- Nick Burgess
The High-Income Earner's Guide to a Tax-Free Retirement: The Backdoor Roth IRA Conversion
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Backdoor Roth IRA Conversion: A Tax Move for High-Earners
Are you one of those that Joe Biden might refer to as a "high earner?" Are you someone that complains about your diamond shoes being too tight, and your wallet is to small to fit all your $50's? Is the stripe on your American Express Centurion Card worn out, so you had to switch to the included Prada RFID bracelet? If any of these apply to you, then you're likely making too much money to qualify for a traditional Roth IRA. However, there is a strategy that you or your big-brained accountant can take advantage of: the Backdoor Roth IRA Conversion!
A Backdoor Roth IRA Conversion is a strategy that allows individuals who earn too much to contribute to a Roth IRA directly to still take advantage of the benefits of a Roth IRA, giving them post-tax retirement dollars when they hit their twilight years. That's right: there are people that earn too much to contribute directly to a Roth IRA! In 2023, the income limits to directly contribute to a Roth IRA are $153,000 for someone filing "single and lonely" on their tax filing, and $228,000 for those filing jointly.
The process involves first contributing to a traditional IRA and then converting that traditional IRA to a Roth IRA.
The first step in the process is to determine if you are eligible to make a contribution to a traditional IRA. In order to be eligible, you must have earned income and be under the age of 70.5. If you are not eligible to make a direct contribution to a Roth IRA because your income exceeds the limits set by the IRS, you can still contribute to a traditional IRA.
Once you have determined that you are eligible to make a contribution to a traditional IRA, you can make a contribution of up to $6,500 for the 2023 tax year ($7,500 if you're over 50). It's important to note that if you or your spouse have a retirement plan at work, your contributions may be limited based on your income. The reason for this is that the IRS has set income limits for those who are eligible to contribute to a Roth IRA directly, these limits are based on your filing status and income. If you exceed these limits, you are not allowed to make contributions to a Roth IRA directly. However, you can still contribute to a traditional IRA regardless of your income.
Next, you will need to convert your traditional IRA to a Roth IRA. This can be done by contacting the financial institution that holds your traditional IRA and requesting a conversion. However, it's important to note that when you convert a traditional IRA to a Roth IRA, you could be required to pay income tax on the amount that is converted. This is because traditional IRA contributions are made with pre-tax dollars, which means that you haven't paid taxes on that money yet. When you convert to a Roth IRA, you are essentially taking that pre-tax money and moving it into an account where you will pay taxes on it now but all future growth and withdrawals will be tax-free.
Once the conversion is complete, the money in your Roth IRA will grow tax-free and you will not be required to take required minimum distributions (RMDs) during your lifetime. Additionally, withdrawals from a Roth IRA are tax-free in retirement as long as you are at least 59.5 years old and the account has been open for at least five years.
Downsides of a Backdoor Roth IRA
It's also important to note that there are some potential downsides to a Backdoor Roth IRA Conversion. One potential downside is that the conversion may push you into a higher tax bracket. Additionally, if you decide to undo the conversion (a process called "recharacterization"), you may be subject to penalties and additional taxes.
Another important consideration is that if you already have money in a traditional IRA, that money will be considered in the conversion and you will be required to pay taxes on it. This is known as the pro-rata rule. To avoid this, it is best to rollover any pre-existing traditional IRA funds into a 401(k) or other employer sponsored plan before doing a Backdoor Roth IRA conversion. This way, your conversion will only include the funds you have recently contributed to your traditional IRA, and you will avoid paying taxes on pre-existing funds.
In summary, the Backdoor Roth IRA Conversion is a strategy that allows high-income earners to take advantage of the benefits of a Roth IRA by first contributing to a traditional IRA and then converting that traditional IRA to a Roth IRA. It's important to note that the conversion will be subject to income taxes, and that there are potential downsides to this strategy. If you're considering a Backdoor Roth IRA Conversion, it's important to consult with a financial advisor to determine if it's the right move for you. A financial advisor can help you weigh the potential benefits and downsides of a Backdoor Roth IRA Conversion and provide guidance on how to best navigate the process. They can also help you develop a comprehensive retirement plan that takes into account all of your financial goals and objectives.