Backdoor Roth for High Earning W-2 Employees

How you invest today will determine the taxes you pay in the future.

So much emphasis is placed on reducing taxes today. The better question to ask is, “how can I reduce taxes for the rest of my life?”.

Lifetime Tax Rate or LTR is the tax rate you pay over the course of your entire life. Roth IRAs are one of the tools that can help you reduce your LTR (Lifetime Tax Rate).

Assuming we stick to our plan, make good investment decisions, and continue to generate a higher income - we’ll have a lot more money and taxes to worry about later in life than we do today. Here’s one strategy high earning W-2 employees can use to help reduce their Lifetime Tax Bill.

Backdoor Roth IRA Contribution Strategy:

The Backdoor Roth IRA is a method that allows individuals, particularly those with high incomes, to contribute to a Roth IRA even if their income exceeds the limits set by the IRS for direct contributions. This strategy involves making a nondeductible contribution to a Traditional IRA and then converting that amount to a Roth IRA.

It’s a called “backdoor” because first we put money into a regular IRA, then subsequently move it into the Roth. Income limits prevent us from walking through the front the door.

Why go through this trouble to get money into a Roth IRA?

1. Money invested in Roth IRA gets invested and grows tax free.

2. No taxes on 1099s to file each year.

3. No taxes on gains from your investments inside the Roth IRA

4. No taxes on the income when you ultimately withdrawal from the Roth IRA during retirement.

5. Helps Reduce your Lifetime Tax Rate (LTR)

Key Details:

• Income Limits: High-income earners typically cannot contribute directly to a Roth IRA. Over $161k if single and $240k married.

• Non-Deductible Traditional IRA Contribution: You can contribute after-tax dollars to a Traditional IRA.

• Roth IRA Conversion: You convert the Traditional IRA funds to a Roth IRA, usually shortly after the contribution.

• Tax-Free Transfer to Roth IRA - When all of the steps are executed properly, you get your money into the Roth IRA even though you make as much as you do.

• IRS Form 8606 - Remind your CPA to file Form 8606 - filing this form keeps a paper trailer for your non-deductible contributions.

• Enjoy Tax-Free Growth starting today and Tax-Free Income during retirement.

Step-by-Step Implementation:

1. Check Income Eligibility: Verify that your income exceeds the Roth IRA contribution limits, making you a candidate for a Backdoor Roth.

2. Open a Traditional IRA: If you don’t have one already, open a Traditional IRA account.

3. Make a Nondeductible Contribution: Contribute the maximum amount allowed (e.g., $7,000 in 2024 or $8,000 if 50+) to your Traditional IRA.

4. Convert to Roth IRA: Convert the amount from your Traditional IRA to your Roth IRA. This step should be done quickly to minimize potential gains that could be taxed.

5. Report to the IRS: File IRS Form 8606 to report the nondeductible contribution and the Roth conversion.

Example:

Imagine you're a high-income earner, earning $450,000 per year, and you want to contribute to a Roth IRA. Direct contributions are not allowed due to your income level. You can use the Backdoor Roth IRA strategy by contributing $7,000 to a Traditional IRA, then converting that amount to a Roth IRA, thus gaining access to tax-free growth and withdrawals.

This strategy is particularly useful for those looking to maximize retirement savings while taking advantage of the tax benefits of a Roth IRA.

You can execute this strategy for both you and your spouse meaning you can put $7,000 or $8,000 if older 50 for a total of $14,000 or $16,000 in additional savings.

Pros and Cons:

• Pros:

  • Tax-Free Growth: Funds in a Roth IRA grow tax-free, and qualified withdrawals are also tax-free.

  • No RMDs: Roth IRAs are not subject to required minimum distributions (RMDs) during your lifetime.

  • Accessibility: Allows high-income earners to effectively bypass Roth IRA income limits.

• Cons:

  • Tax Complexity: The process involves additional paperwork and potential tax complications, especially if you have other Traditional IRAs.

  • Pro Rata Rule: If you have other pre-tax IRA assets, the conversion can lead to a tax bill because of the pro-rata rule.

Pro-Rata Rule

“Pro-Rata” means "in proportion."

The IRS looks at all your Traditional IRAs combined, not just the one you’re converting from.

The Pro-Rata Rule comes into play when you're converting a Traditional IRA (or other pre-tax retirement accounts) to a Roth IRA, particularly when you have both pre-tax and after-tax contributions in those accounts. It ensures that the amount you convert is proportionately distributed between taxable and non-taxable amounts.

EXAMPLE:

Suppose you have $100,000 across all Traditional IRAs, with $20,000 of after-tax contributions. You decide to convert $50,000 to a Roth IRA.

1. Total IRA value: $100,000

2. Non-Taxable basis: $20,000

3. Non-Taxable percentage: $20,000 / $100,000 = 20%

4. Non-Taxable part of conversion: $50,000 * 20% = $10,000 (no tax)

5. Taxable part of conversion: $50,000 - $10,000 = $40,000 (taxed at your ordinary income rate)

In this example, $40,000 of the $50,000 conversion would be subject to income tax.

If you are making $450,000 a year like our previous example, you don’t want to tack on an additional $40,000.

Using this example, making a backdoor Roth IRA contribution, 80% or $5,600 (80% of $7,000) would be taxed as ordinary income.

We want to avoid an unnecessary tax bill. So having an existing IRA is not ideal for this strategy due to the Pro-Rata rule.

Final Tip: If you are eligible to execute this strategy, I recommend making the contributions between May 1st and December 1st, to avoid confusing tax notices arriving the mail.

Securities offered through LPL Financial, Member FINRA/ SIPC. Investment advice offered through IHT Wealth Management, a registered investment advisor. IHT Wealth Management and AutomotiveWealth are separate entities from LPL Financial. 

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