Is A Backdoor Roth IRA Right for You?

by | Aug 14, 2024 | Financial Planning

Roth IRAs offer significant benefits including a wide range of investment options, simple emergency withdrawals, and generous tax benefits during retirement. However, IRS rules are designed to limit high earners from contributing to these accounts.

Fortunately, there is a way to add money to a Roth IRA even if your income is above the IRS limit. It is called a “backdoor” contribution, and it involves making a nondeductible contribution to a Traditional IRA and converting those funds to Roth in the same year. This strategy isn’t right for everyone, but you may be a good candidate if you meet the following criteria.

1. You or Your Spouse Have Taxable Income

To contribute to any type of IRA, you or your spouse must have taxable income that meets the IRS requirements. In general, this is income that you earned from employment like wages, salaries, commissions, tips, bonuses, and net-income from self-employment.

Contrary to the name, not all income that is subject to tax is considered taxable income for the purposes of contributing to an IRA. For example, rental income, interest, dividends, pension income, annuity payments, and deferred compensation do not count as taxable income in this scenario.

2. Your Income Is Above the IRS Limit

For a backdoor Roth IRA contribution to make sense in your situation, you must be unable to contribute directly to the account due to your income. The IRS imposes different income limits depending on your tax filing status and they update these thresholds each year to account for inflation.

In 2024, you are eligible to make a full Roth IRA contribution if:

  • you file as Single or Head of Household and your Modified Adjusted Gross Income [MAGI] is $146,000 or less.
  • you file as Married Filing Jointly or Qualifying Widow(er) and your MAGI is $230,000 or less.

You are eligible to make a partial contribution if:

  • you file as Single or Head of Household and your MAGI is between $146,000 and $161,000.
  • you file as Married Filing Jointly or Qualifying Widow(er) and your MAGI is between $230,000 and $240,000.

Special rules apply if you are Married Filing Separately, and they are a bit more complex. If this is your situation, speak to an experienced financial advisor to determine if you are eligible to contribute.

3. You Don’t Have Traditional IRA Assets

As previously mentioned, a backdoor Roth contribution starts with making a nondeductible contribution to a Traditional IRA. This means you do not receive a tax deduction for those funds, and they are treated as after-tax contributions by the IRS. Then, you process a conversion, and those funds move to your Roth IRA.

When you don’t have any Traditional IRA assets and you complete the conversion quickly, the process is simple. You generally don’t owe any additional tax since your contribution was made with after-tax dollars and wasn’t in the account long enough to earn interest. However, the process becomes more complicated if you have Traditional IRA assets.

The IRS does not allow you to cherry pick only nondeductible contributions to convert from Traditional to Roth. Instead, the amount of a conversion is taken proportionally from your deductible and nondeductible contributions. This means the deductible portion of your conversion is subject to tax like a normal conversion.

Consider this example to illustrate. You have a Traditional IRA valued at $45,000 and all those funds are deductible – meaning you previously received a tax deduction when you contributed them. You make a $5,000 nondeductible contribution, hoping to complete a backdoor Roth contribution. At that point, your Traditional IRA assets are 90% deductible, 10% nondeductible. You convert $5,000 to your Roth IRA and owe tax on 90% of that amount. In this scenario, you owe income tax on the $5,000 nondeductible contribution and $4,500 of your conversion.

It is also very important to note that the IRS considers all Traditional and Rollover IRAs in your name as one account for tax purposes. This is true even if your accounts are held with different sponsors. For this reason, you can’t avoid the negative tax implications by opening a new Traditional IRA solely to complete your backdoor Roth contributions.

4. You’ve Worked with A Financial Advisor to Determine a Backdoor Roth IRA Contribution Is Right for Your Situation

Roth IRAs are popular retirement savings vehicles and offer significant advantages for some people. However, they are not the right choice for every situation.

Some people find that contributing to a workplace retirement account is more beneficial than a Roth IRA due to company matching. Others discover that they need to focus on different priorities like paying off debt, securing adequate insurance, or building an emergency fund before contributing to a retirement account.

A fiduciary financial advisor should take all these possibilities into account and help you determine if a Roth IRA is right for you. Then, they can work with you to evaluate your options for contributing and investing those funds.

Discuss A Backdoor Roth IRA with Brookstone Wealth Management

At Brookstone Wealth Management, we can help you determine if a backdoor Roth IRA is right for you. We will leverage our comprehensive wealth management program, Financial Fingerprint™, to evaluate your complete financial picture, including income, goals, and retirement accounts, to determine how a Roth IRA might fit within your financial plan.

To discuss your individual situation and get your Financial Fingerprint™, contact us today.