INDUSTRY INSIGHT

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Roth IRA can be a great vehicle to save money for retirement . The backdoor Roth IRA contribution is a way to fund a Roth IRA if your income disqualifies you from making a normal contribution .

The Internal Revenue Service ( IRS ) has a lot of rules when it comes to retirement contributions . The two rules below are what make backdoor Roth contributions possible .

• You can always fund a traditional IRA , but your contribution may not be deductible based on your income ( IRS , 2022b ).

• In 2023 , your ability to fund a Roth IRA phases out when your modified adjusted gross income ( MAGI ) is between $ 218,000 and $ 228,000 if you are married and between $ 138,000 and $ 153,000 if you are single ( IRS , 2022a ).

You may want to consider a backdoor Roth IRA contribution if :

• Your income is above the MAGI amounts above .

• You do not qualify for a deductible IRA contribution .

• You do not have traditional IRA accounts .

• You do not have a Simplified Employee Pension ( SEP ) or SIMPLE IRA .

Let ’ s look at an example of a backdoor Roth IRA contribution .

• You open and fund a nondeductible traditional IRA .

• Your income is over the MAGI limit , and you do not receive a deduction for the contribution .

• You open a Roth IRA with your favorite custodian .

• You convert your IRA to a Roth IRA before gains or interest accrue in the account .

• You are now the proud owner of a brand-new Roth IRA .

• You receive Form 1099-R from your custodian reporting the transaction .

• You report the transaction on Form 8606 when you file your tax return .

• The transaction is not taxed .

The Pro-Rata Rule What happens if you have a pretax IRA and make a backdoor

Roth contribution ? Let ’ s look at an example .

• You have $ 95,000 of pretax contributions in a traditional IRA that you rolled over from an old employer plan .

• Your income is over the MAGI limit , and you make a $ 5,000 contribution to a nondeductible IRA .

• You convert $ 5,000 to a Roth IRA .

• $ 4,750 is taxable as ordinary income , and $ 250 is not taxed .

• Your traditional IRA now has a basis of $ 4,750 that you will track on Form 8606 .

The pro-rata rule aggregates your IRA accounts to calculate the taxable amount of the transaction . In some cases , you can move your nondeductible IRA to an employer account to potentially avoid the pro-rata rule , but there are a lot of rules to follow ( Kitces , 2015 , 2020 ).

There are many additional rules I didn ’ t cover about Roth IRAs . I recommend that you work with a competent financial planner and accountant to make sure everything is done correctly !

References

Internal Revenue Service ( 2022a , December ). Retirement topics – IRA contribution limits . https :// www . irs . gov / retirement-plans / plan-participant-employee / retirement-topics-ira-contribution-limits

Internal Revenue Service ( 2022b , October ). IRA deduction limits . https :// www . irs . gov / retirement-plans / ira-deduction-limits

Kitces , M . ( 2015 , August 12 ). Nerd ’ s Eye View . How to do a backdoor Roth IRA ( safely ) and avoid the IRA aggregation rule and step transaction doctrine . https :// www . kitces . com / blog / how-to-do-a-backdoorroth-ira-contribution-while-avoiding-the-ira-aggregation-rule-and-the-step-transaction-doctrine

Kitces , M . ( 2020 , September 2 ). Nerd ’ s Eye View . Isolating IRA basis for more tax efficient Roth IRA conversions . https :// www . kitces . com / blog / roth-ira-conversions-isolate-basis-rollover-pro-rate-ruleemployer-plan-qcd

Securities and advisory services offered through Commonwealth Financial Network ®, Member FINRA / SIPC , a Registered Investment Adviser . Fixed insurance products and services are separate from and not offered through Commonwealth .

This Industry Insight was written by Brian Hill .

Brian Hill , CFP ®, Managing Partner / Advisor . Strategic Path focuses on helping its clients make the transition from work to retirement . Brian specializes in complex planning , tax solutions , and portfolio management .

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