By Joel Chouinard, ChFC®
February 7, 2023
I’m sure at some point in your life, you’ve heard of the benefits of compounding growth. Roth IRAs can enhance compounding growth further because of their tax advantages. However, many individuals, especially attorneys, cannot contribute directly to a Roth IRA because their income is too high. Read below to learn how you can invest in a Roth IRA even if you make above the income limits.
A good rule of thumb for investors is to maximize tax-advantaged accounts before investing in a taxable account. The theory is that because there is no “tax drag” in a tax-advantaged account, if all else is equal, the money should grow faster than in a taxable account, especially when growth starts compounding*.
An Individual Retirement Account (IRA) is a good example of a tax-advantaged account. IRAs come in the form of Traditional or Roth. The primary difference is how each type gets taxed. On the one hand, investments in a Traditional IRA grow without being taxed, but taxes are due when withdrawing money in retirement (tax deferral). On the other hand, investments in a Roth IRA grow tax free, and money can also be withdrawn tax free in retirement as this is after-tax money. You get to reap the benefits of your initial investments and their gains, knowing those taxes have already been paid.** For the 2023 tax year, the contribution limit per person is $6,500, and $7,500 for individuals over 50 years old
So, why wouldn’t everyone just contribute to a Roth IRA since it grows tax free versus tax-deferred? Well, the IRS sets income limits as to whom can contribute directly to a Roth IRA. In 2023, if your Modified Adjusted Gross Income (MAGI) is above $153,000 as a single filer, or above $228,000 as a married filer, you cannot contribute directly to a Roth IRA1.
If you are above the income limit, thankfully there is still a way to take advantage of tax-free growth using the backdoor funding strategy.
How the backdoor Roth IRA funding strategy works
Step 1: Open a Traditional IRA account and make a non-deductible contribution. Traditional IRAs don’t have income limits, so anyone can contribute. Leave the money in cash or a money market account.
Step 2 : Open a Roth IRA account (but don’t fund it). This is the account that will ultimately receive the funds.
Step 3 :Convert your Traditional IRA contribution to your Roth IRA account and invest the money.
Because you made your Traditional IRA contribution with after-tax dollars (money on which you have already paid taxes), and there was no growth in that account (because you left it in cash), you will not owe taxes on the conversion. Please note that if you have other pre-tax IRA accounts, beware of the pro-rata rule (see below).
Caveat: The Pro-Rata Rule
If you have other Traditional IRAs that were opened from rolling over pre-tax 401(k)s or other pre-tax workplace retirement accounts from previous jobs, beware of the pro-rata rule. If this is the case, the Roth conversion, which would normally be tax free if you followed the steps above, would now need to be included in your income.
For example, assume you have $18,000 in a Traditional IRA, which was funded with a rollover from an old pre-tax 401(k). That year, you want to utilize the backdoor funding strategy, so first you make a $6,000 non-deductible contribution to your Traditional IRA (step 1). You now have a total of $24,000 in that account, consisting of $18,000 of pre-tax and $6,000 of after-tax dollars. Due to the pro-rata rule, when you do your Roth conversion (step 3), only 25% (6,000/24,000) of your $6,000 contribution would be tax free. The rest will need to be reported as ordinary income on your tax return for that year.
Keep in mind that it might still make sense to use the backdoor strategy even if the pro-rata rule applies to you. Remember that Roth IRAs grow tax free!
Other things to consider
- Between January 1st and April 15th is a great time to fund IRAs because you are still allowed to contribute for the previous tax year if you haven’t reached the maximum amount allowed yet. Note that contributions for the previous tax year must be made before you file your taxes or before the tax-filing deadline, whichever comes first. During that time, you can also start contributing for the new year that just started.
- Make sure you let your tax professional know that you used the backdoor Roth IRA funding strategy. Some accountants may not be aware of the strategy and mistakenly report your conversion as a premature IRA distribution.
This article is provided for your general information purposes only.
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