Investing

Income Too High for a Roth IRA? Consider the Backdoor Roth

Is Your Income too High for a Roth IRA? Check out your options

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The Roth IRA is an incredible retirement investment vehicle that allows individuals to contribute after tax dollars into an account, invest in it and have all the earnings grow tax free and future withdrawals tax free (so long as certain rules are followed). The downside to the Roth IRA, for some, is that the IRS has created income limitations on who is eligible to contribute to a Roth IRA to prevent high income earners from benefiting from its tax free nature. This may be one of the only downsides to having a high income.

2022 Roth IRA Income Limitations

Income Limitations: Your income eligibility is based on your MAGI or Modified Adjusted Gross Income on your tax return. Your MAGI accounts for all of your income sources – salary, investment income, business income, etc. and is offset by a few deductions.

Single Tax Filer: You may contribute up to the maximum contribution if your MAGI is below $129,000. Between $129,000 to $144,000 your eligible contributions begin to decrease. At $144,000 and above, you are no longer eligible to contribute.

Married Filing Jointly Tax Filer: You may contribute up to the maximum contribution if your income is below $204,000. Between $204,000 and $214,000, your eligible contribution begins to decrease. At $214,000 and above, you are no longer eligible to contribute.

How Can You Still Contribute to a Roth IRA If Your Income Exceeds the IRS Limitations?

A Backdoor Roth IRA

Utilizing the backdoor Roth IRA method is a unique way for individuals to add to a Roth IRA on an annual basis despite the fact that their income exceeds the income limitations.

The backdoor Roth IRA works like this:

  1. You open a Traditional IRA and contribute after tax contributions (a non-deductible contribution) into the account.
  2. Once those funds are in the IRA, do not invest them and wait a few days for the cash to settle.
  3. Convert the Traditional IRA to a Roth IRA. You have already paid taxes on your original contributions to the Traditional IRA and thus when you convert to the Roth, it will not require you to pay taxes again (unless the account earned income while sitting in the Traditional IRA).
  4. Invest and benefit from tax free growth and tax free withdrawals in the future.

Sounds a little too good to be true? The Backdoor Roth IRA method is a well recognized loophole in the industry that is, under current law, permissible and “respected” by the IRS. Read below to learn more about potential upcoming changes from the Build Back Better Act.

Another Way to Benefit from the Roth IRA Tax Free Nature if Your Income is Too High…A Roth Conversion

If you have a Traditional IRA or a Traditional 401K (that you are planning to roll over from a previous employer), you have the option to convert those accounts into a Roth IRA.

You would simply roll those IRA assets into a Roth IRA account, pay ordinary income tax on the amount that is being rolled over and then benefit from tax free growth and withdrawals for years to come.

This scenario would make particular sense for individuals who;

  1. Anticipate being in a higher income tax bracket during retirement when withdrawals are to be taken out
  2. Are able to keep the assets in the Roth IRA for a minimum of 5 years
  3. Have a tax year in which their income is significantly lower than other years where the conversion would have less of a negative impact on your tax bill or tax rate. A few examples include:
    • Significant losses from the sales of securities, business losses or rental real estate losses that would reduce your taxable income
    • A year in transition – on sabbatical, switching jobs and taking time off, but meanwhile have the funds to pay for the tax bill due.
    • A year where you live in a state that may have no state income tax and are moving to or retiring to a state with state income tax.


Timing Matters: Keep an Eye Out for the Build Back Better Act

Now keep in mind, the Build Back Better Act is still in limbo. There is discussion around the idea that individuals who have exceedingly high income would no longer be able to utilize the IRS respected loophole of the Backdoor Roth IRA and talk about high income earners in excess of $400,000 being eliminated from Roth conversions all together.

But here’s the thing, the law has not been passed yet and when it comes to the matter of finances and taxes, it is rare that Congress passes a law that will take effect retroactively. So it will play out in 1 of 4 ways:

  1. The bill won’t pass and the Backdoor Roth IRA method lives on.
  2. The bill will pass and continue to allow the Backdoor Roth and Roth conversions to be permissible despite your income level.
  3. The bill will pass and no longer allow the Backdoor Roth IRA loophole and will be take effect on the date the bill was enacted.
  4. The bill will pass and no longer allow the Backdoor Roth IRA loophole and will be retroactive to the beginning of 2022. In my personal opinion, I find this to be very unlikely and would simply require a form to be filed to undo the contribution or conversion.


Here is What I Would Do Before April 15

Despite the Build Back Better Act pending, if I were in the position where my income exceeded the income limitations and I had an additional $12,000 of cash sitting in an account waiting to be invested, here is what I would do right now to take advantage of the Backdoor Roth IRA method…

  1. I would open a Traditional IRA
  2. You have until April 15, 2022 to make a 2021 IRA contribution. So, before April 15, 2022 I would make a non-deductible max contribution of $6,000 for Year 2021.
  3. I would also make a non-deductible max contribution of $6,000 for Year 2022 immediately after.
  4. I would convert it to a Roth IRA, invest it and tune in to new tax law changes going forward. If it was still a permissible strategy in 2023, I would continue to do it year after year. Will continue to keep you updated via Instagram on the act as new information comes about.

I will continue to keep you updated via Instagram on the BBB Act as new information comes about.

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Read my blog post, All About Roth IRA’s and Why I Love Them to give you some additional insight into why the Roth IRA investment vehicle is such an attractive one for long term wealth building.

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