By Allen Giese, CLU®, ChFC®, ChSNC®, and ChatGPT

For retirement savings, it’s hard to beat the advantages a Roth IRA brings to the table. Funded with after-tax dollars, Roth IRAs grow tax-free, and provided you don’t take a distribution until after age 59 ½ and the account has been open for at least five years, the dollars inside the Roth are available tax-free. For long-term savers, that’s hard to beat.

However, a drawback to the Roth IRA is that it comes with earnings limits on income. If you make too much income, you can’t contribute. To get around that, high-income savers can use something called a “backdoor Roth IRA.”

A backdoor Roth IRA is a financial strategy employed by individuals whose income exceeds the limits for direct contributions to a Roth IRA. While the name may suggest something clandestine, it is a legal and widely acknowledged method within the framework of U.S. tax laws.

As I mentioned, Roth IRAs offer a unique advantage in that withdrawals, including earnings, are tax-free. However, the income limits dictate who can contribute directly to a Roth IRA. As of 2024, the ability to make direct contributions to a Roth IRA begins to phase out for individuals with a modified adjusted gross income (MAGI) above $146,000 (single filers) or $230,000 (married couples filing jointly).

The backdoor Roth IRA strategy allows individuals to navigate these income limits and still benefit from the advantages of a Roth IRA. Here’s a breakdown of how it typically works:

1. Contribution to a traditional IRA: High-income earners who are ineligible for direct Roth IRA contributions can make a nondeductible contribution to a traditional IRA. Unlike Roth IRAs, traditional IRAs do not have income limits for contributions.

2. Conversion to a Roth IRA: After contributing to the traditional IRA, the individual then executes a Roth conversion. This involves transferring the funds from the traditional IRA to a Roth IRA. Importantly, there is no income limit for Roth conversions.

3. Tax considerations: While the initial contribution to the traditional IRA might not be tax-deductible, the conversion to a Roth IRA is a taxable event—but only on the gains. So, if the initial contribution to the nondeductible traditional IRA is made on day one (and not invested into any securities) and then on day two, those dollars are converted to a Roth IRA before they’ve had a chance to grow, there would be no taxable event since there are no gains to tax!

It’s crucial to understand that the backdoor Roth IRA strategy is entirely legal, provided it is executed according to tax regulations. Additionally, tax laws can change, and it’s advisable to consult with a financial advisor to ensure compliance with the latest rules and regulations.

The backdoor Roth IRA strategy is not without its considerations. One key factor is the pro-rata rule, which takes into account all traditional IRA assets when determining the tax consequences of a Roth conversion. If an individual has other traditional IRA funds, including deductible contributions and earnings, the tax implications of a backdoor Roth IRA conversion become more complex.

The backdoor Roth IRA is a legitimate and widely used financial strategy for individuals seeking to contribute to a Roth IRA despite income limitations. By understanding the rules and potential tax implications, individuals can make informed decisions to optimize their retirement savings. It’s important to approach this strategy with transparency and compliance with tax laws, seeking professional advice to navigate any complexities and changes in regulations.

This material was written in collaboration with artificial intelligence (ChatGPT) derived from sources believed to be accurate. This information should not be construed as investment, tax, or legal advice.