John and Andrew explain the backdoor Roth IRA strategy including who should consider making Roth contributions vs. pre-tax IRA contributions….(read more)

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A Backdoor Roth IRA is a strategy that high-income earners use to contribute to a Roth IRA when they are not eligible to make a direct contribution due to income limits. With this strategy, individuals can effectively convert traditional IRA contributions into Roth IRA contributions.

In traditional IRAs, contributions made with pre-tax dollars are not taxed during the year they are made, but are instead taxed when the money is withdrawn in retirement. However, with Roth IRAs, contributions are made with after-tax dollars, and withdrawals are tax-free during retirement. This can be an attractive option for individuals who expect to be in a higher tax bracket in retirement.

But the problem is that not everyone is eligible to contribute to a Roth IRA. There are income limits in place that prohibit high earners from contributing directly to a Roth IRA. In 2021, the income limits for Roth IRA contributions are $140,000 for single filers and $208,000 for married couples filing jointly.

This is where the Backdoor Roth IRA comes into play. It’s a strategy that allows individuals to contribute to a non-deductible traditional IRA and then rollover those contributions into a Roth IRA. Essentially, it involves making a non-deductible contribution to a traditional IRA and then immediately converting that contribution to a Roth IRA.

While this may seem like a straightforward solution, there are some caveats that individuals should be aware of. First, it’s important to note that when making a conversion from a traditional IRA to a Roth IRA, taxes will be owed on any pre-tax dollars that have grown in the account. This means that individuals who have existing traditional IRAs with pre-tax contributions may face a larger tax bill when converting.

It’s also essential to ensure that any income earned on the non-deductible contribution is not co-mingled with pre-tax money in the account. Otherwise, the individual will be subject to pro-rata taxation, where the tax bill is based on the proportion of pre-tax versus after-tax dollars in the account.

Despite these caveats, the Backdoor Roth IRA is still an excellent option for high-income earners who want to take advantage of the tax benefits of a Roth IRA. As always, it’s essential to consult with a financial advisor to determine if this strategy is appropriate for your personal financial situation.