If you are looking for alternative retirement saving options to enjoy tax-free income in the future, you consider a backdoor Roth IRA strategy. A backdoor Roth IRA is a technique that allows you to bypass the income limits of a Roth IRA and contribute more money to this type of account, regardless of how much you earn. In this article, Nathan Faith, CFP®, Partner, explains the considerations and implications of using the backdoor Roth IRA strategy.
What is a Roth IRA?
A Roth IRA (individual retirement account) is a tax-advantaged account that lets your investments grow tax-free. Unlike a traditional IRA, which requires you to pay taxes on your withdrawals in retirement, a Roth IRA allows you to withdraw your money tax-free, as you invest in it with your after-tax dollars. This means you can avoid paying taxes on your investment gains and have more control over your retirement income. However, not everyone can contribute to a Roth IRA, as there are income limits that determine your eligibility. For 2024, the income limits are set by your modified adjusted gross income (MAGI) and your tax filing status. For reference, someone’s ability to directly fund a Roth IRA begins to phase out at $146,000 for a single filer and $230,000 for joint filers. Be sure to check these limits and your savings yearly, as these amounts are adjusted annually to reflect the cost of living. An experienced wealth management advisor can guide the application of these retirement plans, considering your financial goals and current savings.
What is a Backdoor Roth IRA?
A backdoor Roth IRA is a strategy that allows you to get around the income limits and contribute to a Roth IRA indirectly. It involves two steps: first, you make a nondeductible contribution to a traditional IRA, which has no income limits. Second, you convert your traditional IRA to a Roth IRA, which is a taxable event, but since you already paid taxes on your contribution, you only pay taxes on any earnings between the contribution and the conversion. This way, you effectively move your money from a traditional IRA to a Roth IRA, regardless of your income level.
How to Maximize Your Backdoor Roth IRA Contribution in 2024?
If you want to take advantage of the backdoor Roth IRA strategy and max out your contribution in 2024, here are some steps you need to follow:
- Check your existing IRAs. If you have any other pre-tax IRAs, such as a traditional IRA, a SEP IRA, or a SIMPLE IRA, you may be subject to the pro-rata rule, which means you have to pay taxes on the proportion of your pre-tax and after-tax balances when you convert. To avoid this, you can either not have any other pre-tax IRAs or roll them over to a qualified employer plan, such as a 401(k), before converting.
- Open a traditional IRA and a Roth IRA if you don’t have them already. You can open these accounts with any financial institution that offers them, such as a bank, a brokerage, or a mutual fund company. Make sure you choose the right investments for your risk tolerance and time horizon.
- Make a nondeductible contribution to your traditional IRA. For 2024, you can contribute up to $7,000 ($8,000 if you are 50 or older) to your traditional IRA. You cannot claim a tax deduction for this contribution, so you must file Form 8606 with your tax return to report it to the IRS.
- Convert your traditional IRA to your Roth IRA. You can do this as soon as you contribute, or you may wait. There is no waiting period required by the IRS, as Congress legitimized the backdoor Roth strategy in 2018. However, you may want to consider the market fluctuations and your tax situation before you convert. When you convert, you must pay taxes on any earnings between the contribution and the conversion but not on the contribution itself. A wealth management advisor can help you identify the most appropriate time to convert, leading to more overall savings.
- Enjoy the benefits of your Roth IRA. Once you convert your traditional IRA to your Roth IRA, you can enjoy the advantages of tax-free growth and withdrawals if you comply with the rules. You can also withdraw your contributions anytime without taxes or penalties, giving you more flexibility and access to your money.
Helping You Get There…
A backdoor Roth IRA can be a smart way to save more money for retirement and enjoy tax-free income in the future. However, it is not a simple or risk-free process and requires careful planning for proper execution. Consult with a wealth management advisor before you attempt a backdoor Roth IRA, as they can help you determine your eligibility, calculate your tax liability and avoid potential pitfalls and penalties. A backdoor Roth IRA is not for everyone, but it may be a creative option for you to max out your Roth IRA contribution in 2024. Connect with us today to learn more about your retirement saving options and how we are dedicated to helping you get there.
Certified Financial Planner Board of Standards, Inc. (CFP Board) owns the certification marks CFP®, CERTIFIED FINANCIAL PLANNER™, and CFP® (with plaque design) in the United States, which it authorizes use of by individuals who successfully complete CFP Board’s initial and ongoing certification requirements.
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