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Michael B. Fischer
December 15, 2022
Every few months, a reputable financial news website like MarketWatch, CNBC, or The Wall Street Journal releases an article about the benefits of contributing to a non-deductible IRA and converting that contribution to a Roth IRA (a “backdoor” Roth IRA contribution). However, these articles seemingly gloss over the complexity of the strategy and lead to confusion over its appropriateness. In light of the lack of comprehensive guidance on this topic, this blog discusses a major and often overlooked pitfall that you should know about if you are considering a backdoor Roth conversion.
Before continuing, I’d like to take a step back to explain a non-deductible IRA contribution and why someone may consider making one. For many working Americans who are saving for retirement through their own contributions, a company-sponsored 401(k) is a primary vehicle for saving pre-tax dollars. As an employee with access to a 401(k) or 403(b), you can contribute up to $22,500 (or $30,000 if you’re 50 or older) to your plan each calendar year. For most people, socking away $22,500 every year may be enough to comfortably reach their retirement goals. For high earners, however, saving $22,500 a year pre-tax may not be enough to ensure a comfortable retirement. Enter the Traditional IRA.
The Traditional IRA offers an opportunity to save an additional $6,500 (or $7,500 if you’re 50 or older) annually in pre-tax assets. However, if you or your spouse are covered by a retirement plan at work (i.e., 401(k), profit-sharing, SEP-IRA, pension, etc.), a Traditional IRA contribution loses its deductibility between income levels of $73,000 and $83,000 for single taxpayers and $116,000 and $136,000 for taxpayers married filing jointly. These limits significantly cap the ability of high earners to save pre-tax dollars. High earners still do have the ability to make an IRA contribution, however, they cannot deduct the contribution on their taxes. This contribution is called a non-deductible IRA contribution.
Many personal finance articles highlight the ability to further convert a non-deductible (i.e., after-tax) IRA contribution to a Roth IRA. This backdoor Roth conversion allows high-earners to get around the income limits that would otherwise prevent them from being eligible to contribute to a Roth IRA directly (Eligibility phases out at $138,000 to $153,000 of income for single taxpayers and $218,000 to $228,000 for married taxpayers). Roth IRAs have many benefits, but the most significant benefit is that the assets contributed to a Roth IRA, along with all future appreciation, will never be taxed again. With no capital gains taxes due on your investment growth and no ordinary income tax realized when you decide to draw from the account, Roth IRAs are a very powerful saving tool.
So, for the successful young couple earning $250,000 in 2023, each spouse can contribute $22,500 to a 401(k). However, if they wanted to save additional funds for retirement, they are prohibited from contributing to a Roth IRA and they cannot make deductible contributions to a traditional IRA. The backdoor Roth IRA conversion discussed above is an attractive option to put away an additional $6,500 for each spouse. And that $6,500 will grow tax-free!
Converting a non-deductible IRA contribution to a Roth IRA is a great planning strategy that will ensure that the account can grow without being required to take distributions during your lifetime and never paying taxes on these assets in the future.
The problem that is often missed with this strategy is: when converting an IRA to a Roth IRA, all IRA assets (both pre-tax and after-tax) must be considered in the conversion. If you have a Rollover IRA from an old 401(k) plan or have contributed pre-tax assets to a Traditional IRA in the past, a portion of your Roth conversion will be taxable to you in the current tax year. Consider the two scenarios depicted on the next below.
An individual has an IRA she has contributed to over prior years when she earned less income than the phase-out amount. This year she makes a non-deductible IRA contribution of $5,000 and intends to immediately convert this after-tax contribution to a Roth IRA. What she does not know is that a portion of her $95,000 pre-tax IRA assets will be converted on a pro-rata basis with her after-tax contribution. (This holds true whether she opens a new IRA account for the after-tax assets or not.) Assuming she is in the highest 37% federal income tax bracket, this will result in her owing roughly $1,758 in federal taxes for the $5,000 conversion.
This is a much cleaner scenario and is the one that’s typically portrayed in articles detailing the benefits of the non-deductible IRA contribution. If the individual does not currently have an IRA, the non-deductible (after-tax) contribution will make up 100% of her IRA balance. When the conversion is made, there will be no tax due and the assets will grow tax-free indefinitely.
The good news is that qualified plan balances (like your 401(k)) are not considered when making a Roth conversion. An individual can have any dollar amount in a qualified plan without it adversely affecting the conversion. While we typically advise against rolling IRA assets into qualified plan assets (usually due to limited investment flexibility), if an employer plan allows participants to roll existing IRAs into it, it may be prudent to do this prior to executing a Roth conversion. A backdoor Roth conversion using a non-deductible IRA is a complex planning strategy that can have many benefits. Unfortunately, because it is a complex strategy, the drawbacks are often misunderstood and the benefits can be incorrectly overstated. If you are considering a strategy like this, it is important to discuss your unique situation with your tax professional and your Cerity Partners Advisor.
Cerity Partners LLC (“Cerity Partners”) is an SEC-registered investment adviser with offices in throughout the United States. Registration of an Investment Advisor does not imply any level of skill or training. The foregoing is limited to general information about Cerity Partners’ services, which may not be suitable for everyone. You should not construe the information contained herein as personalized investment, insurance, tax, or legal advice. There is no guarantee that the views and opinions expressed in this presentation will come to pass. Before making any decision or taking any action that may affect your finances or your company’s finances, you should consult a qualified professional adviser. The information presented is subject to change without notice and is deemed reliable but is not guaranteed. For information pertaining to the registration status of Cerity Partners, please contact us or refer to the Investment Adviser Public Disclosure website (www.adviserinfo.sec.gov). For additional information about Cerity Partners, including fees and services, send for our disclosure statement as set forth on Form CRS and ADV Part 2 using the contact information herein. Please read the disclosure statement carefully before you invest or send money.
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Michael B. Fischer is a Principal in the New Jersey office. He is responsible for developing customized asset allocations, implementing comprehensive financial planning and coordinating...
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