Back-door Roth IRAs Simplified

Roth IRAs have become one of the most popular wealth-building strategies, and the reason is that they allow you to grow your money tax-deferred AND withdraw your money tax-free!

IRA is short for Individual Retirement Account, meaning it’s an account that you as an individual would establish on your own, and is not provided by your employer. This is where contributions to an IRA differ from that of a 401(k). 401(k)s are employer-sponsored plans, this means that the only way you’re able to get contributions into a 401(k) account is through payroll deductions. IRA contributions are made using cash you have in a checking, savings, or investment account.

The reason that you’re able to withdraw money tax-free from a Roth IRA (subject to certain qualifications) is that contributions into the account are made on an after-tax basis. For example, you go to work and earn a paycheck. Before you receive your net pay, your employer withholds federal taxes and pays you the remaining amount after tax.

The IRS sets income limits for which individuals are eligible to contribute to a Roth IRA as well as the amount they can contribute each year (a simple Google search for “2024 Roth IRA limit” will reveal the answer). For households that exceed these income limits, the IRS will phase out the amount that you’re eligible to contribute until it reaches a $0 eligible amount.

The modified adjusted gross income limits to be eligible to make a contribution in 2024 are:

Single Filers: $161,000
Married Filing Jointly: $240,000

For individuals that earn more than these thresholds, and can no longer make contributions, the IRS will still allow you to make non-deductible contributions to a traditional IRA. If you choose to make these contributions, they will be on an after-tax basis with no tax deduction (but will still grow tax-deferred!).

Further, if you make after-tax contributions to your IRA and that money grows over time, the portion you contributed will be taxed differently than the growth in the account. For example, let’s say over 10 years you contribute $5k a year for a total of $50k. Let’s also say that over those 10 years that your $50k in contributions grew to a balance of $100k. Because you made after-tax contributions of $50k, or 50% of the account balance, then 50% of each withdrawal would be a partial return of your non-deductible contribution (which is tax-free) and a partial return of the tax-deferred growth (which is taxed). Your withdrawals will always come out proportionately. There’s one more step to make your non-deductible contribution a Roth asset.

Once the cash is in your IRA, you can then transfer the cash from your IRA directly into your Roth IRA. This is called a Roth conversion.

The IRS wants to tax your pre-tax contributions, your after-tax contributions, and Roth contributions accordingly. In the example above, $50k of your account balance was after-tax and is 50% of a total $100k IRA. This means that if you convert $50k to Roth, then proportionately 50% is non-taxable and the other 50% is taxable!

If you have $0 in an IRA and your only contribution in 2024 is the non-deductible (after-tax) amount of $7,000, then when you go to convert to Roth, the tax-free portion works out to be 100%! The reason is that you converted your entire account which is made up of 100% non-deductible contributions with no pre-tax contributions or growth. Therefore, it is crucial to keep track of your IRA accounts and the type of contributions within them.

Important planning tip! The IRS looks at all your IRA accounts as one big pool of money, even if it’s in multiple accounts or at different custodians. This is called the IRA aggregation rule. You must have a $0 balance IRA to successfully do a back-door Roth with no additional tax liability.

Here's another example for someone who has pre-tax contributions and makes a non-deductible contribution. Let’s say you have $100k in a pre-tax IRA. If you make an additional $7,000 non-deductible contribution to that IRA and then try to convert that same $7,000 over to your Roth IRA, the IRS will calculate your distribution pro-rata as follows.

$7,000 (conversion amount)
-------------------------------------------------------------------------------------------------------- = 6.54%
[$100k (pre-tax amount) + $7.0k (non-deductible contribution)]

This means that of the entire new balance ($107k), only 6.54% is non-taxable because your new non-deductible contribution of $7,000 only accounts for 6.54% of the entire new account balance as the rest of the funds in the IRA are pre-tax dollars. This would generate income for 93.46% of the $7,000 that you converted.

Ok, let’s review the steps and summarize:

Assuming you make too much to fund a Roth IRA directly and you have no other IRAs in your name…

• Fund a traditional IRA

• Convert the traditional IRA balance to a Roth IRA

• Invest the funds in the Roth IRA *this part is important*

Some tax professionals will recommend either waiting for a period of time or investing the funds in the traditional IRA, before making the conversion to Roth. This is to protect against the step transaction doctrine which essentially says if you complete two or more steps to accomplish something that you couldn’t do in the first place, then you can’t do those steps!

The thought process behind waiting or investing is that you could have funded the IRA and then later decided to complete the Roth conversion. If you funded the IRA and converted to Roth the next day, you may just be going through the steps to fund your Roth when you otherwise make too much money to do so.

So, please check with your CPA or tax professional to get their guidance before executing on this, or any tax strategy.

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