How to Process a Backdoor Roth Contribution in 2023
The Roth IRA is one of the best retirement accounts available to long-term investors. The main benefit of having a Roth account is that contributions are made after-tax which allows you to then withdraw the contribution and its growth, tax-free in the future. However, high-earning individuals cannot contribute to a Roth IRA due to IRS income limitations on Roth IRA contributions. The solution to this obstacle is a Backdoor Roth Contribution. The ability to make this backdoor contribution was created in 2010, when Congress lifted the $100,000 income limit that had previously been in place for IRA conversions. My goal in this blog is to cover the basics of a Backdoor Roth Contribution and provide a step-by-step explanation on how you can do it yourself.
Key Takeaways:
· What is a Backdoor Roth Contribution?
· Benefits of Having Money in a Roth IRA
· When Should I Make My Backdoor Roth Contribution?
· Are There Any Restrictions?
· How Other IRA Monies Affect Roth Conversions
· How to Process a Backdoor Roth Contribution
What is a Backdoor Roth Contribution?
A Roth IRA is an investment account that you contribute to on an after-tax basis. Since the money is contributed post-tax, the money can grow and be withdrawn tax-free. Unfortunately, not everyone can make a Roth IRA contribution due to income limits. A single person can make a Roth contribution if their Modified Adjusted Gross Income (MAGI) is under $153,000 in 2023. While those married filing jointly can contribute to a Roth IRA if their MAGI is under $228,000.
A Backdoor Roth conversion is a strategy employed by high-earning individuals to contribute money to a Roth IRA despite the IRS income limits. I will cover the process below, but conceptually, you will transfer nondeductible Traditional IRA funds to a Roth IRA. This strategy can be used by anyone regardless of their yearly income. Currently, the yearly maximum for a Roth IRA contribution is the same for a Traditional IRA. Individuals may contribute $6,500 with an additional $1,000 contribution for those age 50 and older.
Benefits of Having Money in a Roth IRA
There are multiple benefits to having money in a Roth account. The main benefit is that the investments in the account can grow tax-deferred and be withdrawn tax-free once a few conditions are met. However, there are other benefits that are often overlooked.
Roth IRAs do not have required minimum distributions (RMDs). RMD’s are forced distributions that investors must take from their tax-deferred accounts such as a 401(k) or IRA once they reach age 73. Since contributions to these tax-deferred accounts are made pre-tax, taxes must be paid on the distributions in the future. RMDs could be significant in retirement, creating a heavy tax burden if you have built up a large portfolio in your pre-tax retirement account. The Roth funds are advantageous because you can take distributions at your discretion. This allows the investor to strategically take their Roth distributions in years where they need additional funds, but do not want to pay any more taxes.
Another benefit applies to individuals who are in a higher tax bracket in retirement. A common misconception is that once an individual retires, they will be in a lower tax bracket because they no longer collect a salary. However, this is might not the case for some as Social Security, Pensions, and other types of retirement income can add up. These income sources have the potential to push you into a higher tax bracket, especially once the RMDs begin. The Roth funds are advantageous in this situation because they can be withdrawn tax free and don’t affect your other retirement income. Whereas a pre-tax account would require you to pay taxes on the full withdrawal, potentially at a higher tax rate, so the Roth would have saved you money.
When Should I Make My Backdoor Roth Contribution?
A Backdoor Roth contribution can be made at any time, though I suggest making the contribution annually to take advantage of the annual IRA contribution limits. However, if you want the contribution to count towards a certain tax year then you must make the contribution before the tax filing deadline of April 15th of the following year. You have as much time as you’d like to do the conversion, but as I detail in the steps below, you shouldn’t wait long. The year in which you process your Roth conversion will have an impact on the 5-Year Rule covered below.
Are There Any Restrictions?
The first restriction when doing a Backdoor Roth Contribution is the 5-Year Rule. The 5-Year Rule is composed of three underlying rules. The first is that you must wait five years after your first contribution before you can withdraw the earnings tax-free. The five year count starts on the first day of the tax year that you made the contribution. Therefore, if you made your contribution December 2022, then the count would begin on January 1, 2022, and could be withdrawn after January 1, 2027. If you withdraw the funds within the five year period, then any growth in the investment would be subject to tax.
The second underlying rule applies to those who convert funds from another retirement account into a Roth IRA. This would include the Backdoor Roth contribution that we have covered throughout this blog. Like the rule above, the five year count starts on January 1st of the year of the conversion. However, there is one big difference. The five year clock starts for each conversion which means you must wait five years after each contribution to withdraw those funds. Otherwise, you will be subject to taxes on the gains.
The third and final underlying rule of the 5-Year Rule covers inherited IRAs. If you inherit a Roth IRA from anyone other than your spouse, then you have a few withdrawal options. A beneficiary IRA must be fully drawn down within 10 years, so the first option is to take the related RMDs each year until the balance reaches zero. The other option allows you to take distributions of any amount at any time as long as you fully draw down the account by December 31st of the fifth year. The last thing to remember is if it’s been less than five years since the deceased first contributed to the account then any gains on the withdrawals will be subject to taxes.
How Other IRA Monies Affect Roth Conversions
When making a Roth conversion, you must be aware of Traditional IRAs, SEP IRAs, and SIMPLE IRAs in your name. The IRS requires that you aggregate Traditional IRAs, SEP IRAs, and SIMPLE IRAs in your name when doing a backdoor Roth contribution or conversion. Say for example you have a traditional IRA from a previous job worth $93,500 and you were planning to make the Backdoor Roth IRA Contribution for $6,500 this year. You would first add those amounts together and they total $100,000. Then you would divide the amount you were converting ($6500) by the total ($100,000). This would give you a percentage of 6.5%. That would then then be the amount of the conversion that would be tax free. The other 93.5% of the conversion would be taxable to you. This would mean that you’d pay tax on this $6500 twice. Once when you earned it and a second time when you converted it to the Roth IRA.
One way to get around this would be to transfer to other IRA moneys (Traditional, SEP, and SIMPLE IRAs) into a company retirement plan. If you did that then those monies would not count in the conversion. If you work for a company that has a retirement plan you could transfer it there or if you are self-employed you could set up a self-employed 401K and transfer the money there. The key would be to transfer these monies into a company retirement plan by December 31st of the year you we’re making the Backdoor Roth Contribution. So if you’re making a 2023 Backdoor Roth Contribution then, you’d want to get the monies in the company retirement account by December 31st 2023.
How to Process a Backdoor Roth Contribution
The Backdoor Roth contribution itself is not difficult to do. Follow the steps below to process your own Backdoor Roth contribution!
1. The first step is to open a Roth IRA account and Traditional IRA account at a discount broker/custodian such as TD Ameritrade, Charles Schwab, or Fidelity. You must have both accounts with the same custodian.
2. The next step is to make a non-deductible contribution to the Traditional IRA account. The contribution limit is $6,500 in 2023 with a $1,000 catch up contribution for individuals ages 50 and older. Let the contribution sit in cash or money market, don’t invest the money.
3. The next step is to transfer the money from the Traditional IRA to the Roth IRA. You may be able to do this online or you may have to call the custodian to request this transfer. This is the conversion, moving the money from the Traditional IRA to the Roth IRA. Be aware of paying any related taxes. Most likely there won’t be any taxes due if you transfer the money from the Traditional IRA to the Roth IRA within a few days of making the non-deductible contribution. To get the most out of your backdoor Roth contribution, don’t wait more than a few days after contributing the money into the Traditional IRA to transfer it into the Roth IRA.
4. Next you will need to invest the money. I suggest using index funds, but everyone’s financial objectives are different. You’ve now completely a Backdoor Roth Contribution!
5. Keep the Traditional IRA open, even though it will have a zero balance for future years Backdoor Roth Contributions.
6. Make sure to note this backdoor contribution/conversion on your tax return by filing form 8606. You should also keep track of your conversions in case there are any issues with the IRS in the future.