A little-known tax loophole that the “rich” take advantage of is the backdoor Roth IRA. And yes, this strategy is perfectly legal and widely used by many financial and tax advisors.
Understanding the various rules and tax implications of this strategy can help you reduce your tax bill, save for retirement, and avoid any surprises at tax time.
Here is an overview of backdoor Roth IRAs:
What is a Backdoor Roth IRA?
A backdoor Roth IRA is not actually a type of account, but it is a strategy. In a nutshell, backdoor Roth IRAs allow high-income taxpayers to make contributions to a Roth IRA even though their income is over the IRS-set limit.
While the limit changes each year and is typically increased based on inflation, the current income limit for Roth IRAs in 2022 is:
- Single : $129,000 – $144,000
- Married, filing jointly: $204,000 – $214,000
- Married, filing separately: $0 – $10,000
How do you do it?
The first step to completing a backdoor Roth IRA is to open a Traditional IRA. This can be done at most large financial institutions, such as Charles Schwab, Vanguard, Betterment, Fidelity, etc.
Next, you will contribute cash into the account (transfers of stock are not allowed). For 2022, you can contribute a maximum of $6,000 (or $7,000 for people over age 50).
Finally, you will submit a request to convert the account to a Roth IRA. For some institutions, this is a simple click online, while others require signed paperwork.
That’s it! You have just bypassed the IRS’ income limit rule for Roth IRAs.
What’s the catch?
One thing to be aware of is that any growth that occurs in the account before the conversion occurs will be reported as taxable income. For example, if you contribute $6,000 and it grows to $6,100 before the conversion is complete, you will owe taxes on the $100 of growth.
So why not just submit the conversion immediately after the contribution? Because of the Step-Transaction Doctrine. According to the IRS, even though each step is legal, doing them all together to avoid taxes can be viewed as illegal in tax court. A simple way to avoid this doctrine is to allow time to pass between the contribution and conversion, usually one month.
Another important rule is the Pro-Rata rule. This rule dictates that your Roth conversion will be taxed proportionate to your pre- and post-tax percentages. This means that if you contribute $6,000 to an IRA and also have $94,000 of pre-tax money from a previous 401(k) rollover, the IRS will consider 94% of your conversion to be pre-tax, and you will owe taxes on $5,640 ($6,000 X 94,000 / $100,000). A simple way to avoid this rule is to roll over any pre-tax IRA money into a current 401(k) plan.
Navigating backdoor Roth IRAs can help you boost your retirement savings and limit your current and future tax bill. If you would like to work with a financial planner to walk you through your options, I would love to help you!
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Disclaimer: This blog is for informational purposes only, and should not be considered advice or recommendations. All opinions expressed herein are solely those of Amaral Financial Planning, LLC, unless otherwise specifically cited. Material presented is believed to be from reliable sources and no representations are made to another parties’ informational accuracy or completeness. You should consult your financial advisor, tax professional or legal counsel prior to implementation.