Backdoor Roth IRA Explained: A Retirement Strategy for High Earners
Ever heard of a Backdoor Roth IRA? Despite its shady-sounding name, it's a completely legal way for people who earn too much to contribute directly to a Roth IRA, to still benefit from a Roth IRA’s tax advantages.
Who Should Consider a Backdoor Roth IRA?
The Backdoor Roth IRA might sound like a sexy need-to-use strategy, but depending on your income, you might not need to use it at all.
Whether you need this strategy or not depends on your Modified Adjusted Gross Income, aka MAGI, aka the number the IRS looks at to see how much money you really made after deductions.
If you're MAGI is over a certain amount, you're not allowed to contribute to a Roth IRA. That's where the Backdoor Roth IRA comes in—it's a workaround for those who don't qualify because of their high earnings.
Understanding Income Limits
Here are the numbers as of 2024 (numbers subject to change):
Single filers: If you make between $146,000 and $161,000, you can only put a smaller amount into a Roth IRA. Over $161,000? Then you can't contribute directly at all.
Married and filing together: You can make partial contributions if your combined income is between $230,000 and $240,000, but over $240,000, you can't contribute directly.
How It Works
Start by making an after-tax contribute into a Traditional IRA.
Wait for the money to clear and become available in your Traditional IRA (typically a couple days).
Convert/transfer that money over to your Roth IRA. This switch lets your savings grow tax-free and allows for tax-free withdrawals when you retire.
Warning: Potential Taxes
Before you execute on a Backdoor Roth IRA strategy, you need to know if you have other IRA money that has not been taxed yet (this usually looks like traditional IRA’s, SEP IRA’s, or Simple IRA’s for example).
If you don’t have any other pre-tax IRA money invested, this strategy should be relatively simple and shouldn’t result in any tax consequences.
Either way, consulting a professional is highly encouraged.
If you already have other IRA’s with money that hasn't been taxed yet, a rule called the pro-rata rule comes into play.
This rule will determine how much of the money you convert (change from a traditional IRA to a Roth IRA) will be taxed.
This rule looks at all your IRAs and figures out the mix of taxed and untaxed money and can result in a decent sized tax bill.
Is it worth it?
Though it might sound complex, the effort can really pay off. Your investments in a Roth IRA will grow without being taxed, and you won't pay taxes on withdrawals during retirement.
The Backdoor Roth IRA is a fantastic tool for high earners to save for retirement while enjoying tax benefits. If you're making a lot of money and want a smart way to save, this could be a great strategy to consider.
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