Do you make too much money to contribute to a Roth IRA? If so, the “backdoor” Roth IRA strategy is one of the best loopholes in the tax code you could utilize today. Many high-income earners believe they can’t contribute to a Roth IRA because they make too much money. This is false, and here’s why…
While direct contributions to the Roth IRA (through the “front door”) are not permitted if you make too much, according to the IRS MAGI limits, you can still take advantage of the Backdoor Roth IRA.
What is a Backdoor Roth IRA?
A Backdoor Roth IRA consists of 3 steps facilitated by your IRA’s custodian, such as Directed IRA.
• It combines opening/funding a Traditional IRA (or other pre-tax retirement account)
• Then completing a Roth conversion..
• The result is a Backdoor Roth IRA, and it is treated the same as any other Roth IRA.
What is the income phase out?
•For single filers: The phase-out range begins at $153,000 and ends at $161,000.
•For married couples filing jointly: The phase-out range begins at $228,000 and ends at $240,000.
These phase-out limits determine whether you can make a full contribution, a partial contribution, or no contribution at all to a Roth IRA or Roth 401(k), based on your modified adjusted gross income (MAGI).
What is a Roth conversion?
A Roth conversion is the transfer of retirement funds and/or illiquid assets from a pre-tax retirement account to a Roth IRA. The key is the IRS does not limit who can complete Roth conversions based on income.
Many types of pre-tax accounts can be converted to a Roth IRA. This includes but is not limited to the following common account types:
Traditional IRAs/Rollover IRAs
SEP IRAs
401(k)s
Solo 401(k)s
…and more!
If you do not exceed the MAGI limits set by the IRS, you can contribute directly to the Roth IRA which is not necessary for the backdoor strategy. This is because you can contribute to the Roth IRA through the “front door” directly. Keep this option in mind though, especially if your income increases year over year. You may need to leverage this option in the near future.
Why would someone want a Roth IRA instead of a Traditional IRA/other pre-tax account?
The Roth IRA is the optimal type of retirement account that you can have as part of your retirement strategy. Roth IRAs are funded by post-tax contributions, meaning you cannot deduct them in the year in which you make the contribution. Since the account is funded with taxed dollars, the earnings you accrue on those dollars also grow tax-free for you to withdraw in retirement (or sooner).
The Roth IRA is an account used by the wealthiest people in the United States (i.e. Peter Thiel, Mitt Romney, and many others), but this option isn’t just available for the wealthiest. That is why we want to share this knowledge with as many people as we can. Everyone should be able to enjoy having tax-free income in retirement.
How can I implement the Backdoor Roth IRA strategy?
Regardless of your income level, we can assist you with transitioning your retirement assets to a Roth IRA. It’s as easy as 1-2-3.
You can implement the Backdoor Roth IRA with these three steps:
1. Open a Traditional IRA and a Roth IRA with Directed IRA.
2. Make your annual contribution to the Traditional IRA.
3. Submit a Roth Conversion request, and let us at Directed IRA handle the rest!
That’s it. These 3 steps allow you to leverage the powerful Roth IRA and all its benefits regardless of how much you make.
Does this sound too good to be true? Because it gets even better…
With a Self-Directed Roth IRA, you have the power to Invest in What You Know. A Self-Directed Roth IRA allows you to invest in alternative assets with your tax-free Roth IRA. We can custody a wide array of assets, including but not limited to these popular asset classes:
• Real Estate (rentals/fix and flips)
• Multi-family properties
• Private Lending/Note Investing
• Precious Metals
• LLCs/Private Placements (PPMs)/Syndications
If you don’t understand the stock market, why are you trying to beat it? Invest in a tangible and even physical asset class that helps you build a legacy AND a diverse portfolio.
Here’s an example: imagine you purchase a property with $100,000 from your Self-Directed Roth IRA. You rent that property out for a few years, and then you decide to sell it. You sell the property for $200,000. Rinse and repeat, then you reach 59 1/2 and meet the 5-year rule on roth distributions, and you get to access that money and income and enjoy it tax-free.
How do I know if I can even contribute to a pre-tax retirement account?
If you want to contribute to a Traditional IRA, you must have “earned income” in the U.S. You can contribute up to $7,000 annually for 2024, or 100% of your earned income, whichever is less. The deductibility of this contribution varies based on your income level and whether or not you contribute to a 401(k) plan with your employer.
Although you may contribute to a pre-tax retirement account, these amounts cannot always be deducted. If you make a non-deductible contribution, track it on your Form 8606.
If you are reading this after 2024, the IRS has announced future contribution limits and changes. You can find them here:
IRA Contribution Limits.
Pro-rata Rule on Roth Conversions
If you previously made deductible contributions to a Traditional IRA or other pre-tax account, you should be aware of the pro-rata rule for Roth conversions.
It ensures IRA owners are converting deductible contributions first, then converting the non-deductible contributions thereafter.
Deductible contributions that are converted are subject to taxes. Non-deductible contributions are not.
Top 3 Questions we get regarding the Backdoor Roth IRA strategy:
Q. Is there a dollar limit to a Roth conversion?
A. No. You can convert as much as you’d like within any tax year, regardless of your income. Be aware that you may be triggering a taxable event, but this is intentional and part of the strategy. This allows you to pay taxes now to avoid taxes later.
Q. Can I still do a Roth conversion if I contribute to a 401(k)?
A. Yes.
Q. Do I have to convert my entire account at once?
A. No. You can convert a small amount each year and even forego it for any year. This method is commonly known as “chunking.” Chunking is a strategy if you have a large balance you are trying to convert to a Roth IRA. It allows you to spread out the potential taxes due throughout a few years.
Non-deductible IRA contributions are a typical place to start with your Roth conversions. When you report a non-deductible contribution to an IRA on your 1040, you already don’t benefit from the advantages of a deduction… so why not formally make these funds post-tax in a Roth IRA?
Tax Forms
Here are a few tax forms to be familiar with when you are planning to do a Roth conversion or when implementing the Backdoor Roth IRA strategy.
1099-R
This form reports funds or assets distributed from your pre-tax retirement account. Your custodian files this on your behalf.
5498
This form reports funds or assets received in your Roth IRA. Your custodian also files this on your behalf.
Form 8606
This is where you report your non-deductible contributions made to pre-tax retirement accounts. You are responsible for filing this form.
Form 1040
The 1040 is where you report your IRA distributions and the taxable amount (taxable amount= the distribution amount on your 1099-R minus the total non-deductible contributions from your 8606. This amount could range from $0 up to the amount on your 1099-R). You are responsible for filing this form.
Converting non-deductible contributions does not cause a taxable event. Converting earnings within your pre-tax account will cause a taxable event.
Spousal IRAs
Spousal IRAs also qualify for this strategy. Even if your spouse has no earned income, if you are married and filing jointly then your spouse can also contribute to a pre-tax retirement account and convert it to a Roth IRA!
How do I get my Backdoor Roth IRA started?
Contact the team at Directed IRA for a complimentary, getting-started call today to see if a Self-Directed Roth IRA is an option for you. We walk you through each step, assist in identifying what accounts you can utilize immediately, and begin your self-directed Roth IRA journey with you in 15 minutes or less.
Our committed team can be contacted at 602.899.9396, and we are ready to assist you in achieving a financially stable future.
If you need a new Roth IRA, be sure to enter this discount code BLOG50 to get $50 off your first year’s annual fee!
