Financial Planning, Millennials

How To Do ROTH IRA Contributions If Your Income Is Too High

I hear from someone almost weekly who says their income is too high to make contributions to a ROTH IRA. This is a major myth that many people believe, so I felt it was necessary to write this blog post and inform everyone on why this statement is false.

These people are not entirely wrong as there are income restrictions to using a ROTH IRA. What they do not know is there is a loophole that lets you contribute to a Roth IRA at any income level. It’s called the backdoor ROTH IRA and it’s one of the most utilized strategies out there for high income earners.

In this blog post I will walk you through ROTH IRA income limits, contribution limits, what the backdoor ROTH is, and how to correctly do it. 

Income Limits

If you make under $138,000 (Modified Adjusted Gross Income) in 2023, you can contribute to a regular ROTH IRA. However, if you make more than that, you cannot. Anyone making over $138,000 a year (single) or $218,000 (married), will want to read this post and learn how to use the backdoor ROTH. 

Contribution Limits

Starting in 2023, you will be able to do $6,500 (If you are age 50 or over by December 31, you can contribute an extra $1,000) to a ROTH IRA or backdoor ROTH. This is up from 2022 where it was $6,000. I know it’s not a super high amount, but it is still a nice amount of tax free dollars you can put away for the future. 

What Is The Backdoor ROTH IRA?

The backdoor ROTH is not a type of account, it is more so a strategy that can be used for high income earners to get more tax free dollars for the future. So how do you do this? To complete a backdoor ROTH, you put money into a traditional IRA and then convert it over to your ROTH IRA. It really is just one added step. The key though is you have to use a nondeductible IRA. All this means is that when you put money into the IRA, you cannot deduct it when you file your taxes. If you deducted your traditional IRA contributions and then decide to convert your traditional IRA to a backdoor Roth, you’ll need to give that tax deduction back. All that means is if you do deduct the IRA contribution, you will then have to pay taxes on the conversion. 

Here’s the exact 3 steps you need to know to do it:

  • Contribute money to a traditional IRA (you may need to open one)
  • Convert your traditional IRA to a Roth IRA (but remember, do not deduct it)
  • Report your Backdoor Roth IRA contribution on your own form 8606 (you need to do 2 if both you and a spouse complete the backdoor ROTH). Form 8606 is needed to keep track of your basis for the future.

You have up until April 15th of the following calendar year to complete it for the prior year. So April 15, 2023 is the deadline to get your $6,000 in for 2022.

Things To Be Aware Of

It is important to know that you do not want to have other pre-tax IRA’s out there when doing this (other accounts where this becomes an issue is all traditional, rollover, SEP, and SIMPLE IRAs, but not 401(k)s, 403(b)s, 457(b)s, Roth IRAs, or inherited IRAs). If you have other pre-tax accounts besides a 401(K) out there, then the pro-rata rule comes into effect. Here’s what it means: The IRS mandates that conversions from traditional IRAs to Roth IRAs be carried out pro rata.  Meaning the IRS will consider all of your traditional IRA accounts when calculating your tax obligation for converting from a regular IRA to a Roth IRA. This ratio determines what portion of the money you convert to a Roth will be taxable if all of your traditional IRAs combined contain, say, 60% pre-tax money and 40% after-tax money. In this case, 60% of the amount you convert to the Roth will be taxable, regardless of how much money you convert or whatever IRA account you withdraw the money from. You cannot choose to convert only after tax money. To help you avoid the issue above, you can roll an old IRA into your current 401k. 

Here’s an example: If you have $6,000 and half of that is in a deductible IRA and half is non deductible IRA, then when you make the conversion, half will be taxed and the other half wont.

This is exactly why it is critical that you DO SOMETHING with any IRA balance you have PRIOR to December 31st of the year in which you do a Roth conversion of after-tax money or you will owe taxes.

This is the basics in understanding backdoor ROTH IRA’s, who can use them, and how to!

If you are a high income earner and either you or your advisor has not thought about utilizing the backdoor ROTH, hit us up! We are here to help.

Disclaimer: Consult your tax advisor and financial planner before utilizing this strategy as it is easy to mess up! 

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