Q: A co-worker recently mentioned that she did a “Backdoor Roth” last year. I’ve been told that I’m not allowed to make any Roth IRA contributions because my income is too high. But, we likely earn a similar amount. Maybe I’ve been missing something. What is a “Backdoor Roth” and how does it work?
A: Your colleague may have clued you in on a little-known trick. However, it takes some careful planning. If you fully understand the rules and nuances, it might just be worth doing.
Let’s start with the income limits for making a Roth contribution. If you are single and your income in 2023 is greater than $153,000, you are not allowed to make a Roth contribution. The income limit in 2023 for those married filing jointly is $228,000.
Now, even if you happen to earn above those income limits, you are always allowed to make a “non-deductible” IRA contribution. Most people discover “non-deductible” IRA contributions totally by accident. This typically happens when you participate in your work-based retirement plan and end up making too much money to qualify for a tax deduction on your IRA contribution. Your IRA contribution then gets classified as “non-deductible.”
So, why would anyone make a non-deductible IRA contribution on purpose? Because you plan to immediately “convert” your non-deductible IRA contribution into a Roth IRA with no tax owed. And, if done right, you’ll have gone from not being allowed to make a Roth contribution to getting money into a Roth IRA “through the backdoor.”
But, there’s a small catch. This move only results in zero tax, if and only if you didn’t already have any pre-tax IRA balances in your life. If you do have pre-tax IRA accounts, then part of your subsequent Roth conversion will be taxed. In fact, the more existing, pre-tax IRA money you have will result in a greater proportion of your Roth conversion being taxed. Of course, voluntarily making a non-deductible IRA contribution and then getting taxed on a Roth conversion is not a good plan!
To fix this problem, however, there’s a perfectly legal “trick” you might consider. If you happen to be enrolled in a work-based retirement plan, you might be able to empty out your IRA balance by first doing a rollover into your retirement plan.
After the rollover is done, you’ll no longer have any existing, pre-tax IRA money mucking things up and none of your follow-on Roth conversion will be taxed. Following your rollover and after your subsequent non-deductible IRA contribution, the only dollars sitting in your regular IRA are considered to be after-tax money. With no tax deduction ever taken on that fresh IRA balance, no tax will be owed on your Roth conversion!
Jason P. Tank, CFA, CFP® is both the owner of Front Street Wealth Management, a purely fee-only advisory firm and the founder of the Money Series, a non-profit program committed to providing open-access to financial education, for all. Contact him at (231) 947-3775, by email at [email protected] and at www.FrontStreet.com