Think you make too much to fund a Roth IRA? Think again.
What is a backdoor Roth IRA?
You’re surely familiar with Congress’s efforts to get folks to save for retirement and know well the creatures to emerge from their handiwork, most notably 401(k) plans and individual retirement accounts (IRAs).
The Roth IRA is often preferred by the wealthy because contributions are not deductible (since they’re after-tax), and earnings are tax-free (qualified distributions are not taxed).
But if you make too much money, direct Roth IRA contributions are not permitted. Though what Congress did not allow directly is allowed indirectly via the chimera known as the backdoor Roth IRA strategy.
Also known as a backdoor Roth conversion, this maneuver allows high-income individuals to fund a Roth IRA through a traditional IRA. Essentially, Roth IRA income limits are circumvented by contributing instead to a traditional IRA (with no income ceiling) and then converting the traditional to a Roth.
What are the Roth IRA limits in 2022?
For 2022, the most you can contribute to all of your traditional and Roth IRAs is $6,000 or—if you’re age 50 or older—$7,000 (as long as you have at least that much taxable compensation). And for Roth IRAs, if modified adjusted gross income (MAGI) exceeds certain amounts, a contribution limit is triggered.
A Roth IRA contribution is phased out if:
- Your filing status is married filing jointly or qualifying widow(er) and your MAGI is at least $204,000. You can’t make a direct Roth IRA contribution if your MAGI is $214,000 or more.
- Your filing status is single, head of household, or married filing separately and you didn’t live with your spouse at any time in 2022 and your MAGI is at least $129,000. You can’t make a Roth IRA contribution if your MAGI is $144,000 or more.
- Your filing status is married filing separately, you lived with your spouse at any time during the year, and your MAGI is more than zero. You can’t make a Roth IRA contribution if your MAGI is $10,000 or more.
For example, a 35-year-old single taxpayer with MAGI of $128,000 in 2022 may contribute up to $6,000 to a Roth. But with MAGI of $145,000, the same taxpayer would be ineligible to contribute.
If these MAGI limits thwart your desire to fund a Roth, the backdoor Roth IRA strategy may be worth exploring.
Steps to setting up a backdoor Roth
The backdoor Roth IRA strategy emerged in 2010 when Congress lifted income restrictions on converting (rolling over) traditional IRA funds to a Roth IRA, thereby allowing high earners to contribute indirectly to a Roth IRA with the following steps:
Step 1. Open a new traditional IRA.
Step 2. Make non-deductible contributions to the traditional IRA.
Step 3. Transfer the funds from the traditional IRA to a Roth IRA.
Your financial institution should be able to implement these steps. For step 3, if the traditional and Roth IRAs are with the same institution, a transfer would be all the simpler; if at different institutions, a direct transfer to the Roth IRA provider would be best.
If your traditional to Roth IRA transfer is by check, be sure to deposit in the Roth IRA within 60 days to avoid costly “early withdrawal” pitfalls.
The “backdoor Roth IRA pro-rata rule” adds to the complexity. Under this rule, when converting a traditional IRA to a Roth, all traditional (as well as SEP and SIMPLE) IRAs are treated as one basket. To determine the transfer amount treated as already taxed, the converted amount is multiplied by the ratio of total after-tax dollars to total dollars. The balance would be taxable.
Is it worth the trouble to do a backdoor Roth?
Whether a backdoor Roth IRA conversion is worth the trouble is best determined in concert with your tax or personal finance advisor. Still, taking the backdoor route is likely not worthwhile if:
- You will need the money in five years or less. The Roth IRA rules include some strictures on withdrawals, including a 5-year rule applicable to earnings, conversions from a traditional IRA, and inherited Roth IRAs.
- You expect to have a lower tax rate in retirement.
- You would have to pay any taxes from conversion from tax-advantaged sources.
But if you can wait five years, expect a higher tax rate in retirement, and don’t have any pre-tax money in IRAs, the backdoor Roth strategy may be worth pursuing.
The backdoor Roth IRA is but one retirement strategy to consider
Retirement planning can be complex, and maximizing wealth is but one consideration when considering your financial future. Whatever your retirement strategy, the sooner you start saving and investing, the better. For if we fail to plan, we plan to eat cat food in retirement.