Backdoor Roth IRA

The Backdoor Roth IRA: Sneak into the benefits

The backdoor Roth IRA is an excellent conversion strategy that allows you to contribute to a Roth even if your income is over the modified adjusted gross income phase-out ($146,000- $161,000, single or $230,000- $240,000, married filing jointly for 2024). The best part? The conversion may be entirely or at least partially tax-free.

How do you go about contributing to a Roth through the backdoor?

  1. Open a Traditional IRA and make a nondeductible contribution. I recommend a separate IRA for nondeductible contributions.
  2. Open a Roth IRA
  3. Convert the non-deductible contribution in the Traditional to the Roth
  4. Continue every year until it doesn’t make financial sense, your earned income decreases below the phase-out level, or the loophole is closed.

Backdoor Roth IRA = Tax-free conversion goodness

A great cup of coffee, my Grandmom’s crumb cake, and tax-free conversions. These are three of my favorite things. Yes, the backdoor Roth IRA could be 100% tax-free with non-deductible contributions.

The ifs, ands, or buts of tax-free

It’s retirement savings and taxes; there are always ifs, ands, or buts. So don’t go out and try the Backdoor Roth IRA just yet. There are other considerations when determining the level of tax-free goodness.

  • Do you already have any Traditional (including a Rollover IRA), SEP, or SIMPLE IRAs?
  • Are those IRAs funded with deductible/before-tax contributions?

If the answers are yes, then some calculating is needed to determine how much tax-free fun you can have.

Backdoor Roth IRA Examples

#1 No other IRAs

If you have no other Traditional, SEP, or SIMPLE IRAs and just made a nondeductible contribution of $7,000 to your new Traditional IRA. Congratulations, the entire $7,000 will be tax-free when you convert it to a Roth. That’s easy, and when the Backdoor Roth IRA gets the biggest bang.

#2 Other IRAs

You have the following:

  • Traditional IRA $25,000,  funded with deductible contributions
  • SEP IRA $25,000,  funded with deductible contributions
  • New Traditional IRA with $7,000, funded with non-deductible contributions

Here are the steps to figure out the tax-free amount:

  1. Add up the all IRA’s $25,000 + $25,000 + $7,000= $57,000
  2. Divide the non-deductible contribution by the total IRA amount: $7,000/$57,000 = 12.3% (.123)
  3. Multiply $7,000 x 12.3% = $861 is the non-taxable conversion amount
  4. $6,139 is the taxable conversion amount

This is not as beneficial as the first example, but that doesn’t necessarily mean it’s a deal-breaker. This is more of a typical Roth conversion, and we need to dig deeper to find out how appropriate and beneficial this is for you. This leads me to…

How often do I recommend the Backdoor Roth IRA?

I’ve been recommending the Backdoor Roth IRA strategy since 2010, when the $100,000 MAGI limit for Roth conversions was eliminated. But I don’t recommend it for every client above the threshold. Other factors such as age, current tax rate, future expected tax rate, other IRA balances, and cash available to pay taxes on the conversion, if there are any (example 2), enter into the equation of appropriateness.

Desperate for tax-free

There is a way to avoid including all of your other IRAs. If you can roll your other IRAs into your company retirement plan or solo 401(k), that would take them out of the equation and increase the tax-free conversion amount. I have rolled IRAs into a solo 401(k) to increase the benefits of the Backdoor Roth IRA. Whether you want to roll it into your 401(k) or 403(b) depends on if they permit rollovers into the plan, if the plan has a robust selection of funds available, and if the plan’s fees are reasonable.

Don’t do it

What happens if you got a hot stock tip from your brother-in-law and invested that $7,000 non-deductible contribution, which grew to $10,000 before you implemented the backdoor Roth IRA? You’ll end up paying tax on the growth. Do what I do, don’t listen to your brother-in-law. When did his stock tip ever pay off? Sorry, I meant to say that within days of the non-deductible contribution, move that baby over to the Roth.

The backdoor Roth IRA is not something you should try at home. It’s a great strategy to get you into a Roth when otherwise you would be unable to. So before you do anything, give me a call, and we can analyze whether it’s appropriate, and if it is, we can take the correct steps to avoid any tax surprises.

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