If you have been a high earner for a few years, or if you are moving up to a higher income threshold, you will have certainly noticed by now that you are no longer able to receive many tax breaks and deductions you used to get. Aside from paying higher effective taxes every year, you may also notice that you are no longer eligible for many retirement saving opportunities. Read on to learn about how you may be able to take advantage of a backdoor Roth IRA.
The Roth IRA: Helping the Rich Get Richer
The Roth IRA is a unique retirement vehicle that allows tax payers to make after-tax contributions to their account in return for qualified distributions from the account being received tax free in the future. Many participants are starting to opt for the Roth IRA over the traditional IRA, especially if they are already involved with an existing employer plan. Saving on both a tax deferred (401(k), defined benefit, etc.) and a tax-free basis (Roth IRA) can be very beneficial from a tax diversification standpoint. Though participants can still contribute a significant amount of their salary toward their employer’s plan, high earners of a certain level cannot take full advantage of a Traditional IRA or a Roth IRA if they have been phased out of the earning limits. (For more, see: An Introduction to Roth IRAs.)
Business owners all throughout the United States have found themselves in this situation. Many small business owners neglect to set up an IRA or Roth IRA account for themselves during the start up stages of their companies because they are reinvesting all of their earnings back into their growing business. Once their business becomes successful, they may find themselves in a higher tax bracket unable to take advantage of saving opportunities that were afforded to them years ago. Though this group of entrepreneurs and highly paid individuals are likely to max out their 401(k) plan contributions for the year, they still might be missing out on the opportunity to capitalize on the benefits of tax free growth that a Roth IRA offers.
In recent years the IRS has made somewhat of a backdoor for these high earners who are looking to contribute to a Roth IRA. Because the earner cannot make a deductible IRA contribution, due to earning limits, they will make a nondeductible IRA contribution and then convert that contribution to their Roth IRA account. Roth IRA contributions are always nondeductible and distributions from Roth IRA accounts are tax free so in effect this contribution and conversion will be treated just the same as a normal Roth IRA contribution if certain steps are taken. (For more, see: How a Roth IRA Works After Retirement.)
Is a Backdoor Roth IRA Right for You?
There are a few caveats that are worth mentioning. If you have a traditional IRA and want to employ this strategy, instead of letting you convert new nondeductible contributions without any tax consequence, the IRS will use the total value of your pre-tax contributions and after-tax contributions in your existing IRAs to determine what portion of your new conversion is to be considered non-taxable and what portion is considered taxable on a pro-rata basis. In other words, if you want to convert nondeductible contributions, you must also include a certain amount of your tax-deductible contributions.
For this reason, if your existing traditional IRA is already sizable, and you aren't planning on rolling it over to your Roth IRA, then this nondeductible conversion strategy may not be the best option considering that much of the tax benefit this strategy provides will be lost when the pro rata formula for the conversion is taken into account. If you were to implement this strategy, it’s a good idea to open a designated nondeductible IRA that you can use to contribute to and then convert funds out of. This will make the process much easier to track for you and your tax or financial professional.
The bottom line is that if you are a top earner who is currently maxing out your 401(k) contributions and has no traditional IRA account, you are an excellent candidate for this backdoor Roth IRA strategy. This backdoor Roth IRA is considered a gift to high earners especially to those who’s top priority is saving sufficient funds for retirement as well as lowering their future tax burden. (For more from this author, see: 5 Questions to Ask Before Opening a Roth IRA.)