What is a Back Door Roth IRA contribution?
Welcome back to another edition of Written by A(ndrew) I(ntelligence). In today’s article I will be talking about the Back Door Roth IRA strategy. Let’s get started!
To set the stage, the Roth IRA is a powerful retirement account that let’s you contribute after tax dollars, where those dollars get invested and grow tax free, and distributions can be taken out tax free as well. In short, you pay the tax TODAY to withdrawal money tax free LATER.
To restrict this benefit from high earners, the IRS has limited direct Roth IRA contributions to individuals and married couples who make below a certain $ amount per year measured by Modified Adjusted Gross Income (MAGI).
As of the date of this article, the current limits are below
Single Filing Status
MAGI < $153,000 = full $7,500 contribution
MAGI $153,000 to $168,000 = reduced contribution
MAGI > $168,000 = $0
Married Filing Joint Status
MAGI < $242,000 = full $7,500 contribution
MAGI $242,000 to $252,000 = reduced contribution
MAGI > $252,000 = $0
For example, if you are married and you and your spouse have a combined MAGI of $260,000, you are restricted from contributing directly into your Roth IRA. Full stop. If you decide to go ahead with your contribution anyways, the IRS will enforce a penalty of 6% tax on the excess amount EACH YEAR it remains in the account uncorrected. NOT COOL!
As you can imagine, there are plenty of people who make above these limits who still like the idea of building their retirement savings in a tax free vehicle. I cannot say I agree with them 100% of the time (see my apple tree example in my previous post HERE), but depending on what they are looking to accomplish + future income estimates it could work.
Thanks to a removal of income restrictions on Traditional IRA to Roth IRA conversions in The Tax Increase Prevention and Reconciliation Act of 2005, Congress created a legal loophole that allowed these high earners to reap the benefits of a Roth.
Keeping it simple - The Back Door Roth IRA strategy is a way for high earners to contribute to a Roth IRA via an indirect way.
Quick clarification - The Back Door Roth IRA does not require a special type of IRA to be opened, specifically for this loophole. The “Back Door Roth IRA” is just a name for the strategy itself.
How does the back door strategy work?
Contribute to your Traditional IRA first
Immediately contact your custodian and let them know you want to transfer this contribution to your Roth IRA. Delaying the transfer could cause your contribution to earn interest and the earnings becomes taxable.
File form 8606 with your tax return to let th eIRS know of the conversion so you are not double taxed!
MAJOR KEY - make sure you do not have any other Traditional, SEP, or SIMPLE IRA balances out there otherwise you will trigger the pro rata rule! See my next blog for details.
Like I explained before in my previous blogs, it does not make much sense to pay taxes in a higher bracket now and take out money tax free in a lower bracket down the road. But depending on your specific financial situation, the backdoor Roth can still make sense.
If you are looking to see if this strategy could work for you, book time on my calendar HERE!
Until next time,
Andrew
The information presented in this blog is the opinion of the author and does not reflect the views of any other person or entity unless specified. The information provided is believed to be reliable and obtained from reliable sources, but no liability is accepted for inaccuracies. The information provided is for informational purposes and should not be construed as advice. Advisory services offered through AMD Wealth Management LLC, an investment adviser registered with the state of New Jersey.