What is a Backdoor Roth IRA?

A Backdoor Roth IRA is a way of getting around the income caps on Roth IRA contributions.

What, however, is a Roth IRA, and why would you want to get around contribution limits?

Let’s start with some brief fundamentals…

A Traditional IRA, a type of tax-advantaged individual retirement account, allows people with earned income to save some of that income for retirement. You can contribute to an IRA with pre-tax or after-tax dollars and then invest that money; the contributions are often tax-deductible, and investment gains grow tax-deferred, meaning they are not taxed until you withdraw them during retirement.

The advantages of a Traditional IRA include avoiding paying tax now while earning interest, dividends, and capital gains tax-free over many years. Additionally, if you are in a high tax bracket now, you may be in a lower tax bracket in retirement. Since you will pay tax based on your retirement tax bracket, you may pay less tax overall.

This type of account also comes with some disadvantages. For example, there are annual maximum combined IRA contribution limits: $6,500 if you are under 50 and $7,500 if you are over 50. Moreover, a Traditional IRA comes with required minimum withdrawals, taxed as ordinary income at withdrawal time.

A Roth IRA is an attractive alternative for two significant reasons:

  • Withdrawals are tax-free. You pay tax on the funds you contribute today, but you never pay tax on distributions.
  • No minimum distributions are required; you can leave your money in a Roth IRA until you need it.

There are, however, income limits (unlike a Traditional IRA). If you earn more than $138,000 as an individual ($218,000 if married and filing jointly), your maximum allowable contribution decreases. And if you earn more than $153,000 (or $228,000 as a couple), you cannot contribute directly to a Roth IRA at all!

Enter the Backdoor Roth IRA—and yes, it’s legal (for now).

In simple terms, a Backdoor Roth IRA is a process by which you contribute to a Traditional IRA and then convert the account to a Roth IRA, thereby reaping the benefits of a Roth IRA while avoiding the income limits on your contributions.

This adds a level of complexity, but any bank or brokerage offering IRAs will have a quick and easy way to make this conversion—provided, of course, that institution allows conversions. (Most do, but it’s a good idea to double-check.)

By utilizing the Backdoor Roth IRA strategy, individuals can enjoy tax-free growth and tax-free withdrawals in retirement, regardless of their income level.

One important note: the Backdoor Roth IRA strategy has specific rules and considerations, and individuals should consult with tax professionals (like us!) to ensure compliance and understand the potential tax implications.

Is Backdoor Roth still allowed in 2023?

While discussions about potentially eliminating the Backdoor Roth have surfaced in recent years, as of 2023, this strategy is still permissible.

It’s important to note that future developments remain uncertain, and it is impossible to predict any potential changes that may occur. Once again, when in doubt, consult with an expert.

What are the new Roth IRA rules and restrictions for 2023?

With so many sweeping changes to the United States tax code over the past few years, it’s easy to feel uncertain about which rules and restrictions still apply in 2023.

So let’s dive into some current information related to Backdoor Roth IRAs this year (while remembering that all of this is subject to change and does not constitute tax advice).

How much can you contribute to your Backdoor Roth IRA in 2023?

Since the Backdoor Roth process entails converting your Traditional IRA account to a Roth IRA after making contributions, the same limits apply to $6,500 if you are under 50 and $7,500 if you are over 50.

Furthermore, the IRS has introduced updated income phase-out ranges that determine the eligibility for contributions to a traditional IRA and Roth IRA.

 

Suppose an individual or their spouse is enrolled in a workplace retirement plan in the tax year. In that case, the maximum contribution to a traditional IRA may be gradually reduced or phased out to zero based on the taxpayer’s filing status and income. (It’s important to note that if neither the taxpayer nor their spouse is covered by a retirement plan at work, the phase-out rule does not apply.)

 

The 2023 phase-out ranges for a Traditional IRA are:

  • For single taxpayers covered by a workplace retirement plan, the phase-out range begins at $73,000 and ends at $83,000.
  • For married couples filing jointly, if the spouse making the IRA contribution is covered by a workplace retirement plan, the phase-out range increases to between $116,000 and $136,000.
  • For an IRA contributor who is not covered by a workplace retirement plan and is married to someone who is covered, the phase-out range increases to between $218,000 and $228,000.
  • For a married individual filing a separate return covered by a workplace retirement plan, the phase-out range is not subject to an annual cost-of-living adjustment. It remains between $0 and $10,000.

Who is eligible for a Backdoor Roth IRA?

To put it simply: Anyone with income. It’s a loophole to get around limitations on Roth IRAs. So, if you can open a Traditional IRA account, and if your bank can convert it to a Roth IRA, then you are eligible for a Backdoor Roth IRA.

However, just because you can convert to a Roth IRA doesn’t mean you should.

Is a Backdoor Roth a good idea?

The answer to this question depends entirely on the specific nuances of your unique financial circumstances. Broadly speaking, some considerations may impact your decision.

For example, factor in your current and future tax brackets, the expected growth of your investments, and the time value of money. If you’re in a low tax bracket now and anticipate being in a higher bracket later, converting some Traditional IRAs to Roth IRAs could be beneficial.

Conversely, if you’re in a high tax bracket now and expect a lower bracket in the future, taking advantage of tax savings today might be advantageous.

The time horizon also plays a role, as a longer investment period allows for significant growth before retirement.

What are the downsides to a Backdoor Roth IRA?

First, there is a five-year wait to withdraw earnings tax-free, which can be a disadvantage if you’re close to retirement. Withdrawing contributions before meeting this five-year rule could result in income taxes and a 10% penalty.

Additionally, unlike a traditional IRA, you aren’t eligible for tax deductions in the year you contribute to a Roth IRA. However, you may qualify for the saver’s credit with income restrictions.

Moreover, there may be better choices than a backdoor Roth IRA if you can only pay the taxes with money from your IRA withdrawal, as it sacrifices future investment growth and could incur the 10% early withdrawal penalty. If you anticipate needing the converted money within five years or if the withdrawal pushes you into a higher tax bracket, it’s generally recommended to convert only enough to avoid a higher tax rate in that year.

Again, how you weigh these downsides against the potential benefits is unique to your situation. The best way to evaluate whether or not a Backdoor Roth IRA is a good idea for you is always to seek guidance from a tax professional.

Would you like some help?

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