There’s a little-known tool available for high-income earners that opens the opportunity to fund a Roth IRA even if you may not otherwise be eligible due to being a high-income earner. The strategy is often called the backdoor Roth IRA, and, if circumstances are right, it could be a way to create income tax-free dollars for your future. Without knowing the future of tax rates, having some dollars that are accessible to you income-tax-free and not subject to Required Minimum Distributions (RMDs) during your lifetime could potentially lead to significant tax savings over the Roth IRA owner’s lifetime. This strategy has potential risks, particularly if you have more than one IRA. Before implementing this strategy, you should review the outcomes with an independent tax professional for advice that is specific to your situation.
For tax year 2022, if your income is under approximately $129,000 as a single-filer and $204,000 if you are married filing jointly, you are not able to contribute directly into a Roth IRA. That said, currently the Internal Revenue Code (IRC) permits you, regardless of income level, to contribute to a Traditional IRA on a non-deductible basis. Once a non-deductible contribution is made to a Traditional IRA, it can then be converted to a Roth IRA. If converting Traditional IRA dollars to a Roth IRA the IRC requires that you be taxed on any after-tax dollars and any gains in the account (or prorata on all of your IRAs if you have more than one). If your income is above the permitted Traditional IRA deduction range, your contribution would be after tax and therefore not deductible. If you had no deductible amounts and no gains in the Traditional IRA (or any other IRA) the conversion to a Roth IRA would not be subject to tax. *
The 2022 maximum Traditional IRA contribution per participant is $6,000 per year (if under the age of 50) and $7,000 per year (if the age of 50 or over). Depending on your age and time horizon, it can result in a significant amount of capital that could potentially be accessed income tax free down the road. In addition to the tax benefits, it may be possible to utilize contributions penalty free that have been in your Roth IRA for the later of five years or until age 59½ toward other financial goals, such as your children’s education. As a result of the SECURE act, Roth IRAs could be a better inheritable asset vs. Traditional IRAs.
A word of caution: Before implementing a backdoor Roth IRA, it is very important to seek guidance from a financial planner or CPA. Without guidance from a professional, you can encounter a few pitfalls during the process that could result in unfavorable tax consequences, including potential snares if the strategy is implemented when owning other IRA assets (aka: the aggregation rule).
*Current law also includes step-transaction doctrine and substance over form doctrine which, in an individual case, does not permit this strategy.