The Backdoor Roth IRA: A Very Little Key May Open a Very Heavy Door

Charitable donations and contributions to IRAs are well-worn entryways when it comes to offsetting taxable income, but as a high earner, you may not realize that you can also take advantage of the tax diversification offered by Roth IRAs – even if you earn more than IRS contribution limits technically allow.

Reviewing Roth

A Roth IRA allows taxpayers to set aside after-tax dollars for retirement without owing taxes on qualified withdrawals. Annual contributions cannot exceed the lesser of your earned income or IRS contribution

thresholds. In general, you can contribute up to $6,500 to an IRA (traditional, Roth or a combination of both) in

2023. Add an extra $1,000 if you’ll be 50 or older by the end of the year. However, contributions may be reduced or eliminated based on your modified adjusted gross income, or MAGI, for the year.

The Nitty Gritty on Backdoor Roths

Despite MAGI limits, a high-income earner can convert a traditional IRA into a Roth IRA under specific conditions – sometimes known as a backdoor Roth. If you earn too much to do a normal Roth IRA contribution, you can make a nondeductible contribution to a traditional IRA (which anyone can do, no matter how much you earn), then convert that traditional IRA contribution to a Roth IRA. However, this strategy only works when the taxpayer has not used any pretax dollars to fund their traditional IRAs. The reason? The IRS’ pro-rata rule totals all your IRA balances and calculates a proportional amount of pre-tax and after-tax dollars to determine your tax liability on a conversion. 

For example, suppose a taxpayer funded a $94,000 traditional IRA withpre-tax dollars, then contributed $6,000 after tax into a separate traditional IRA. An attempt to convert just the new IRA with the $6,000 after-tax contribution would prompt the IRS to prorate the $100,000 IRA total (94% pre-tax and 6% after-tax), meaning you’d owe taxes on 94% of the amount converted to the Roth.

Bottom line: To avoid the tax liability on a backdoor Roth conversion, you must have $0 pre-tax in any IRAs. You’ll want to ensure your existing IRAs meet the guidelines and you do everything correctly when executing a conversion like this. Otherwise, the strategy may not be effective.

Tom King CFP®, CLU®, AEP® is Registered Principal of King Financial Partners goKFP.com at 222 Blue Course Drive, State College, PA. King Financial is a team of credentialed professionals specializing in retirement, investment management, wealth transfer, and estate planning. Tom can be reached at Tom@goKFP.com or (814) 234-3300.

Implementing a Roth conversion means paying more taxes now, which may not be beneficial if you are in a higher tax bracket today than you expect you will be in the future, or if you expect tax rates to decline. Also, Roth conversions increase your AGI in the year of conversion. This may affect other tax deductions, credits and related items, such as Medicare premiums. A Roth conversion also isn’t beneficial if you need the distributions for immediate expenses.

Many individuals may still rely on traditional IRA distributions for a component of their income. IRAs used for current income may not see the benefit of tax-free appreciation of the Roth IRA. When implementing a Roth conversion, consider paying taxes from an outside source, allowing all of the converted funds to grow as opposed to taking a withdrawal from the plan to pay taxes. Keep in mind, distributions from an IRA when the participant is under 59 1/2 may be subject to a 10% penalty. Also, consider your beneficiaries. If you intend to leave your traditional IRA to a charity, it may not make sense to pay additional taxes today for money that the charity wouldn’t be taxed on upon receipt. Please speak with your advisor about whether a Roth conversion may be beneficial for you.

In order for earnings to be tax-free, converted funds must be held in the Roth IRA for five years and distributions must occur after age 59 1/2 or as a result of death, disability or first time home purchase of $10,000. A separate five-year period applies for each conversion. Raymond James does not provide tax services. Please discuss these matters with the approved professional.

Sources: Raymond James Worthwhile Fall 2022. Securities offered through Raymond James Financial Services, Inc., member FINRA/SIPC.© 2021 Raymond James Financial Services, Inc., member FINRA/SIPC. Investment advisory services offered through Raymond James Financial Services Advisors, Inc. King Financial Partners is not a registered broker/dealer and is independent of Raymond James Financial Services.