Do You Need a Back Door Roth IRA?

When planning for retirement, many people put their money into a Roth IRA. But what do you do if you make too much money to take advantage of the current low-income tax rates and use a Roth account to set yourself up for future tax-free income in retirement? First, pat yourself on the back because your monetary success is one that most people envy, and second, utilize the strategy we discuss below known as the backdoor Roth. 

What is a backdoor Roth IRA?

A backdoor Roth IRA is a retirement savings strategy where you contribute to a traditional IRA, which anyone can do, and then immediately convert the account to a Roth IRA. 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 to a Roth. We know what you're thinking… this feels like cheating! Well, it's not. 

If you are single, the head of household, or married filing separately if you didn't live with your spouse during the year and your income is above the phase-out limit of $153,000 for 2023, you can't contribute to a Roth IRA at all, but you can still contribute to a traditional IRA. The same goes for those married filing jointly or a qualifying widow or widower at the phase-out limit of $228,000 and those married filing separately if you lived with your spouse at any point during the current year at the phase-out limit of $10,000.  

Backdoor Roth IRA Contribution Limit And Conversions

In 2023, the IRA contribution limit is $6,500 per person or $7,500 if the account owner is 50 or older. If you plan to utilize the backdoor IRA method to convert the account to a Roth IRA, that is the most you can contribute this year. Please note that the limit changes from year to year.

When you convert a traditional IRA to a Roth IRA, any amount that you received a traditional IRA tax deduction on will be considered taxable income. 

For example, if you contributed $6,000 to a traditional IRA in 2022 and claimed it as a deduction on your 2022 tax return, and then converted that into a Roth IRA account, whatever the amount of the account is, even if it's more than the original $6,000, is considered taxable income. You will have to report this on your 2023 tax return.

Alternatively, if you make a non-deductible traditional IRA contribution or if you immediately convert the account after making a traditional IRA contribution, there generally won't be any taxes due on the conversion. 

It seems like a win, right?

Not always. If you have additional traditional IRA assets, you may run into a problem. The IRS won't let you treat the conversion as coming from a non-deductible IRA. Instead, you'll have to include a portion of the conversion in your taxable income based on the pro-rata value of your non-deductible and other traditional IRA assets. This isn't something most people want to do. If you have a great deal of retirement assets in a deductible traditional IRA, this may not be the strategy for you. 

The main takeaway is that this strategy works, but may only work for some. If you are in a low tax bracket right now (10-12%), it makes sense to lock in your current tax rate by contributing to a Roth IRA and not have to worry about taxes in retirement. But, if you're in a relatively high tax bracket right now and qualify for the traditional IRA tax deduction, a traditional IRA might make more sense when it comes to tax optimization.

We recommend that you speak with your financial advisor and find what works best for you. If you have any questions about how a backdoor Roth IRA could impact your taxes, reach out to us today!