Tax Tip: The Backdoor Roth IRA
Do you find yourself with some extra cash as the year comes to an end? By this time of year, many of our higher earning clients have maxed out their 401k contributions, hit the maximum for Social Security tax, and now find each paycheck much higher because they’ve hit these limits. (Yes, it is a wonderful problem to have!). If you are looking for a tax-advantaged way to invest those extra dollars, consider a backdoor Roth IRA. Taking a few extra steps to move the money into a Roth IRA could result in tax-free earnings on the money – forever.
Because of the limits on making tax-deductible contributions to IRA’s, many higher earning taxpayers don’t consider IRA contributions. Similarly, Roth IRA contribution limits prevent high earners from directly contributing to a Roth IRA. However, there may still be a path for Roth IRA contributions even for the highest earners. The strategy takes advantage of two distinct provisions in the tax code. First, the strategy takes advantage of the ability for most taxpayers, even high earners, to make non-deductible contributions to a Traditional IRA. Secondly, the strategy takes advantage of the fact that most taxpayers, even high earners, can convert a Traditional IRA to a Roth IRA. The result of the two-step process is a balance in a Roth IRA, even when a direct contribution is not allowed, and that is why it is sometimes called a ‘back-door Roth IRA contribution’.
There are more than a few traps to the strategy and so I do highly recommend that you employ an advisor or CPA. One key rule to keep in mind is that converting a Traditional IRA to a Roth IRA is normally a taxable event. If you have existing Traditional IRA accounts where you have made deductible contributions, or existing Traditional IRA accounts that are the result of a 401k or other pre-tax rollover, then the conversion could be at least partially taxable.
With proper execution, however, the strategy results in significant advantages. While there is no immediate tax deduction, the earnings on the Roth IRA grow tax-free, and are not taxed even when ultimately distributed in retirement. This is a wonderful strategy for those that are trying to make sure they are saving enough for retirement or are trying to catch up on savings for retirement. If you would like to learn more and see if a backdoor Roth IRA contribution would be right for you, please give us a call.