Unlock the Secrets to Tax-Free Wealth: Your Guide to Backdoor Roth IRAs
Written on
The Benefits of Roth IRAs
Roth IRAs are considered some of the most advantageous investment accounts available. They allow your investments to grow without being taxed indefinitely, meaning that when you retire, withdrawals from your Roth IRA are entirely tax-free. Additionally, these accounts are exempt from required minimum distributions and don't count towards the taxable income for Social Security purposes. Despite these benefits, there is a limitation: the IRS imposes contribution restrictions based on income. If your earnings exceed specific thresholds, you might find yourself steered toward taxable accounts. But don't worry! Today, I will explain how you can still make contributions to your Roth IRA even if you exceed those income limits.
Who Is Eligible to Contribute?
Let’s clarify the eligibility criteria for Roth IRA contributions in 2024. If you’re single, your modified adjusted gross income (MAGI) must be below $161,000, which is your total income minus contributions to 401(k) or 403(b) plans. For those filing jointly, the threshold is a combined income of less than $240,000. If you meet these criteria, you can easily contribute to your Roth IRA without any hassle. No need to stress about the rest of this discussion; you’re in the clear!
However, if you’re single with an income over $161,000 or married with a combined income above $240,000, you may not qualify for full contributions. In this scenario, you might still be eligible for a partial contribution, but the permissible amount will gradually decrease as your income rises. So, let’s explore how you can still harness the fantastic tax benefits Roth IRAs provide.
What Are Your Options?
You can implement a strategy known as the backdoor Roth conversion. It’s essential to note that this method comes with its own set of regulations, so be sure to read all the way through as it may not suit everyone, and there are common pitfalls to avoid.
Here’s how it works: For 2024, the contribution limit for an IRA or Roth IRA is $7,000 (or $8,000 if you’re 50 or older). If your income is too high, you cannot directly deposit into a Roth IRA, nor can you make deductible contributions to a traditional IRA, which means you miss out on immediate tax benefits.
At first glance, it may appear that a Roth IRA is off-limits to you. But this is where the backdoor Roth conversion comes into play. Instead of making a direct contribution to a Roth IRA or a tax-deductible traditional IRA, you can contribute to a non-deductible traditional IRA.
If you promptly convert the balance from that non-deductible IRA into your Roth IRA, you’re effectively switching $7,000 of after-tax dollars into another after-tax account. Unlike a pre-tax IRA, where you could have deducted contributions or rolled over funds from a 401(k), converting here means that any amount converted will be entirely taxable. However, since you didn’t take a deduction for this traditional IRA contribution, you can switch it to a Roth IRA without incurring taxes on the conversion.
Engagement Matters!
Dear readers! If you find this information helpful, please engage with it! I recently read an insightful article by Lea Bardot that inspired me to ask for similar engagement on Medium as I do on YouTube. So, if you enjoy what you read, please clap, comment, and highlight your favorite parts. Thank you for being such fantastic supporters!
Returning to the Topic
Essentially, you’re breaking down a process that typically involves a single step into two distinct steps. It sounds simple: open an IRA, make a non-deductible contribution, convert it, and then invest those funds in your Roth IRA. Here’s the important thing to remember: while there are income limits for Roth contributions, there are no limits on Roth conversions. You can earn any amount and still convert a traditional IRA (with no deductions) to a Roth IRA.
However, there are details that can complicate matters—details that could lead to issues. For instance, you might think, “This is great! I already have a traditional IRA; I’ll just open a new one for my non-deductible contributions and use the backdoor Roth conversion.”
Not So Fast!
Let’s consider what happens in this scenario. Suppose you have a pre-tax IRA worth $24,000. Eager to pursue the backdoor Roth strategy, you open a separate IRA and contribute $6,000 (we’ll use this figure for simplicity). Now, you have $6,000 in your non-deductible IRA. The next step is to convert this amount to your Roth IRA, which allows the funds to grow tax-free. However, the IRS views this differently.
The IRS employs what's known as an aggregation rule. They consider all of your IRA accounts as one large $30,000 IRA, not as two separate entities. Thus, they view 80% of your IRA as pre-tax. So, when you convert your $6,000 to a Roth IRA, 80% of that amount becomes taxable because 80% of your total IRA balance is pre-tax. As a result, $4,800 of the conversion is taxable, and only $1,200 is tax-free.
So, what's the solution? You need to eliminate the pre-tax IRA. If the balance is minimal—say just a few thousand dollars—you might consider converting it and paying the tax. However, I strongly recommend consulting your tax planner or financial advisor before taking any action.
If you have a significant IRA balance, like $1 million, converting it all at once could lead to a hefty tax bill. To avoid this, there are alternatives. For example, if you have a 401(k) with your employer, many plans allow you to transfer your pre-tax IRA balance into that 401(k). This move effectively clears your IRA balances while keeping your funds invested and tax-deferred.
If you're self-employed, consider establishing a solo 401(k) to manage your retirement funds. The objective is to clear out any pre-tax IRA assets to avoid complications and ensure tax-free conversions. If you have no IRA or can transfer it to a 401(k) or another retirement account that isn’t a SEP IRA, SIMPLE IRA, or traditional IRA, then you can use the backdoor method to fund your Roth IRA.
Key Takeaways
- Ensure No Pre-Tax IRA Assets: Before proceeding, confirm you don't have any pre-tax IRA assets. Traditional IRAs, SIMPLE IRAs, and SEP IRAs must be cleared out. The IRS treats all these accounts as one, so if you convert after-tax contributions, you're not just converting the non-deductible portion. Notably, inherited IRAs do not count towards your pre-tax balance, which is beneficial unless it was inherited from a deceased spouse and is now in your name.
- Fund and Convert Immediately: When funding the non-deductible IRA, don’t delay the conversion. Contributing $7,000 and letting it grow before converting could lead to taxes on the gains, whereas immediate conversion keeps the entire amount tax-free.
- File Form 8606: This form informs the IRS of your non-taxable contributions, ensuring that the conversion is recognized as tax-free.
Always consult your CPA and financial advisor. While the backdoor Roth strategy is advantageous for high-income earners, correct execution is essential for compliance with IRS regulations.
Conclusion
Utilizing a backdoor Roth conversion can be an effective strategy for gaining access to Roth accounts, even with a high income. By following the steps outlined, you can enjoy the benefits of tax-free growth associated with Roth IRAs. However, it's crucial to approach this strategy with care and seek professional guidance to maximize its advantages and ensure adherence to tax regulations.
A Study in Advisor Relationships
Research shows that working with an investment advisor can significantly enhance your financial outcomes and overall well-being. Individuals who collaborate with advisors typically have net worths three times higher than those who don’t, along with greater happiness and less anxiety.
Finding a Trustworthy Fiduciary
Locating a reliable fiduciary advisor can be challenging. Many search for terms like "Fiduciary financial advisors near me" and "Best fiduciary financial advisor" online, indicating a widespread need for trustworthy financial guidance.
We're Here to Help!
We have experience supporting clients through various life stages. Engaging in discussions with your investment advisor about potential financial changes is an excellent way to keep your goals in sight. For specialized solutions in cross-border wealth management, don’t hesitate to reach out.
For more insights, connect with me via email at [email protected] or explore my engaging YouTube channel for valuable discussions on financial planning and investing:
Feel free to contact us at 1-888-324-4259 to learn how we can assist you in reaching your investment goals.
Joe A. Macek, FMA, CIM, DMS, FCSI
Investment Advisor, Portfolio Manager
iA Private Wealth | iA Private Wealth USA
Toll Free North America: 1-888-324-4259
Email: [email protected]
238 Portage Ave, 3rd Floor
Winnipeg, Manitoba R3C 0B1
26 Wellington Street East, Suite 700
Toronto, Ontario M5E 1S2
iA Private Wealth is a member of IIROC and the Canadian Investor Protection Fund. iA Private Wealth (USA) Inc. is a registered investment adviser with the SEC. This platform is solely for informational purposes. Investing involves risk and possible loss of principal capital. Viewer comments and third-party rankings do not guarantee future investment outcomes. Please visit our website for further disclosures related to iA Private Wealth (USA) Inc.: www.iaprivatewealthusa.com