Tax Planning for Retirement–The Backdoor Roth IRA

Some people make way too much money! Sounds like a nice problem to have doesn't it? In many cases it is, but one downfall about having too much income is that it is sometimes harder to find tax efficient ways to invest for retirement. Many times, when performing a tax consult for clients they have asked questions like: "I've maxed out my 401K and it looks like I am over the income limit for a Roth IRA. What other options to I have in planning for retirement?"
When it comes to planning for retirement, there are limits to how much you can make before any tax incentives to investing in retirement phase out. Those limits are often lower than you think. Therefore, the tax planning advantages to investing in an IRA start to fade. In this post we'll examine the Backdoor Roth IRA which is a vehicle used by many in tax planning in order to grow their retirement savings tax free. We'll go over the basics of Traditional IRA and the Roth IRA, looking at the basic concepts of both of these. Next we will see how a Backdoor Roth IRA works and how it may help you if you find yourself making too much money.
Traditional IRA vs. Roth IRA Basic Concepts
You may have discussed Individual Retirement Accounts (IRA's) with your CPA or tax preparer. There are two types of IRA's that are most common--the Traditional IRA and the Roth IRA. We will take a look at the general concepts of each of these.
- Traditional IRA--The traditional IRA offers retirement savings before taxes. Typically, the amount contributed to the IRA will be used to reduce the taxable income or "Adjusted Gross Income" (AGI). This means that when the current year's taxes are calculated they will be based on a lower taxable income amount (thus reducing taxes). The amount contributed to an IRA is then invested in mutual funds or stocks (or crypto or whatever) and will grow. Once the money is drawn out of the IRA it will be taxed--it is presumed that the individual will be in a lower tax bracket at that point and the tax rate will be lower. This is referred to as "deferring taxes".
- Roth IRA--Unlike the Traditional IRA, the money invested in a Roth IRA is after taxes; this means that the contribution to the Roth IRA will not lower taxes in the current year. However, unlike the Traditional IRA, the money grows tax free from that point forward. When it is drawn, it will not be taxed at all (neither the amount invested or the growth). Many people favor the Roth because, the tax savings on the growth of the investment can be significantly more than that on the initial amount invested.
The Rules: Maximum Contributions, Income Limits, RMD's, Deadlines
Like anything that saves you money on taxes there are rules and limitations on each type of IRA. In this section, we will look at the maximum contributions to each of these types of plans, the income limitations, Required Minimal Distributions (RMD's) and deadlines for the contributions.
- Traditional IRA--For 2023, the maximum contribution to a Traditional IRA is $6,500 for most individuals or $7,500 for those 50 or over. This is true even if you contribute to a 401K through your employer. However, if you are covered by a 401K at work, there are income limitations: If you file single and make over $73,000 this maximum contribution is lowered and is completely phased out if you make $83,000 per year. For people married filing jointly, the phase-out starts at $116,000 and is completely phased out when household income reaches $136,000. If neither you nor your spouse are covered by a 401K at work then there is no limit on AGI for deducting the maximum contribution.
- Roth IRA--For 2023, the maximum contribution allowed into a Roth IRA is $6,500 and $7,500 (for those 50 and older) for each individual. It should be noted that these contribution limits are the combined limits--in other words, if you have $3,000 invested into a Traditional IRA you are only allowed $3,500 into a Roth that year. The AGI limitations for contributions are a bit higher than Traditional IRA's and apply regardless of whether you have a 401K at work or not. Contributions allowed into a Roth IRA start to phase out when a single taxpayer makes $138,000 and phases out completely when AGI reaches $153,000 (For married filing jointly the phase-out starts at $218,000 and no contribution to a Roth is allowed over $228,000).
Required Minimum Distributions for both Traditional and Roth IRA's start at 72 years of age (for 2023). The deadline to contribute is the same as the tax filing deadline (April 15th).
Non-Deductible IRA
Why would one want to contribute money to an IRA that doesn't reduce their taxes? There are, in fact, good reasons that somebody may want to use a non-deductible IRA in their tax planning. While you cannot deduct contributions made to a non-deductible IRA, the money within the IRA will grow tax free until it is distributed. This could be an attractive alternative to investing money in an after-tax brokerage account and recognizing capital gains and dividends on transactions.
Also, since this is non-deductible there are no income limits to worry about nor does it matter if you have a 401K at work. There is no "phase-out" for contributions. Nor is there a contribution limit for a non-deductible IRA. For those who wish to sock away more cash for retirement, the traditional IRA may be an option to consider.
The Back-door Roth IRA
Another benefit of the Non-deductible IRA is that it can be used in a tax planning strategy called the Back-door Roth. This is basically a scenario where contributions are made to a Non-deductible IRA and then that IRA is then "converted" to a Roth IRA. This allows for not only tax free growth of the invested funds but also, no tax upon withdrawal regardless of AGI.
Tax Preparation Considerations of the Back-door Roth
There are considerations when deciding whether to contribute to a Back-door Roth. If you have made contributions in the same year to a traditional IRA (one that you were able to deduct on your taxes) and converted a non-deductible IRA to a Back-door Roth you could be subject to taxes on a portion of the amount converted. The reason for this, is that the IRS will consider the "pro-rata" portion of how much money was contributed to a deductible IRA vs the amount contributed to a non-deductible IRA when considering how much tax is due on conversion.
Some people may want to consider a multi-year conversion strategy to help minimize the amount of taxes paid.
Whenever planning to utilize the Back-door Roth strategy it is important to work with your Tax Consultant or CPA to ensure you understand the amount of taxes that may be due and avoid any pitfalls.
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