What if you want to contribute to a Roth IRA but your income is too high to qualify? The IRS sets annual income limits that phase out the ability for high earners to make direct contributions. Fortunately, there is a widely used and legal strategy known as the “Backdoor Roth IRA.”
This strategy allows you to get money into a Roth IRA regardless of your income. Here’s how it works in its simplest form:
- Contribute to a Traditional IRA: You make a contribution to a traditional IRA. Since your income is high, this contribution will likely be “non-deductible,” meaning you don’t get a tax deduction for it.
- Convert to a Roth IRA: Shortly after making the contribution, you convert the traditional IRA to a Roth IRA. Because your original contribution was made with after-tax dollars (it was non-deductible), the conversion itself is generally a non-taxable event, except for any small amount of earnings the funds may have generated before conversion.
The Most Important Rule to Know: The Pro-Rata Rule
This strategy is straightforward only if you do not have any other existing pre-tax funds in any traditional, SEP, or SIMPLE IRAs. If you do, the IRS’s “pro-rata rule” comes into play. This rule calculates the tax on your conversion based on the ratio of your pre-tax IRA funds to your total IRA funds. Ignoring this rule can lead to an unexpected and significant tax bill.
For high-income earners looking for a path to tax-free growth and withdrawals, the Backdoor Roth IRA is an essential planning tool. However, due to the complexity of the pro-rata rule, it’s highly recommended to work with a financial advisor to ensure it’s executed correctly.
At Vernon Management Group, we help our clients determine if a backdoor Roth IRA is a smart move for their specific situation.
Ready to explore if a backdoor Roth IRA can work for you?
Schedule a complimentary consultation with our team
Disclaimer: This content is for informational and educational purposes only and does not constitute financial, legal, or tax advice. The information provided is general in nature and is not intended to be a substitute for professional advice tailored to your specific financial situation. All investing involves risk, including the potential for loss of principal. Past performance is not indicative of future results. Vernon Management Group, a registered investment advisor, provides this information with the understanding that you will consult with a qualified professional before making any financial decisions. We are not responsible for any actions taken based on the information contained in these blog posts. This article was written with AI and edited by a Vernon Management Group team member. Contact us today for a personalized consultation to discuss your specific financial needs.