Pro Tips from Maggie Polisano, Co-Founder, CamaPlan LLC

You know the cliche “more money, more problems.” This is one of the nasty surprises that many Americans discover as their incomes increase — they are no longer eligible to contribute to a Roth IRA, that powerful vehicle of tax-free wealth growth.

However, there is a solution for high-earning individuals and couples to keep the Roth IRA in their retirement-planning toolkits — the Backdoor Roth IRA strategy.

The Problem: You Earn Too Much Money for a Roth IRA

According to the law, individuals and married couples do not qualify to contribute to a Roth IRA if their income exceeds a certain level.

“At a certain point the government tells high earners ‘You make too much money to be allowed to use a tax-free retirement account,” said Maggie Polisano, co-founder of self-directed IRA custodial service CamaPlan.

So what’s the threshold? At what income do you become ineligible for Roth IRA contributions? It changes based on the tax law. In 2021, the limits were $140,000 in gross income for single filers, and $208,000 for joint filers.

In 2022, those limits increased. In 2022 you can contribute to a Roth IRA if you make $144,00 or under as an individual filer or $214,000 as joint filers. Limits for 2023 should be available in the Fall of 2022.

If you (or you and your spouse) earn over those limits, you are no longer eligible to contribute after-tax funds to a Roth IRA so they can appreciate and yield tax-free over time.

The Solution:  A “Backdoor” Roth IRA Conversion

“If you’re cursing your luck for being such a high earner, there’s hope,” said Carl Fischer, Polisano’s partner and the other co-founder of CamaPlan. “The backdoor Roth IRA strategy exists in the tax code to do just that — give high-earners a ‘back-door’ method to put money in a Roth IRA.”

Here’s how it works — first, you deposit money in a traditional IRA. Remember, contributions to traditional IRAs count as pre-taxed income. You pay taxes on that money only when you retire and start to take disbursals.

Once that pre-tax money is in the traditional IRA, you then transfer those funds to a Roth IRA. Basically, you are moving money from one IRA to another — the salient detail being that the final destination for the money is a Roth IRA.

What Are the Tax Implications of Doing This?

Roth IRAs are the opposite of traditional IRAs — money you contribute to a Roth gets taxed first, but you owe no taxes upon withdrawal, no matter how much that money has yielded or appreciated in the meantime. You owe no income taxes, no long-term capital gains taxes … nothing.

But what if you are transferring pre-tax contributions from a traditional IRA into a Roth IRA? It means you will have to pay taxes on that money.

Usually, this taxation will be reconciled on the tax return you file for the year in which the transfer occurred. Be prepared for your tax bill to be a little higher or your refund a little lower as you pay back the taxes you initially avoided with the traditional IRA contribution.

“Even though you owe taxes immediately, this is still a powerful strategy,” Polisano explained. “After-tax money left to grow tax-free in a Roth IRA tends to result in much higher tax savings over the course of years and decades.”

“Plus,” she added, “taxes are actually historically low right now. There’s no guarantee that taxes won’t be higher in the future. In fact, lots of experts think higher taxes are likely in the future.”

“So by paying taxes now rather than later with a Roth IRA, you could be getting a bargain on your tax liability. By deferring your taxes until years or even decades from now with a traditional IRA, you could be setting yourself up to pay much higher tax bills at the worst possible moment — just when you’re getting ready to retire.”

How Do I Do a Backdoor Roth IRA Transfer?

You have three options, any of which will help you avoid excessive fees and penalties:

  • Rollover. Withdraw money from the traditional IRA directly into your own possession, then deposit that money into a Roth IRA within 60 days.
  • Same-Trustee Transfer. If you have a traditional IRA and a Roth IRA with the same provider, the provider can do the transfer directly. You never touch the money personally.
  • Trustee-to-Trustee Transfer. If your traditional and Roth IRAs are with different providers, the trustee of the traditional IRA can send the funds directly to the trustee of the Roth IRA. Again, you never touch the money personally.

The Pro-Rata Rule

When deciding how much of the backdoor transfer is taxable, the IRA uses the pro-rata rule.

Traditional IRAs may contain both pre-tax and after-tax income. You may expect the taxable portion of your transfer to be based on how much pre-tax income is in the specific traditional IRA from which you are transferring the money.

But according to the pro-rata rule, the IRS looks at the pre-tax/after-tax ratio of every traditional IRA you own.

“Let’s say you want to do a backdoor Roth transfer from a traditional IRA that contains 70% pre-tax income and 30% after-tax income,” Fischer explained. “You may expect only 70% of the transfer to be taxable.?

“However, if you have multiple traditional IRAs, and the average distribution is 80% pre-tax and 20% after-tax across all of them, then your transfer will actually be 80% taxable.”

“On the other hand,” he said, “if your total traditional IRA average is only 60% pre-tax income, only 60% of the income is taxable, even if that particular traditional IRA contains a higher proportion of pre-tax income.”

Backdoor Roth IRA Transfer Mistakes to Avoid

Here are three pitfalls to avoid when using the backdoor Roth IRA strategy so you don’t end up paying taxes and fees you could have avoided …

  • Don’t do the transfer if you have to withdraw IRA funds to afford the extra taxes. Settling the tax bill is not a part of the back-door transfer — that takes place 100% outside of both IRAs.

If you are under the age of 59½, withdrawing from your IRA to pay the taxes counts as a premature disbursal, and you will end up paying a 10% penalty on the money you withdraw to pay the taxes.

Only attempt the backdoor Roth IRA strategy if you have enough cash outside of your IRAs to afford the taxes.

  • Don’t try this strategy if you anticipate needing the money within five years or less. Roth contributions must stay in the account for at least five years. If you break this rule, you will owe a 10% penalty and taxes — the exact taxes you were trying to avoid by putting the money in a Roth IRA.
  • Don’t push yourself into a higher tax bracket. If the extra taxable income from the traditional IRA withdrawal pushes you into a higher tax bracket, you could end up worse off than if you had just left the money in your traditional IRA.  One way to avoid this is to do partial conversions over two or more years if it’s going to bump you into a higher bracket.

The backdoor Roth IRA strategy allows high-earning individuals to keep a powerful retirement strategy working for them — taking after-tax income (taxed at what might be bargain rates) and allowing them to grow tax-free, often over the course of decades.

“Increasing your income shouldn’t be a parade of annoyances and pitfalls,” Polisano said. “It’s a good thing, something to be celebrated. It should be easier to save for retirement, not harder. The backdoor Roth IRA strategy effectively eliminates a key downside to a higher income.”

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CamaPlan LLC is a custodian and administrator of self-directed IRA, 401(k), Health Savings, and Education Savings accounts.  Located in Ambler, PA, and serving a nationwide client base, CamaPlan accounts enable investors to allocate capital from their tax-exempt or tax-deferred retirement accounts to real estate, private lending, venture, precious metals and other alternative assets.  Self-directed retirements accounts from CamaPlan provide investors with maximum control over the direction their retirement savings for wealth accumulation, preservation and legacy provision. Learn more at www.camaplan.com.

The above should not be construed as advice or recommendation. We strongly suggest you consult with tax, financial and legal professionals before making any investment decisions.