Make the Most of a Roth’s Back Door – Kiplinger’s Personal Finance

The Roth IRA is that rare prize in the U.S. Tax code: a way to earn tax-free income. Savers using these accounts withdraw their investment gains completely tax-free in retirement. The government designed this generous tax break for the middle class, which is why the Roth has strict income limits for who can use it. In 2022, you cannot contribute directly to a Roth IRA if you’re single and have a modified adjusted gross income of more than $144,000 or are married with joint modified AGI over $214,000.

Wealthier investors, however, can still access these accounts indirectly through a backdoor Roth IRA. “This strategy gives a workaround for the Roth IRA income restrictions,” says Rob Burnette, a financial adviser and tax preparer at Outlook Financial Center in Troy, Ohio. At least it does for now. “The IRS has said they’re OK with this move short of new legislation formally blocking it,” says Wade Pfau, a professor of retirement income at The American College of Financial Services.

Reports of billionaires funding Roths through the back door put this strategy on Congress’s radar last year, with some Democratic lawmakers looking to restrict the practice or even abolish it altogether. But the hubbub also has prompted upper-middle-class families to wonder if backdoor Roths should play a role in their financial planning.

Beware of the Pro-Rata Rule

A backdoor Roth IRA is a two-step process. First, you open a traditional IRA using after-tax dollars instead of the pre-tax money you usually fund these accounts with to get a deduction. Nondeductible contributions are not only simpler for the backdoor strategy but also circumvent the income limits for deductible traditional IRA contributions, which are even more restrictive than those for a Roth if you have a retirement plan at work and either you or your employer contributed to it. Second, you convert the traditional IRA to a Roth, but because none of the contributions were deductible, no income tax is owed on the conversion. You report to the IRS that your contributions were nondeductible using Tax Form 8606 when you file your return.

There are no income limits for setting up nondeductible IRAs or making a Roth conversion, so the backdoor strategy is available to everyone. Contributions through the back door have the same annual maximums in 2022 as other IRAs: $6,000 for people younger than 50 and $7,000 for those 50 or older, provided they have at least that amount in earned income. A backdoor Roth IRA conversion can be made every year, but if you’ve contributed pre-tax money to a traditional IRA in the past, a tax law called the pro-rata rule complicates things.

Under the pro-rata rule for Roth conversions, the IRS looks at the proportion of pre-tax versus after-tax dollars in …….


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