How High-Income Earners Can Take Advantage of Long-Term Tax Benefits
Roth IRAs are fantastic investment vehicles. They’ve been around for more than 20 years, and they allow investors the opportunity to set up individual retirement accounts and fund them each year with after-tax dollars up to the IRS contribution limit: in 2021, that’s $6,000 a year if you’re under the age of 50; $7,000 a year if you’re over the age of 50. You make annual contributions, at which point the money can be invested and can grow and compound throughout the rest of your life on a tax-free basis so that later in life, ideally decades down the line, you’ve got a bucket of money that you can make withdrawals from and not pay any income tax on withdrawals if done correctly.
The problem with Roth IRAs? The IRS restricts who can contribute directly to them. In 2021, if you are single and your Modified Adjusted Gross Income (MAGI) is more than $140,000 a year or if you’re married, filing a joint tax return and your MAGI is more than $208,000 a year, the IRS says that you cannot contribute directly to the Roth IRA. And that’s where the backdoor strategy comes into play.
How the Backdoor Roth IRA Strategy Works
With the backdoor strategy, you need to set up a traditional IRA account alongside your Roth IRA. You make the same $6,000 or $7,000 contribution to the traditional IRA but do so on an after-tax or non-deductible basis. That means you don’t take a tax deduction for putting money in the account. You then covert the funds from the traditional IRA over to the Roth IRA, moving the funds into the Roth IRA via this backdoor channel, hence the name of the strategy.
The reason that you’re able to do this is because your initial contribution to the traditional IRA was done so on an after-tax basis, similar to how you contribute directly to a Roth IRA. This is not a loophole. It’s allowed by the IRS.1 They simply say that if your income is higher than MAGI limits, you can’t contribute directly to a Roth IRA. That’s why we use this traditional IRA and conversion strategy to get money into the Roth IRA.
Ensure the Traditional IRA Includes Only After-Tax Funds
An important caveat: If you already have an existing traditional IRA (or multiple IRAs) that holds pre-tax money in it, you need to move those pre-tax dollars out of the traditional IRA before doing the backdoor Roth. Failure to do so will result in the Roth conversion being somewhat taxable2 (depending on the ratio of pre-tax vs. after-tax dollars in your traditional IRA) and you will lose much of the tax-advantage of the backdoor strategy. Pre-tax money in these IRAs can be moved to other non-IRA retirement accounts such an employer retirement plan or an individual 401(k).
The backdoor Roth IRA strategy for higher-income earners with good cash flow is a great way to supercharge your retirement savings. If you’re maxing out your employer retirement plan, and looking for other ways to save, a backdoor Roth strategy gives you another way to accumulate tax-efficient assets. If you have the cashflow to do it, even if you’re restricted due to the income limits, this strategy is a savvy way to add a lot of value to your savings and investment plan over time.
An Experienced Advisor Can Help
This is a nuanced strategy, and you may want a professional to guide you through it. At Creative Planning, we help our clients develop custom strategies to achieve their long-term goals. As a nationally recognized wealth management firm, we deliver a team of credentialed, educated, experienced and action-oriented advisors, including CERTIFIED FINANCIAL PLANNER™ practitioners, certified public accountants, insurance specialists, attorneys and other professionals dedicated to helping you achieve your goals. We work together to help ensure all aspects of your financial life are well cared for.
If you’d like help developing your wealth management strategy, or for any other financial matter, please schedule a meeting with us today.