Backdoor Roth IRAs: The Hidden Retirement Tool

In the ever-evolving world of finance, there are always new techniques and strategies emerging to help individuals save for their retirement. One such strategy that has gained popularity in recent years is the backdoor Roth IRA. In this blog, we'll delve into the world of backdoor Roth IRAs, exploring what they are, who can benefit from them, and the steps involved in setting one up. 

What is a Backdoor Roth IRA? 

A backdoor Roth IRA is a strategy that allows individuals to sidestep the income limits usually barring higher earners from contributing to a Roth IRA. Traditional Roth IRAs have income limits that restrict higher-income individuals from making direct contributions.

However, the backdoor Roth IRA provides a workaround solution to this limitation — first, you make a non-deductible contribution to a traditional IRA, and then you convert that into a Roth IRA. 

Income Limits and Contribution Thresholds

The income limits for contributing to a Roth IRA vary depending on marital status and filing type.

For the 2024 tax year, a single individual can make a full Roth IRA contribution if their modified adjusted gross income (MAGI) is less than $146,000. For MAGI between $146,000 and $161,000, a partial contribution is allowed, while any MAGI equal to or above $161,000 disqualifies an individual from making any Roth IRA contribution. 

Married individuals have slightly different income limits. For those filing jointly, a MAGI below $230,000 allows for a full contribution, while a MAGI between $230,000 and $240,000 permits a partial contribution. Any MAGI equal to or above $240,000 prohibits any contribution to a Roth IRA. 

Setting Up a Backdoor Roth IRA

To set up a backdoor Roth IRA, there are a few steps involved. Firstly, individuals need to open a traditional IRA account. This can be done through a financial advisor or by utilizing online brokerage services like Ameritrade. 

Next, a non-deductible contribution is made to the traditional IRA. It's important to note that individuals should consult with a tax professional to ensure they properly file the necessary forms (such as Form 8606) when making these contributions. 

Once the non-deductible contribution is made, the final step is to convert the traditional IRA into a Roth IRA. This conversion transfers funds from the traditional IRA to the Roth IRA, allowing for tax-free growth and withdrawals during retirement. 

Considerations and Limitations 

While a backdoor Roth IRA can be a powerful savings strategy, there are a few considerations and limitations to keep in mind. First and foremost, if an individual's income falls within the Roth IRA contribution limits, there is no need to go through the backdoor process. Direct contributions to a Roth IRA would be more suitable. 

Additionally, individuals with existing traditional IRA balances that have a tax deferral basis may encounter tax consequences when attempting a backdoor Roth IRA conversion. The IRS has pro rata rules that could lead to taxation on the conversion, nullifying the benefits of the backdoor strategy. It is crucial to consult with a tax professional to understand the specific implications for your specific situation. 

Final Thoughts

The backdoor Roth IRA strategy presents a unique opportunity for individuals to save for retirement, regardless of income limitations. By combining a non-deductible traditional IRA contribution with a conversion to a Roth IRA, you can enjoy tax-free growth and tax-free withdrawals during retirement.

However, it is vital to understand the rules, limitations, and potential tax consequences associated with this strategy. Consulting with a financial advisor and tax professional can provide invaluable guidance and ensure you make the most of this powerful retirement savings technique.

Is the backdoor Roth IRA right for you? Click the ‘Let’s Chat’ button to find out how Kaizen CPAs + Advisors can help you manage your financial future with confidence.