Roth IRA – Part 2 Backdoor Case Study

Roth IRA – Part 2 Backdoor Case Study

This month’s blog is part 2 of a 3-part series on building Roth dollars for high-income households.

Last month we looked at what happens to high income households (for 2024: >$230,000 Married, >$146,000 Single) when they can no longer make Roth IRA contributions, specifically in the year they find out they were over the limit after previously making contributions. Go back and read March’s blog if you’re unsure on when you can or cannot make Roth IRA contributions.

This month, I want to dive deeper into how high-income households can continue to get their hard-earned income into a Roth IRA even if their household income is above the limits I mentioned above through a fictional case study of John and Jane Smith.

John & Jane Smith are in their mid-40s, they have 2 children in middle school, and their household income just crossed the Roth IRA contribution limit last year due to a big promotion Jane received at work. They worked with their accountant last year to recharacterize their Roth IRA contributions to Traditional IRA contributions (like we discussed in last month’s blog) and are ready to continue to save but are unsure about how. After working with an advisor who analyzed their expected income with the promotion, reviewed their 401(k)s and the funds/expenses in them, reviewed their prior year tax return, and most importantly made sure they were on target for all their other goals, they decided it was best for them to continue to save in their IRAs with the Backdoor Roth IRA strategy.

Their advisor described how they can continue to “fund” Roth IRAs each year, but there would be a few more steps before the dollars actually land in the Roth IRA account. A backdoor Roth IRA strategy is when you make non-deductible Traditional IRA contributions and then complete a Roth Conversion, moving those dollars from the Traditional IRA to the Roth. The reason you can do this is because there is no income limit to process Roth Conversions, only to make Roth Contributions.

However, the advisor made sure to let them know of two major pitfalls he often sees for those attempting to complete the Backdoor Roth:

1. Not considering the pro-rata rule.

Jane has always kept her pre-tax money in her workplace 401(k) so she does not have any Traditional IRA dollars other than the $6,500 non-deductible contributions she made from last year’s recharacterization. She can simply complete the backdoor Roth IRA by converting the $6,500 in her Traditional IRA to her Roth IRA. None of the conversion is taxed because Jane did not receive a tax deduction when she made the non-deductible contributions. The pro-rata rule does not apply to her.

However, John has a $106,500 Traditional IRA. His Traditional IRA is composed of $100,000 in pre-tax contributions from an old employer 401(k) and $6,500 is after-tax due to the recharacterized Roth contributions from last year. If John were to complete a Roth Conversion like Jane for the $6,500, the pro-rata rule would apply because the IRS makes you convert dollars in an IRA pro-rata. You cannot pick and choose which dollars get converted and which don’t. So, of the $6,500 conversion, ~94% of the conversion would be taxable because ~94% of the Traditional IRA is pre-tax dollars. The $6,500 conversion would add $6,103 in taxable income to their current year tax return.

This is where the advisor suggests that John roll $100,000 of his $106,500 Traditional IRA into his current 401(k) plan. As long as those pre-tax dollars are in an employer sponsored plan like a 401(k), 403(b), etc., John can complete the backdoor Roth IRA. The rollover into an employer sponsored plan separates the pre-tax and after-tax portions because you cannot roll after-tax dollars into a plan; therefore, only non-deductible Traditional IRA contributions remain which can be converted tax-free to Roth!

As long as John & Jane only have non-deductible contributions in their Traditional IRA each year, they can convert those to their Roth IRA tax-free.

2. Not correctly filing Form 8606

The second pitfall the advisor discussed with them is IRS form 8606. Form 8606 helps the tax preparer correctly alert the IRS that non-deductible IRA contributions were made. Without appropriately filing form 8606, it’s possible the Roth Conversion would be taxable when it shouldn’t be. Also, form 8606 reports the Roth Conversion and makes sure it doesn’t run afoul of the pro-rata rule! The advisor works with the client and their tax preparer every year to make sure form 8606 is filed.

In Summary:

I often read online where people will suggest Backdoor Roths, but rarely understand the technical aspects of what they are suggesting. It is very easy for your average investor to not consider the pro-rata rule or know how to correctly file form 8606. However, for those who do understand the process or are working with an advisor to help them, those backdoor Roth IRA dollars can make a meaningful difference in building tax-free income for retirement!

Next month, in part 3 of 3 in this series for high income households, I’ll discuss how an employer sponsored plan like a 401(k) can be a significant contributor to building Roth dollars on top of strategies like the Backdoor Roth.

If you have questions regarding this article, please feel free to contact Kotys Wealth Professionals at 219.465.6924.

Mark Rosinski, CFP®, CPA

Wealth Advisor

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