If your annual income excludes you from being able to utilize the tax-code benefits of a Roth IRA, you may be a good candidate for a Backdoor Roth IRA. This is the coined name for the strategy of funding a Roth IRA, specially designed for tax-payers subject to the restrictions that prevent high-income earners from contributing to a Roth IRA in a traditional manner.

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As we all know, there are several tax-advantaged retirement saving options available in the United States, contributing to which can help people prepare for a comfortable retired life. One such option, the Roth IRA, has become increasingly popular in recent years. However, many people are unaware of a lesser-known method to contribute to Roth IRAs, known as the Backdoor Roth IRA, which may provide additional advantages for some people.

Generally, high-income earners are ineligible to contribute directly to a Roth IRA, as their income exceeds the threshold defined by the Internal Revenue Service (IRS). However, there is a loophole in the tax code that allows individuals to convert traditional IRA contributions made with after-tax dollars to a Roth IRA, irrespective of their income level. This process is known as a Backdoor Roth IRA contribution.

To illustrate, consider someone as an unmarried individual with an adjusted gross income exceeding $139,000, or as a married couple filing jointly with an income above $206,000, would usually be unable to contribute directly to a Roth IRA. But if they were to make a non-deductible contribution to a traditional IRA account, they could then convert that account to a Roth IRA, allowing them to make a Backdoor Roth IRA contribution.

One of the advantages of a Backdoor Roth IRA contribution is that Roth IRAs grow tax-free and allow for tax-free withdrawals later in life. By contributing to a Roth IRA using a Backdoor contribution, an individual can still enjoy the benefits of a Roth IRA while potentially avoiding higher taxes later in life. For example, if an individual expects their income or tax rate may rise in the future, they can choose to contribute to a Roth IRA via Backdoor contributions, allowing them to withdraw funds from the Roth IRA tax-free at a later date.

However, there are some caveats to consider when it comes to Backdoor Roth IRA contributions. For one, individuals should already have a traditional IRA account set up to take advantage of this strategy. If an individual has other traditional IRA accounts that have pre-tax dollars, any conversion from the traditional IRA to a Roth IRA via Backdoor will be subject to the pro-rata rule, meaning taxes will be applied to the converted funds. As such, individuals considering a Backdoor Roth IRA contribution should be aware of this rule and consult with a financial advisor or tax professional for guidance on whether this strategy is the best option for their individual situation.

At Voisard Asset Management, we specialize in providing personalized financial guidance to clients, including advice on the benefits of Backdoor Roth IRA contributions. We work with our clients to identify the best strategies for their individual financial goals, and help them make informed decisions that support their long-term financial health.