How High Earners Can Use a Backdoor Roth IRA

IRAs have a Annual contribution limit of $7,000 for 2024. Investors aged 50 or older can save an extra €1,000, or €8,000 in total this year.

Investors who save in an IRA before taxes typically get a tax deduction on their contributions. However, they generally pay income taxes on earnings and withdrawals later. Roth contributions don’t get the same upfront tax benefit: Investors fund Roth IRAs with after-tax money, but generally don’t pay income taxes on earnings or withdrawals in retirement.

However, many high earners cannot take full advantage of these tax benefits.

For example, married couples who file a joint tax return cannot contribute to a Roth IRA in 2024 if their adjusted adjusted gross income is $240,000 or more. The income threshold for individual filers is $161,000. (Eligibility begins to gradually decline even before these dollar thresholds, reducing the share of investors.)

There are like that too income limits on the deductibility of pre-tax (aka “traditional”) IRAs, for those who do too have access a workplace retirement plan such as a 401(k).

For example, single filers with income of $87,000 or more in 2024 will not get a tax deduction for contributions to a traditional IRA if they are covered by a workplace retirement plan.

The same goes for married couples filing jointly. For example, if your spouse participates in a 401(k) plan at work, you won’t get a deduction on IRA contributions if your combined income is $240,000 or more. If you are the one participating in a workplace 401(k), the limit is $143,000. (Again, you may only get a partial deduction under these dollar thresholds due to the income phase-out.)

However, high income earners can contribute to a so-called non-deductible IRA.

This is a traditional IRA, but investors don’t get a tax deduction for their contributions; they fund the accounts with after-tax money. Investors will later, upon withdrawal, owe income tax on the growth.

The ability to use the Roth IRA backdoor is a major benefit of these accounts, tax experts say.

It only applies to investors who make too much money to contribute directly to a Roth IRA or make a tax-deductible contribution to a traditional IRA, Slott said.

Here’s the basic strategy: A high-income investor would make a non-deductible contribution to his traditional IRA and then quickly convert the money to his Roth IRA.

“The only reason you would do that [a nondeductible IRA] is if the intention was to do a backdoor Roth,” Slott said.

After making the non-deductible contribution, Slott recommends waiting about a month before converting the money to a Roth IRA. This ensures that your IRA statement reflects the nondeductible contribution, in case the IRS ever requires proof, he said.

Some investors may also be able to benefit from a similar strategy in their 401(k) plan, called a mega backdoor Roth conversion. This involves shifting after-tax 401(k) contributions to a Roth account. However, the strategy is not available to everyone.

“All high earners should consider looking at both a backdoor Roth IRA and a mega backdoor Roth IRA if they can’t set up a Roth IRA,” says Ted Jenkin, a certified financial planner and founder of oXYGen Financial, based in Atlanta. He is also a member of the CNBC Financial Advisor Council.

A non-deductible IRA probably doesn’t make sense for investors who don’t plan to use the backdoor Roth strategy, according to financial advisors. In such cases, the investor would simply let the contributions remain in the non-deductible IRA.

First, non-deductible IRA contributions come with potentially burdensome administrative and accounting requirements, Slott said.

“It’s a life sentence,” he said.

Taxpayers must file a tax return Form 8606 each year to the IRS to track their after-tax contributions to a non-deductible IRA, according to to Arnold & Mote Wealth Management, based in Hiawatha, Iowa. Revocations “add more complexity” to that administrative lift, it added.

Without a backdoor Roth in play, most investors would be better suited to save in a taxable investment account rather than a non-deductible IRA, advisors said. That’s because investors who use the first option are likely to pay less tax on their profits in the long run.

Taxable investment accounts “are probably better in most respects,” Slott said.

Investors who hold assets such as stocks in a taxable investment account for more than a year generally pay a favorable rate on their profits compared to other income taxes.

These “long-term” capital gains tax rates – which only apply in the year investors sell their assets – are as high as 20% at the federal level. (High earners may also owe 3.8%Medicare surchargeon the win.)

By comparison, the top marginal income tax rate is 37%. Investors in non-deductible IRAs are subject to these generally higher earnings rates upon withdrawal.

While taxable investors in brokerage accounts pay taxes every year further dividend incomeSuch taxes are generally not enough to offset the relative tax benefits of such accounts, advisers said.

“The Tax Deferral of Non-Deductible IRAs May Be a Benefit for Some,” according to Arnold & Mote Asset Management. “However, we find that this is quite rare.”

Additionally, investors in taxable investment accounts can generally access their money at any time without penalty, while IRAs typically do tax penalties when income is withdrawn before age 59½. (There are some IRA exceptions, however.)

Taxable accounts have no required minimum distributions as long as the account holder lives, unlike traditional and non-deductible IRAs.

“A taxable account provides the flexibility to add and withdraw money with few limits, penalties or restrictions,” Judith Ward, a certified financial planner at T. Rowe Price, a wealth management firm, wrote recently.