Is The Backdoor Roth IRA Contribution Right For You? 2024 Edition.
This "loophole" is a legitimate way for higher earners to be able to contribute to Roth IRAs every year. But there is one potentially huge possible pitfall to be aware of.
Despite its slightly shady-sounding name, the Backdoor Roth contribution is a perfectly legal and efficient strategy that can be used by higher earners to be able to make Roth IRA contributions that they are otherwise prohibited from making. But care is required.
In this article, I will address:
Who needs to make use of a Backdoor Roth contribution?
Who does not need to make use of it?
What is the process for implementing the strategy and by when does it have to be completed?
The one big thing that you need to be VERY aware and careful of before deciding whether or not to implement a Backdoor Roth strategy
If your Modified Adjusted Gross Income (MAGI)*** for the calendar year ending December 31st 2024 is going to be above the 2024 IRS upper income limits which are $161k for a single filer and $240k total of the two MAGIs for those filing jointly, then you are not permitted to make a direct contribution to a Roth IRA for that year and will face penalties if you do so.
For a review and an explanation of all the most recent contribution limits of Roth IRAs as well as Traditional IRAs and workplace retirement plans, see my newly-updated article “New 401k and IRA Contribution Limits for 2024”.
Your tax preparer will be able to tell you what your current year MAGI is once they have all your information.
*** See attachment below for what constitutes MAGI and how it may differ from simply Earned Income.
Note that if you are a single filer whose MAGI in 2024 is going to be above $146k but below $161k or a married filer whose total joint MAGI with your spouse is going to be above $230k but below $240k you are entitled to a partial, pro-rated direct contribution, but will need to use the Backdoor method for the balance.
So if your MAGI for the 2024 is less than $146k (single filer) or less than a total between the two of you of $230k (married filer), then you have no need to employ the backdoor contribution strategy and can directly make up to the maximum contribution for this year in one step (2024 maximum is $7k per individual or $8k if aged 50 or over) any time before April 2025 by simply contributing as normal.
In fact, you have no need to read this article any further. Enjoy the rest of your day! :-)
For the rest of you, here is the best-practice process for making a Backdoor Roth IRA contribution:
Before early- to mid-March of the year following the tax year for which you are contributing, (do not leave it till the last few days before tax day in April) put the amount you want to contribute by this method into a Traditional IRA, NOT a Roth. If contributing after January 1st, make sure the contribution is tagged as being for the “older” previous year, not for the “newer” current year. If you do not have a Traditional IRA in place then open one for this purpose at the same provider where you hold your Roth, it's usually very easy to do. Because of how much you earn, this will be considered a non-deductible contribution to the Traditional IRA, i.e., you get no tax break this year for this contribution.
Wait at least two or three business days (days that the stock market is open), just to be sure. The reason for this is that the IRS still prefers to see this as a two-step process.
Rollover the contributed amount from your Traditional IRA to your Roth IRA at the same provider as a "same trustee transfer". Your investment platform provider support staff or your financial advisor can help implement this for you.
Assuming the Traditional IRA was empty before you contributed to it (see below, very important), your only potential tax liability for this transaction is on any short term capital gain that may have occurred during the short period of time that it sat in the Traditional IRA account before the conversion.
Voila! The contribution dollars are now in your Roth IRA and all future qualified withdrawals will be tax and penalty free.
BUT THERE IS A VERY BIG "HOWEVER .." !!
.. The Pro-Rata Rule.
The IRS requires that rollovers from Traditional IRAs to Roth IRAs to be done pro-rata. If you have no existing balance in any Traditional-style IRAs, you do not need to worry about this but if you do already have any money sitting in any of these Traditional-style IRAs, then please read the following very carefully before deciding upon implementing a Backdoor Roth contribution strategy.
Here's how it works: When determining any tax bill on a conversion from a Traditional IRA to a Roth IRA, the IRS is going to look at all of your existing Traditional-type IRA accounts combined as of year-end (that is; the total of any regular Traditional IRAs, any Rollover IRAs, any SEP IRAs and/or any SIMPLE IRAs).
However, Traditional 401k/403b/457 balances do not count as an existing balance for this purpose and need not be considered in this equation and nor do any inherited IRAs (which are not allowed be converted to a Roth anyhow).
If any of your existing Traditional-type IRAs already have a balance of pre-tax money in place (as would be the case if you had previously-made deductible contributions or had earlier rolled over a 401k or other workplace plan into any kind of Traditional IRA, for example) prior to the conversion, then that ratio will determine what percentage of the money you convert to a Roth is going to be taxable. You can't just pick and choose to convert only the specific piece of non-deductible money you just contributed; the IRS won't allow that.
Example 1: You have no existing balance in any Traditional-type IRA(s) .. you contribute $7k to your Traditional IRA, wait at least two business days, then convert all of it into your Roth IRA. Your tax liability is limited to any capital gains that might have been made in the Traditional IRA during that short waiting period, so likely negligible, if any at all.
Example 2: You already have a total existing balance of $93k of pre-tax $$ (from prior deductible contributions and/or maybe 401k rollovers) in your Traditional-type IRA(s). The $7k that you add as a non-deductible contribution is immediately commingled with the existing pre-tax $93k, creating a total balance of $100k of which 93% is as-yet-untaxed dollars and only 7% is already-taxed dollars. Whatever amount you then choose to convert to a Roth IRA will therefore be deemed to be 93% untaxed and 7% already-taxed. So if you then convert $7k to your Roth, then 93% of that ($6,510) will be taxed right away by having it added to your taxable income for the year of the conversion and only 7% ($490) will be converted tax-free. The money to pay this additional income tax will need to come from a source other than the IRA itself.
This pro-rata rule means that the Backdoor Roth contribution may not a good idea if you have a significant existing balance in any Traditional-type IRAs and do not want to convert the entire and "bring forward" the tax bill on the untaxed portion of whatever amount you convert (bear in mind though, the $ in your Traditional IRA has never been taxed and will be one day anyhow, you are just bringing that day forward for a portion of it if you have existing untaxed balances - so this process does not create a tax liability that you wouldn't otherwise have).
Note also that, if you are prepared to pay the taxes now on a conversion (which you may be inclined to do if, for instance, you believe that future tax rates on your withdrawals may be significantly higher and you are lucky enough to have the funds currently available elsewhere to make the tax payments or if you are presently experiencing an "outlier" low income year and therefore are temporarily in a lower tax bracket than usual), you can actually convert as much of the Traditional IRA balance as you want.
You are not restricted to being able to convert just the up to the $7k that you may have just put into the Traditional IRA - but the ratio-ed percentage of taxable/non taxable will remain the same and apply to whatever amount it is that you convert (e.g., in Example 2 above if you decide to instead convert, say, $20k then that amount will be pulled from the newly-commingled total pool of $100k and $18,600 of it - 93% of the total converted amount - would be added to your taxable income the year of the conversion and only $1,400 of it - 7% of the total converted amount - would be converted tax-free).
But the result will be that the converted funds are now in your Roth IRA instead of your Traditional IRA and therefore will never be taxed again.
Below is an explanation of the difference between Modified Adjusted Gross Income and plain old Earned Income ..
For Anglia Advisors clients, I am happy to offer assistance in coming to a decision on and/or implementing this strategy.
WWW.ANGLIAADVISORS.COM | SIMON@ANGLIAADVISORS.COM | CALL OR TEXT: (929) 677 6774 | FOLLOW ANGLIA ADVISORS ON INSTAGRAM