roth
Roll over your 401k to a Roth IRA
Tax implications and considerations
Keep in mind that all or part of a backdoor Roth IRA conversion can be a taxable event. You may have to pay taxes (federal, state, and/or local) on converted earnings and deductible contributions. And Remember conversions could bump you into a higher tax bracket for the year. Tax-free distributions are available, but only after you’ve completed the 5-year aging rule. Talk it through with a financial expert to fully understand the potential costs and consequences.
Steps to convert a traditional IRA to a Backdoor Roth IRA
How to execute a Backdoor Roth IRA:
Open and make a nondeductible contribution to a new traditional IRA or contribute to an existing traditional IRA. You can open an IRA at most financial institutions. Note the maximum contributions available.
Research how a Roth IRA conversion works. It’s always smart to consult with a financial professional prior to revising retirement plans. You may need to file additional tax forms too.
Convert your contributions to a Roth IRA. The nondeductible contribution principal amount won’t be taxable, but earnings will be taxable. Making the conversion quickly may minimize taxable earnings.
Repeat these steps annually. Rinse, later, and repeat every year (if you want).
Conclusion
Summary of key points
The Backdoor Roth IRA allows high earners to fund a Roth IRA by converting nondeductible contributions from a traditional IRA into a Roth IRA.
It works like this: You open a traditional IRA, make after-tax (or nondeductible) contributions, and then convert those funds to a Roth IRA at a later date.
The big advantages to a Backdoor Roth IRA:
Tax-free growth and withdrawals
No required minimum distributions
Flexibility in contribution and withdrawal options
Final thoughts and recommendations
A Backdoor Roth IRA can be a great fit because it lets you contribute to a Roth IRA even if your income is too high to contribute directly. This can help with your retirement planning since the money converted to a Roth is not subject to required minimum distributions (RMDs) after an account holder turns 73.
Also, having money in a Roth IRA provides tax diversification for account holders after retirement.
A Roth can also help with estate planning. Talk it through with a financial expert to fully understand the potential costs and consequences.
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Matt Ruby is a seasoned content writer helping educate million worldwide about Bitcoin for Swan. Matt work with tech companies to create words, videos, and other content that makes them seem human. He specializes in taking boring/drab tech topics and making them interesting, educational, funny, and accessible to regular people.
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