Crack the Code to Tax-Free Wealth: The Backdoor Roth IRA Made Easy!
How to Initiate a Backdoor ROTH IRA Conversion and Supercharge Your Savings!
ROTH IRAs Rock!
ROTH IRAs stand out as some of the best accounts you can have. They offer the perk of tax-free growth on your investments indefinitely. Come retirement, you can withdraw funds from your Roth IRA completely tax-free. Not only that, but Roth IRAs also spare you from required minimum distributions and don’t factor into Social Security income tax calculations. The list of advantages goes on. However, there’s a catch: the IRS restricts contributions if your income exceeds certain thresholds. This limitation can push you towards other taxable accounts. But fear not! There’s a solution. Today, I will dive into how you can still contribute to your Roth IRA, even if you surpass those income limits.
Who Can Contribute?
Alright, let’s break down the numbers for 2024 regarding Roth IRA eligibility. If you’re single, your modified adjusted gross income, which is essentially your gross salary minus any contributions to 401(k) or 403(b) plans, needs to be under $161,000. For those filing taxes as married filing jointly, if your combined income is less than $240,000, you’re also eligible to make a Roth contribution. If you fall within these income brackets, you can contribute directly to your Roth IRA without any complications. No need to worry about the rest of this video; you’re good to go!
However, if you find yourself in a situation where you’re single and your income is over $161,000, or if you’re married and your combined income is over $240,000, you’ll face restrictions on making a full Roth IRA contribution. In this case, if your income exceeds these ranges, you may still be eligible for a partial contribution, but the amount you can contribute will gradually decrease as your income rises. Now, let’s focus on a solution for those of you who exceed the income limits. How can you still take advantage of the fantastic tax benefits offered by Roth IRAs? Well Here’s what you can do.
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What Can You Do?
You can initiate a powerful strategy that’s known as a backdoor Roth conversion. However, it’s important to understand that this method has its own set of rules. So, please read until the end of the article because it might not be suitable for everyone, and there are common mistakes to avoid.
Here’s how it works: If you’re looking to contribute to an IRA or a Roth IRA in 2024, the contribution limit is $7,000, or $8,000 if you’re 50 or older. But if your income exceeds these limits, as we have said, you can’t directly put money into your Roth IRA. You also cannot make deductible contributions to a traditional IRA, meaning you will not get a tax break on those contributions.
Right from the start, it might seem like you’re out of luck. It can feel like a Roth IRA is for someone else, but not for you. But here’s where the concept of the backdoor Roth conversion comes into play. Instead of depositing your contribution directly into a Roth IRA or a traditional IRA with tax deductions, you can channel your contribution into a non-deductible traditional IRA.
If you convert the balance from your non-deductible IRA immediately into your Roth IRA, you’re essentially changing $7,000 of after-tax dollars into another after-tax dollar account. Unlike a pretax IRA, that could have been a traditional IRA contribution you deducted in the past, or a rollover from a 401(k) when changing jobs, converting it to a Roth IRA in this case means any amount converted would be fully taxable. However, because you did not take a deduction for this traditional IRA contribution, you can convert it to a ROTH IRA, and you can avoid taxes on the conversion.
So essentially, what you’re doing is splitting up a process that would typically be a single-step process into a two step process. It sounds straightforward enough: you open an IRA, make a contribution without taking a tax deduction, then promptly convert it, and finally invest the funds in your Roth IRA. Here’s the key point to know before we go any further. Even though there are income limits on Roth contributions, there aren’t any limits on Roth conversions. You can earn as much as you want and still convert a traditional IRA (with no deductions) to a Roth IRA. However, there are nuances — details that can trip people up and lead to trouble — that’s what I now want to cover. Imagine you’re reading this article and you’re thinking, “This is fantastic! I already have another traditional IRA, but I’ll just open a new one to make this non-deductible contribution and take advantage of the backdoor Roth conversion.”
Not So Fast!
Well, let’s see what happens if you try to do this! Let’s make some simple assumptions for illustration purposes. Suppose you already have a pretax IRA with a balance of $24,000 — fully funded and operating. Now, you’re eager to pursue a backdoor Roth strategy, and to do this, you open up a separate IRA on the side and make a $6,000 non-deductible contribution — we will use $6,000 dollars instead of $7,000 to make the math easy. At this point, you have $6,000 in your Non-deductible IRA. The next step is to convert this amount to your Roth IRA, allowing the funds to grow tax-free indefinitely. However, the IRS views this process differently.
The IRS applies what’s known as an aggregation rule in this scenario. They assess all of your IRA accounts, treating them all as if you have one sizable $30,000 IRA, not two separate 24,000 and 6000 IRA’s respectively. The IRS will treat it as $30,000 in IRAS, of which 80% is pretax. In other words, $24,000 divided by $30,000 equals 80% pretax and 20% after-tax, considering the new non-deductible contribution. So, if you proceed to convert just $6,000 to your Roth IRA for the backdoor Roth conversion, 80% of that conversion becomes taxable because 80% of your aggregate IRA is pretax. Conversely, the 20% that’s after-tax means that 20% of the conversion is non-taxable.
So what winds up happening is out of the $6,000 conversion, $4,800 ends up being taxable (80% of $6,000), which is what we’re trying to avoid. Only $1,200 of that conversion is tax-free. So, what’s the solution? Well, We essentially need to eliminate this IRA altogether. and how can we do that? Well, there are a few options. If the IRA balance is small enough — let’s say just a few thousand dollars — consider just converting it to your Roth IRA and paying the tax. However, it’s critical to emphasize the importance of consulting with your tax planner or financial advisor before taking any action. Again, I add this as a specific disclaimer, do not proceed until you’ve spoken with a CPA or a financial advisor who fully understands how this process works. If you have a small enough IRA, converting it to your Roth IRA helps ensure you will no longer have any traditional IRA assets, allowing you to initiate backdoor Roth conversions in subsequent years without tax implications.
If your IRA has a substantial balance, let’s say $1 million, you’ll likely want to avoid converting it all at once. A large conversion could result in a hefty tax bill, as the IRS would treat it as if you earned an additional million dollars of ordinary income for that year, potentially leading to several hundred thousand dollars in taxes. To circumvent this scenario, there are some workarounds. For instance, if you have a 401(k) with your current employer, most plans allow you to transfer any pretax balance from your IRA into your 401(k). This action effectively clears out your IRA balances while still allowing you to invest that money. It remains pretax and accessible for the future, just in a different plan, your money is in a 401(k) and not in an IRA, so that’s one option. If you’re self-employed, you can create a retirement plan that suits you. For example, you could set up a solo 401(k) if you have a legitimate business. Then, you could transfer your IRA funds into your solo 401(k). The main goal is to clear out any pretax IRA assets. Otherwise, it can complicate things and hinder tax-free conversions. But if you don’t have an IRA or if you can move it to your 401(k) or another retirement account that’s not a SEP IRA, SIMPLE IRA, or traditional IRA, then you can use the BACKDOOR method to fund your Roth IRA.
So, in short, remember these three important points!
First Point, ensure you don’t have any pretax IRA assets before proceeding. This means traditional IRAs, SIMPLE IRAs, and SEP IRAs should be cleared out. If you have any of these, the IRS will combine them and treat them as one account. So, when you convert after-tax or non-deductible contributions, you’re not just converting the non-deductible portion. It’s crucial to note a couple of things here. Inherited IRAs aren’t considered part of the pretax IRA balance, which is good. For instance, if you inherit someone’s IRA, it won’t count towards your pretax IRA balance. That’s an account that cannot be transferred to a 401(k) or modified significantly. However, there’s an exception to this rule. If you inherited the IRA from your deceased spouse and it’s now solely in your name, it’s treated as a traditional IRA, not as an inherited IRA. Another issue to consider is whether your spouse has any traditional IRAs. If you’re wondering whether your spouse’s IRA, SIMPLE IRA, or SEP IRA affects your ability to execute a backdoor Roth conversion, the answer is no. While it could affect your spouse’s ability to do so based on the steps we’re discussing, it doesn’t impact your own eligibility. Therefore, if one spouse doesn’t have any traditional assets, only that spouse would be able to carry out a $7,000 backdoor Roth conversion, or $8,000 if both spouses are 50 or older.
Point Two involves funding the Non-deductible IRA and immediately considering conversion. Some individuals wonder whether they should start saving monthly to this IRA, understanding they won’t deduct any contributions, so they can invest along the way and then convert it to a Roth once the full $7,000 of contributions is made. Ideally, this isn’t recommended. When you execute a backdoor Roth conversion by putting $7,000 into your non-deductible IRA and promptly converting it to your Roth IRA, there are no taxes due. However, if you make a $7,000 contribution and, for instance, invest it, allowing it to grow to $9,000, by the time you convert it to your Roth IRA, you’re essentially converting $9,000.
In this scenario, the $2,000 of growth is entirely taxable, whereas only the initial $7,000 contribution remains tax-free. Ideally, we aim for all the growth to occur within the Roth IRA. It’s preferable to avoid growth within the IRA itself. Instead, it should serve solely as a funding mechanism to facilitate contributions, conversions, investments, and ultimately benefit from tax-free growth in the Roth IRA.
Lastly, the third point is, it’s crucial to remember to file Form 8606 with the IRS. This form informs the IRS about the contribution made to your IRA, indicating it as non-taxable. By doing so, when you perform the conversion, the IRS doesn’t perceive it as a taxable conversion. They’ll view it as a tax-free transaction.
Once again, it’s essential to consult with your CPA and financial advisor . While this strategy can be highly beneficial for funding Roth accounts, even with a high income, it’s crucial to ensure you’re following the correct steps.
The Bottom Line
Executing a backdoor Roth conversion can be a powerful strategy for accessing Roth accounts, even with a high income. By following the steps outlined in this video, you can potentially benefit from tax-free growth and enjoy the advantages of Roth IRAs. However, it’s vital to proceed with caution and seek guidance from your CPA or financial advisor to ensure compliance with IRS regulations and optimize the benefits of this approach. With proper planning and execution, the backdoor Roth conversion can serve as a valuable tool in your financial toolkit for achieving long-term wealth accumulation and tax efficiency.
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