In the middle of the tax filing season for 2022, many investors may wonder about making contributions to a non-employer retirement account for the prior tax year before the April 17th filing deadline. However, there are income limits on deducting contributions to a traditional Individual Retirement Arrangement (IRA) as well as on contributing to a tax-free Roth IRA. This article will discuss a workaround strategy—known as the backdoor Roth IRA—for savers who earn above the income limit but still would like to contribute to a personal retirement account.
The two main types of IRA are the traditional (also known as pre-tax) and the Roth (tax-free). With a traditional IRA, the account owner typically takes a deduction from their income for any contributions into the account that year and then the entire account balance, including any investment earnings, is taxed as income when the funds are withdrawn in retirement. In contrast, there is no up-front tax benefit to contributing to a Roth IRA, but all contributions and earnings within the account are not taxed when withdrawn in the future as long as some basic requirements are met. Both types have an annual contribution limit set by the IRS; for tax year 2022, this is $6,000/$7,000 for savers under/over age 50. This limit is for both traditional and Roth IRA contributions combined and is separate from the contribution limit into a 401(k) plan or other employer-sponsored retirement program.
Both traditional and Roth IRAs also have income limits for making contributions. If you have access to a retirement plan at work (i.e. 401(k)), your modified adjusted gross income must be under $68,000 (single) or $109,000 (married filing jointly) to make the full contribution into a traditional IRA for 2022 and receive a tax deduction for it. Getting to deduct traditional IRA contributions can help reduce taxable income for the year, but by the time someone earns enough money for the tax deduction to become very valuable, their income is likely too high to be allowed to take advantage of it. The limits for Roth IRA contributions are higher but can still be restrictive: $129,000 for single filers and $204,000 for married filing jointly. The maximum contribution phases out as income increases until no deductions/contributions are allowed at certain income levels—Roth IRA contribution eligibility for 2022 is completely eliminated at $144,000 for single and $214,000 for married filing jointly.
Backdoor Roth IRA Contributions
For investors that find themselves ineligible for deductible IRA contributions or direct Roth IRA contributions, there exists a strategy known as the “backdoor” Roth IRA contribution. This requires a two-step process but the end result is the same: contributions get into a Roth IRA and can be invested to grow tax-free for the investor’s entire lifetime.
In order to make this backdoor Roth contribution, the first step is to contribute to a traditional IRA. Remember, though, that income is likely too high to take a tax deduction for the contribution, so this money going into the traditional IRA is a nondeductible contribution, meaning no tax benefit was taken from putting the money there. Unlike the deductible contribution, there is no income limit for making a nondeductible contribution; there only needs to be earned income in excess of the annual contribution limit.
The second part of the process is to convert this contribution from the traditional IRA to a Roth IRA. Typically, a Roth conversion entails some tax consequence, as the more well-known strategy involves intentionally moving pre-tax dollars from a traditional IRA into a Roth IRA and paying taxes on the converted amount in order to get the money into a tax-free account. However, with the backdoor Roth contribution, there is no tax owed when converting the nondeductible contribution because no tax write-off was taken in the first place when the contribution was made to the traditional IRA. Once the nondeductible IRA contribution is converted to the Roth IRA, it can be invested and all future growth is tax-free, just like if the contribution was made directly into the Roth IRA. There is no income limit on making Roth conversions, so both steps of this workaround process are available to high earners. Important to note is that these nondeductible contributions should be documented on tax returns with Form 8606 to ensure that any conversions of nondeductible contributions from traditional to Roth IRA do not get taxed.
Limitations on the Strategy
The biggest potential hiccup to this strategy involves investors who already have existing pre-tax balances in an IRA. The IRS considers all conversions from a traditional IRA to a Roth IRA to be pro rata, meaning pre-tax and after-tax money is converted in the same proportion as the existing balances in the account. This calculation is across all traditional IRAs owned by the same individual, so one cannot simply open a new IRA account to utilize this strategy. Let’s illustrate by assuming someone already has $6,000 of pre-tax money in a traditional IRA and goes to make a $6,000 backdoor Roth IRA contribution for 2022. After completing step one of the backdoor process, the traditional IRA will have $6,000 in pre-tax money and $6,000 in nondeductible/after-tax funds. When the $6,000 Roth conversion is executed, the IRS will see 50% of the traditional IRA balance as pre-tax and assess income taxes on 50% of the Roth conversion using the pro rata rule. The end result is still $6,000 going into the Roth IRA but there will be $3,000 ($6,000 conversion * 50%) of taxable income in the year of conversion instead of no tax consequence to convert a solely nondeductible contribution. This example kept the math simple but, for large existing pre-tax IRA balances, executing a backdoor Roth IRA contribution could result in nearly the entire conversion being taxed as income as the proportion of pre-tax money relative to the nondeductible contribution amount grows. For high earners in top tax brackets, this is likely an inopportune time to be generating unnecessary taxable income.
The easiest way to avoid this hurdle is to keep pre-tax IRA balances at $0 and only use the traditional account for making annual backdoor Roth IRA contributions. Because pre-tax 401(k) money does not count in the pro rata calculation when converting traditional IRA balances, the most common method is to keep employer plans (both previous and current) within a 401(k) plan instead of rolling over old 401(k)s to an IRA which may render the backdoor Roth strategy less useful due to the pro rata rule described above.
This article reviewed the basics of the backdoor Roth IRA contribution strategy that allows high earners to contribute to personal retirement plans regardless of income. There are certainly additional nuances, as the deduction/contribution limits for IRAs and usefulness of backdoor Roth IRA contributions are dependent on each investor’s individual situation. We would be happy to discuss retirement account savings strategies in further detail as they relate to specific circumstances.