Your Future Self May Thank You

Answer: Let’s start with a quick overview of what a ROTH IRA (Individual Retirement Account) is and how it differs from Traditional IRA. Roth IRAs came on the scene in 1998 created by the Bipartisan Taxpayer Relief Act of 1997. The Roth IRA is named after Sen. William Roth (R-Del), allows taxpayers to contribute after-tax money and as long as they held the account for at least five years. At age 59 ½ Roth IRA owners have the ability to withdraw funds tax-free. In contrast, Traditional IRA contributions generally reduce current year taxable income, however funds are taxable when withdrawn and are subject to required minimum distributions (RMDs). 

Back to your question: Once your modified adjusted gross income (MAGI) tops $161,000 for single tax filers or $240,000 if married and filing jointly, the IRS begins phasing out your ability to invest directly in a Roth IRA. Workaround strategies are referred to as “backdoor Roths.” These let you enjoy the benefits of a Roth while getting around some limitations. 

For people looking to build a balanced retirement savings portfolio, a Roth IRA can serve as a great companion to an employer plan such as a 401(k). But if you earn too much money, you may not qualify to invest fully, or at all, in a Roth IRA. 

No matter how much you earn, you may find that contribution limits prevent you from building as substantial a fund as you’d like. Fortunately, there are “backdoor” strategies that may help you get around these limitations. Here’s what you need to know.

Backdoor Roth IRA

You can contribute after-tax dollars to a traditional IRA, then shortly thereafter convert those funds to a Roth IRA. Because there are no income limits restricting your ability to put after-tax dollars in a regular IRA, you can use this backdoor strategy to build a Roth IRA no matter how much you earn.

You can’t go through this backdoor if you own any IRAs with any pretax dollars in them. The reasons for that are complicated, but it all boils down to two IRS rules (the pro rata rule and the aggregation rule). Consulting your CERTIFIED FINANCIAL PLANNER™ Professional and tax professional before establishing and implementing a backdoor Roth strategy to ensure that you’re following every rule.

Mega backdoor Roth IRA 

If your problem isn’t how much you earn but the size of contribution limits, there’s a mega backdoor strategy that could help boost your savings. For 2024, IRA contribution limits are $7,000, or $8,000 if you’re over fifty. A mega backdoor strategy may empower you to put away much more than that.

Your current employer must offer a 401(k) or 403(b) plan, and you must pay into it. Whichever of those plans you use must also allow employees to make after-tax contributions into the plan, which count above and beyond employee elective deferral limits. 

This is simplest to do if your employer offers a Roth option attached to its retirement plans and supports in-plan conversions to the Roth. That’s the ticket for your mega backdoor to a bigger retirement fund.

There are plan-specific limits on how much you may contribute in after-tax dollars to convert into the Roth and are other rules affecting whether you can apply a backdoor strategy and how big a fund you can build. Again, a consulting your financial and tax advisors is an essential step in any backdoor plan.

Pros:

• You may still be able to fund a Roth IRA even if your income is above IRS limits.

• If you have access to an employer plan with a Roth feature, you may be able to save more than the usual IRA limits.

• Because the money going into the Roth has already been taxed, you can take tax-free distributions in retirement.

Cons: 

• Not everyone is eligible to apply a backdoor or mega backdoor approach.

• Typically, only high earners benefit.

• Both require careful planning with a tax professional.

Additionally, each converted amount may be subject to its own five-year holding period. Be sure to discuss these matters with the appropriate professional. Raymond James does not provide tax or legal services. Before doing anything regarding these ideas, consult with a tax advisor because of the complexity. Here are a few examples: 

Contributions to a traditional IRA may be tax-deductible depending on the taxpayer’s income, tax filing status, and other factors. Withdrawal of pre-tax contributions and/or earnings will be subject to ordinary income tax, and if taken prior to age 59 1/2, may be subject to federal income tax and may be subject to state taxes. Consult your tax advisor to assess your situation. 

401(k) plans are long-term savings vehicles. Withdrawal of pre-tax contributions and/or earnings will be subject to ordinary income tax and, if taken prior to age 59 1/2 , may be subject to a 10% federal tax penalty. 

Roth 401(k) plans are long-term savings vehicles. Contributions to a Roth 401(k) are never tax deductible, but if certain conditions are met, distributions will be completely income tax free. Unlike Roth IRAs , Roth 401(k) participants are subject to required minimum distributions at age 72 (70 ½ if you reach 70 ½ before January 1, 2020). 

Unless certain criteria are met, Roth IRA owners must be 59 1/2 or older and have held the IRA for five years before tax-free withdrawals are permitted. Converting a traditional IRA into a Roth IRA has tax implications. Earning income higher than the limits to contribute to a Roth IRA is a good problem to have, or “luxury problem.” Stay focused and plan accordingly.