The Backdoor Roth Contribution is a financial strategy that allows high-income earners to contribute money to a Roth IRA, even if they make too much to contribute directly. By contributing to a Traditional IRA and then converting that money to a Roth IRA, investors can effectively bypass the income limits and take advantage of the benefits of a Roth IRA. This strategy may sound complicated, but it can provide significant advantages in tax-free growth and flexibility for tax planning purposes.
Roth IRAs are one of the best tools available for retirement planning because they offer tax-free growth, tax-free withdrawals in retirement, and no required minimum distributions. However, the ability to contribute to a Roth IRA is limited by income; in 2023, for example, single taxpayers making over $153,000 and married taxpayers filing jointly making over $228,000 cannot contribute directly to a Roth IRA.
However, by utilizing two different rules, the concept of a backdoor Roth contribution was born. The first rule is that anyone can contribute to a Traditional IRA, regardless of income. However, High-income earners cannot deduct Traditional IRA contributions because they are subject to income limits. In 2023, single taxpayers that contribute to an employer-sponsored retirement making over $83,000 and married taxpayers filing jointly making over $136,000 cannot deduct their Traditional IRA contributions. The second rule is that you can convert funds from a Traditional IRA to Roth IRA regardless of income. This was not the case prior to 2010. Before that, if your MAGI (Modified Adjusted Gross Income) was higher than $100,000, you were not eligible for Roth Conversions.
Let’s look at an example:
A 40-year-old individual with a Modified Adjusted Gross Income (MAGI) of $200,000.
His income is too high for direct Roth IRA contributions. Instead, he can make a contribution to a Traditional IRA. Because of his high income, he is ineligible for a deduction for the Traditional IRA contribution. After the contribution, he immediately converts the Traditional IRA to a Roth IRA. He does not owe taxes on the conversion because he wasn’t eligible for a deduction.
It’s important to note that the conversion to a Roth IRA can get complicated if you already have money in a Traditional IRA. Depending on how much of your Traditional IRA money is pre-tax versus after-tax, you may have to pay taxes on a portion of the conversion. Therefore, consulting with a financial advisor before attempting a Backdoor Roth Contribution is recommended if you have money in a Traditional IRA.
Overall, the Backdoor Roth Contribution is a legitimate way for high-income earners to take advantage of the benefits of a Roth IRA. While it may sound complicated, with our assistance, it can be a valuable tool for retirement savings. Please let us know how we can assist you in planning your retirement future.
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