Are you wondering what a Backdoor Roth contribution is and if you can take advantage of it? Contributing to a Roth IRA may seem straightforward, but when your income surpasses certain limits, it can become a bit tricky. In 2023, the maximum annual contribution for a Roth IRA is $6,500 (or $7,500 if you’re 50 or older), provided your modified adjusted gross income (MAGI) falls below specific thresholds:
- Single: $138,000
- Married Filing Jointly: $218,000
- Married Filing Separately: $10,000
If your MAGI exceeds these thresholds or you want to contribute more than the allowed limit, the solution lies in a Backdoor Roth contribution strategy. With this approach, you can contribute the maximum annual amount to your Roth IRA, irrespective of your MAGI.
To understand the mechanics of a Backdoor Roth contribution, let’s first differentiate between deductible and non-deductible IRA contributions. When you make a deductible IRA contribution, you can deduct the contributed amount from your annual income taxes, provided you meet the income limit for deductible contributions.
However, the deductibility limits for an IRA are much lower than the contribution limits for Roth IRA contributions. Therefore, if your income surpasses the Roth contribution limit, you cannot deduct your IRA contribution from your income taxes. This results in a non-deductible basis within your IRA when you make the contribution. When you convert this non-deductible basis to Roth before any earnings accrue, there are no additional tax implications. Following these steps allows you to contribute funds to your Roth IRA without regard to your MAGI:
- Open a Traditional IRA and a Roth IRA account in your name.
- Contribute funds to the Traditional IRA account.
- Convert the funds from the Traditional IRA to the Roth IRA account before any earnings accumulate. (If there are earnings, they will be taxed as income in the conversion year.)
Before you complete the Backdoor Roth contribution strategy, it’s crucial to understand what might prevent this strategy from working. The ‘pro-rata’ withdrawal rules come into play when you hold both deductible and non-deductible funds in your IRA. This can introduce additional tax implications and potentially make the strategy ineffective. This rule applies to funds in a Traditional IRA, SEP IRA, or SIMPLE IRA, but not to a 401(k).
For example, let’s say Tom has a SEP IRA with $92,500 and learns about the ‘Backdoor Roth’ from a friend who suggests he can still contribute to a Roth IRA despite his high income. Lacking an understanding of the pro-rata rules, Tom contributes $7,500 to a newly established IRA and promptly converts it to a Roth, assuming there won’t be any tax consequences. However, since a SEP IRA is part of the fund pool considered by the IRS for pro-rata taxation, he has $100,000 in IRA funds and a $7,500 basis.
When he completes his Roth conversion, only 7.5% of the converted amount is considered non-deductible basis, which means that 92.5% (equivalent to $6,937.50) is taxable as income for the year. This tax liability arises even though he already paid income taxes on the $7,500 he contributed. To navigate these complexities, Tom must ensure his CPA tracks his ongoing basis using Form 8606 to prevent double taxation on the remaining portion of the $7,500 he contributed.
In conclusion, Backdoor Roth contributions can be a valuable strategy to contribute to your Roth IRA when your income exceeds the limits. However, it’s essential to be aware of the pro-rata rules and consult with a tax professional to ensure you execute the strategy effectively and minimize tax implications.
Disclosures: Neither Raymond James Financial Services nor any Raymond James Financial Advisor renders advice on tax issues, these matters should be discussed with the appropriate professional.
Opinions expressed in the are those of the author and are not necessarily those of Raymond James. All opinions are as of this date and are subject to change without notice. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete.
Unless certain criteria are met, Roth IRA owners must be 59½ or older and have held the IRA for five years before tax-free withdrawals are permitted. Additionally, each converted amount may be subject to its own five-year holding period. Converting a traditional IRA into a Roth IRA has tax implications. Investors should consult a tax advisor before deciding to do a conversion.
Like Traditional IRAs, contribution limits apply to Roth IRAs. In addition, with a Roth IRA, your allowable contribution may be reduced or eliminated if your annual income exceeds certain limits. Contributions to a Roth IRA are never tax deductible, but if certain conditions are met, distributions will be completely income tax free.
IRA tax deductibility and contribution eligibility may be restricted if your income exceeds certain limits, please consult with a financial professional for more information.
