The Roth IRA Loophole
If you want to build tax-free wealth (and who doesn't?) look no further than the Roth account.
With the Roth - your money goes in after-tax but grows tax-free and comes out tax-free for "qualified distributions".
It's a powerful account.
So are Traditional 401(k)s and Traditional IRAs, which are pre-tax. You get the tax deduction today and pay taxes later in a hopefully lower tax bracket.
I find that many people in their peak earning years would be better served having a current-year tax deduction.
So for a 401k, you may opt to do a Traditional rather than a Roth 401k.
But what about the Roth IRA?
This is different because high earners typically cannot make a deductible Traditional IRA contribution.
This is because they are covered by an employer retirement plan and make too much money.
So this brings us back to the Roth IRA.
If we can’t make a deductible IRA contribution, why not make a Roth IRA contribution?
One little problem.
There are income limits.
If you make too much money:
$161,000 (filing single) or $240,000 (filing married)
you are “phased out”.
But there is a way around it..
The Backdoor Roth IRA
The Three Steps for a Backdoor Roth
1) Make a nondeductible contribution to your IRA.
2) Convert the money from the IRA to a Roth IRA.
3) File Form 8606 at tax time.
Let’s dive in.
1) Make a non-deductible contribution to an IRA.
You need to place post-tax dollars in a pre-tax account.
How do you do this?
In 2024, you can contribute up to $7,000 (or $8,000 if you are 50 or older) to the IRA and you will not deduct this contribution at tax time.
2) Convert the funds to a Roth IRA.
After you transfer the money into your IRA, you will wait a few days for the funds to “settle”.
Then you will transfer the money from the IRA to the Roth IRA.
Many custodians (like Fidelity, Vanguard, Schwab) make this process easy and will even walk you through it.
If you do this step correctly, there should be no tax impact.
3) File Form 8606 at tax time.
Now we need to make sure everything gets reported correctly.
You will report steps 1 and 2 on this form:
- The non-deductible IRA contribution
- Roth conversion
If you work with an accountant, they should know how to do this.
Before you take any of these steps, you need to know about 1 very important rule ↓
The Pro Rata Rule
If you have an empty IRA ($0 balance), this process will be simple & smooth.
But if you already have money anywhere in a:
- IRA
- SEP IRA
- SIMPLE IRA
- ROLLOVER IRA
you will be negatively impacted by this rule.
Example)
You have $14,000 in an IRA from a previous employer’s 401(k).
Because you received a tax deduction when you contributed to your old employer’s 401(k), you have pre-tax dollars in your IRA.
This means, when you convert the funds to the Roth IRA, some of it will be taxed.
But to do this correctly: we want $0 to be taxed when you convert.
You avoid the Pro Rata Rule by starting with $0 in your IRA.
So, if you already have money in your IRA, you have 2 options to empty it:
1) Convert the money to your Roth IRA, or
2) Transfer the money into a 401(k).
Option 1) Convert the pre-tax IRA money to your Roth IRA.
There are no limits to Roth conversions, so you can convert the entire $14,000 from your IRA to your Roth IRA.
But this is a taxable event, meaning the entire $14,000 will be added to your taxable income.
If you are in a high tax bracket or have a lot of money in your IRA, this may not be ideal.
So, we can look at option 2.
Option 2) Transfer the money into a 401(k).
If you are employed, you can ask the 401(k) with your employer if they accept rollovers (many do now).
If you are self-employed, you can look into a Solo 401(k) or group 401(k) and be sure you create a plan that accepts rollovers.
This should not be a taxable event.
We are simply transferring from one pre-tax account (Traditional IRA) to another (Traditional 401k), but the 401(k) protects you from the Pro Rata Rule.
Both of these options will leave you with an empty IRA.
Empty IRA = clean conversion.
Two dates to remember:
If you want to avoid the Pro Rata Rule, your IRA needs to be empty by December 31st for the year you want to do the conversion.
You have until April 15th of the following year to fund the Roth IRA.
Note: This is not tax or financial advice. You should always consult with the appropriate professional before implementing anything you read online. A qualified accountant and planner is one of the best investments you can make.
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