What is a Backdoor Roth IRA?
A backdoor Roth IRA is not an official type of IRA, (Individual Retirement Account). Instead, the backdoor Roth IRA is an informal name for a complex method used by high-income taxpayers to create a permanently tax-free Roth IRA, even if their incomes exceed the modified gross income limits that the tax law prescribes for regular Roth ownership.
Roth IRAs are a great retirement investing tool, but as you probably know, there are income maximums above which you’re no longer able to contribute to one. In 2022, these limits are $144,000 for single filers and $214,000 for married couples filing jointly.
However, there’s currently a loophole that allows high earners to convert a traditional IRA to a Roth IRA known as the “backdoor Roth conversion.”
How is a backdoor Roth IRA conversion done?
If your income level disqualifies you from opening a Roth IRA and directly contributing to it, you can simply fund a traditional IRA and immediately convert it to a Roth IRA.
This conversion will trigger a taxable event and it’s important to be aware of how Uncle Sam looks at this type of transaction for tax purposes if you have multiple IRAs.
Each traditional IRA you have may contain pre-tax money, post-tax money, or a combination of the two. For backdoor Roth conversions, the IRS considers your IRAs in aggregate when determining how much tax you’ll owe.
If your traditional IRAs combined consist of 75% pre-tax money and 25% post-tax money, those ratios factor into how much of your Roth IRA conversion will be taxable. Assuming the 75/25 scenario, 75% of your conversion to the Roth IRA will be taxable even if the source of the conversion is mostly pre-tax money. The IRS doesn’t allow you to pick and choose just the post-tax money from your traditional IRA when you do a Roth conversion.
Is the loophole at risk of being closed?
While the House of Representatives passed a bill called the SECURE 2.0 bill that closed the backdoor Roth IRA conversion loophole, that bill did not make it any further. An updated version passed in March, but the 2022 version of the bill did not include the backdoor conversion provision. This updated version of SECURE 2.0 hasn’t been passed by the Senate either.
Since the backdoor conversion provision was removed from the 2022 SECURE Act 2.0, it would take another bill – or an addition of the provision into the Senate version, which would then have to get passed by the House again – to close the loophole before 2023. Given the existing legislative calendar and the upcoming election, this is unlikely to happen.
Backdoor Roth IRA Strategy
If you’re considering a backdoor Roth IRA conversion, 2022 is a good year to execute it. Regardless of the results of the election, closing the loophole could end up on the congressional menu in 2023. Need help deciding if a backdoor conversion is right for you or how much you should convert? Take advantage of a complimentary, no-obligation meeting with one of our financial advisors to explore further. Click here to schedule your appointment now!