Is your income too high to contribute to a Roth IRA? Are you concerned that doing post-tax contributions to the PrAP will create more RHA spillover than what you want? Well, if you have not heard of it there is something called a back door roth ira that can help you get around both of these obstacles. But then, there’s a third obstacle to the back door Roth IRA and that’s paying taxes on existing IRAs when doing these conversions. With the PRAP available to us there is a way around that too. That’s what this video is about.

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Back Door Roth IRAs and the PRAP: Avoiding Aggregation for High Earners

Saving for retirement is essential for everyone, but high earners often face limitations and restrictions when it comes to contributing to tax-advantaged accounts. The IRS imposes limits on contributions to Roth IRAs based on income, but there is a workaround known as the Back Door Roth IRA. However, another issue high earners face when contributing to Roth IRAs is aggregation, which limits their ability to enjoy the tax benefits. Fortunately, there is a solution to this problem as well – using the PRAP.

What is a Back Door Roth IRA?

A Roth IRA is an investment account that allows you to contribute post-tax income and then withdraw money tax-free in retirement. However, the IRS sets income limits on who can contribute to a Roth IRA. In 2021, the income phase-out starts at $198,000 for married couples filing jointly and $125,000 for single filers. Those who earn more than the phase-out limit are not allowed to contribute to a Roth IRA directly.

This is where the Back Door Roth IRA comes in. It involves two steps – first, an individual makes a non-deductible contribution to a traditional IRA, and then they convert that traditional IRA to a Roth IRA. Because the contribution was already taxed, there is no tax owed at the time of the conversion. This strategy allows high earners to enjoy the benefits of a Roth IRA even if they are above the income limits set by the IRS.

What is Aggregation?

Aggregation is a rule that, if not understood, can cause a headache for high earners who are trying to contribute to Roth IRAs. The rule applies if you have multiple IRAs, including traditional, Roth, SEP, or SIMPLE IRAs. When calculating contribution limits for the year, the IRS treats all these accounts as one IRA. If you exceed the contribution limit for one account, you cannot “make up” the difference by contributing to another account. Therefore, having multiple IRAs can limit your ability to contribute to Roth IRAs.

Avoiding Aggregation with the PRAP

The Pro-Rata Rule Anti-Abuse Provision, or PRAP, is a solution that can help high earners avoid aggregation when doing Back Door Roth IRA conversions. The PRAP applies when converting a traditional IRA to a Roth IRA and essentially ensures that only the pre-tax contribution portion of the traditional IRA is subject to taxation.

The PRAP works by calculating the percentage of the pre-tax and after-tax contributions in your traditional IRA(s). If your traditional IRA contains only after-tax contributions, then the entire conversion is tax-free. However, if you have pre-tax contributions in any of your traditional IRAs, then you must prorate the conversion, which means you will owe taxes on a portion of the amount being converted.

To avoid any unintended taxes or penalties when doing a Back Door Roth IRA conversion, it is crucial to understand the PRAP and the rules for avoiding aggregation. Consulting with a financial advisor or tax professional can help you navigate these rules and ensure that you are contributing to a Roth IRA in the most tax-efficient way possible.

Conclusion

For high earners, the inability to contribute directly to Roth IRAs can be frustrating, but the Back Door Roth IRA strategy provides an opportunity to continue saving for retirement tax-efficiently. However, it is important to understand the PRAP to avoid any unintended tax consequences. By utilizing the PRAP and following the rules for avoiding aggregation, high earners can ensure that they are maximizing their retirement savings while minimizing their taxes.