How To Get Around The Roth IRA Income Limits (Backdoor Roth IRA)
Let’s talk about a popular tax loophole question: “How do Backdoor Roth IRAs Work?”
What is a Roth IRA?
A Roth IRA is a unique retirement account that allows you to contribute your earned income (income AFTER taxes) into this particular brokerage account. The Roth IRA brokerage account operates like any other stock brokerage account.
The only difference is that all the stocks and funds you buy within the Roth IRA account will grow TAX-FREE, so long as you don’t withdraw until 59.5-years-old and have had that account for 5 years minimum.
(You can learn more about Roth IRA accounts here).
Sounds pretty cool, huh?
Now there are some restrictions to this Tax-Free growth account.
The maximum amount you can contribute to a Roth IRA for 2022 is $6,000 if you're younger than 50.
If you're 50 or older, you can add an extra $1,000 per year in "catch-up" contributions, bringing the total contribution to $7,000.
To be eligible to contribute the maximum amount in 2022, your income must be less than $129,000 if single or $204,000 if married and filing jointly.
Contributions begin to phase out above those amounts. You can't directly contribute any money into a Roth IRA once your income reaches $144,000 if a single filer or $214,000 if married and filing jointly. (You can calculate how much you can contribute here based on your income).
But what happens if you make above the Roth IRA income limit? Is there a way around it?
Well, yes, there is! And it’s referred to as the “Backdoor Roth IRA.”
What is a Backdoor Roth IRA?
A backdoor Roth IRA is NOT an account. It's just a tax strategy to get around the Roth IRA income limit. A loophole, if you will. Hence, the Backdoor part.
This strategy was made famous around 2010. Laws have been proposed to close the loophole, but none have passed.
Here is how you would get around the Roth IRA limits:
Make a contribution to a non-deductible traditional IRA. A non-deductible traditional IRA is one where you contribute with after-tax money. So you have paid taxes on the money you are contributing with. In other words, no contributions to this account will be deducted from your taxes.
Only after-tax money can go into a Roth IRA. So if you deducted contributions on ANY traditional IRA that you have, you’d owe that tax deduction back, and the pro-rata rule will apply. If you aren’t sure what the pro-rate rule is, check out this great article that explains the pro-rata rule in detail.
2. Open a Roth IRA. You’ll need to open up a Roth IRA account if you haven't already. Ideally, with the same brokerage you are transferring your traditional IRA from.
3. Start the Conversion. Contact your stock brokerage to transfer the funds in your non-deductible traditional IRA account to your Roth IRA account. Each stock brokerage process will be a little different, so reach out to your broker to get that process started.
Now you’ll want to be careful with the backdoor conversion.
If you don’t follow these rules closely, you could get hit with a big tax bill at the end of the year. Your best bet is to talk with a tax professional before making any moves on your own. That way, you can make sure no surprises come up down the road based on your specific tax situation.
Bottom line, the backdoor Roth IRA can be an excellent strategy for those who make too much to contribute to a Roth IRA directly but want to take advantage of the Roth tax benefits.
It’s always a good idea to talk with a tax professional to appropriately execute this loophole based on your specific tax situation.
As always, this blog post is intended to be used for educational purposes only. If you have any questions regarding your tax situation, please reach out to a tax professional.
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As Always: Buy things that pay you to own them.
-Josh
Blog Post: #008
