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Backdoor Roth Conversion: Don’t Miss Out on the Misunderstood Tax Credit

For individuals with high incomes, contributing directly to a Roth IRA may not be an option due to income limitations set by the Internal Revenue Service (IRS). However, there is a little-known loophole called the backdoor Roth conversion that allows high earners to bypass these restrictions and contribute to a Roth IRA indirectly. This strategy has gained popularity in recent years, but many people are missing out on an additional tax credit that comes along with it.

Before diving into the details of the tax credit, let’s first understand the concept of a backdoor Roth conversion. It involves making non-deductible contributions to a traditional IRA and then converting the funds into a Roth IRA. Since there are no income limits on making non-deductible contributions to a traditional IRA, higher-income individuals can take advantage of this workaround to indirectly fund a Roth IRA. This method allows them to benefit from all the advantages that Roth IRAs provide, including tax-free growth and tax-free withdrawals during retirement.

While backdoor Roth conversions are widely discussed, there is an often-overlooked tax credit called the Saver’s Credit, or Retirement Savings Contributions Credit, that can further enhance the benefits of this strategy. The Saver’s Credit is a non-refundable tax credit available to eligible individuals who make contributions to retirement accounts, such as traditional IRAs or Roth IRAs.

The credit is based on a percentage of the individual’s contributions to their retirement accounts, with a maximum credit of $1,000 for single filers and $2,000 for joint filers. The amount of the credit depends on the filer’s income and filing status. For example, a single filer with an adjusted gross income (AGI) of up to $19,500 for the tax year 2022 can claim a credit equal to 50% of their contributions, up to the maximum credit of $1,000. The credit gradually decreases as the income level increases, phasing out completely for single filers with an AGI of $33,000 or more.

Here’s where the backdoor Roth conversion comes into play. When executing a backdoor Roth conversion, an individual can claim the Saver’s Credit on the non-deductible contributions made to the traditional IRA, even though those funds are eventually converted to a Roth IRA. This provides an additional tax benefit that can offset their tax liability and make the backdoor Roth conversion even more advantageous.

To illustrate this, let’s consider an example. Sarah, a single filer, earns $35,000 per year and decides to make a $5,000 non-deductible contribution to a traditional IRA with the intention of converting it to a Roth IRA. She can claim the Saver’s Credit of 10% on her AGI of $35,000, resulting in a $500 credit. This effectively reduces her tax liability by $500, making the backdoor Roth conversion a more financially savvy move.

It is essential to note that the Saver’s Credit has different income thresholds and credit percentages for different filing statuses. The calculations can sometimes be complex, so individuals considering a backdoor Roth conversion should consult with a tax professional to determine if they qualify for the credit and how much they can claim.

In conclusion, a backdoor Roth conversion is an excellent strategy for high-income earners to contribute to a Roth IRA indirectly. However, many individuals overlook the potential tax benefits provided by the Saver’s Credit when executing this strategy. By claiming this often-missed tax credit, individuals can further maximize their tax savings and make the most of their backdoor Roth conversions. Always consult with a tax professional for guidance regarding your specific financial situation and the applicability of the Saver’s Credit.