A Roth IRA is a rare prize in the U.S. Tax code: an opportunity to earn income tax-free. Investors who use these accounts can withdraw their investment gains tax-free in retirement. This generous tax break was designed to benefit the middle class, which is why Roths have strict income limits. In 2022, if you’re single and have a modified adjusted gross income over $144,000, or if you’re married with a combined modified AGI over $214,000, you won’t be able to contribute directly to a Roth IRA.
However, wealthy investors can access these accounts indirectly through a Roth IRA. According to Rob Burnette, a financial advisor from Outlook Financial Center in Troy, Ohio, Roth IRA income restrictions can be circumvented through this strategy. The IRS has not closed this loophole a grey area for wealthy investors that exceed the income thresholds.
Last year, Congress was alerted to reports that billionaires were funding Roth IRAs through the back door, and some Democrats proposed restricting or even abolishing this practice. Upper-middle-class families have also questioned whether backdoor Roths should play a role in their financial planning because of the commotion.
Backdoor Roth IRAs require two steps. For the first step, you use after-tax funds instead of pre-tax funds to open a traditional IRA. For the first step, you use after-tax funds instead of pre-tax funds to open a traditional IRA. In addition to simplifying the backdoor strategy, nondeductible contributions circumvent income limits for deductible traditional IRA contributions, which are even more restrictive than Roths if you have a retirement plan at work. Second, the traditional IRA is converted to a Roth, but since the contributions were not deductible, there is no income tax due. You report your nondeductible contributions to the IRS by using Tax Form 8606.
Since there are no income limits for nondeductible IRAs or Roth conversions, everyone can use the backdoor strategy. In 2022, back door contributions will have the same annual maximums as other IRAs: $6,000 for people under 50 and $7,000 for those 50 and over. Backdoor Roth IRA conversions are possible every year, but if you contribute before-tax funds to a traditional IRA, a tax law called the pro-rata rule complicates things.
To determine the pro-rata amount of pre-tax versus after-tax dollars in your traditional IRA, the IRS analyses how much of your traditional IRA is pre-tax and how much is after-tax. Backdoor Roth conversions are taxable at this percentage. The amount of the taxable conversion would also increase your taxable income for the year.
Due to this, backdoor Roth IRAs are most tax-effective for those who have not already funded a traditional IRA with pre-tax funds. The IRS looks at all your IRAs in aggregate. You cannot avoid taxes by opening a new IRA with a new brokerage firm if you already have a traditional IRA with a brokerage.