Welcome to inDinero’s Pot of Gold. In this series, you’ll learn quick, actionable tips to protect and build your company’s capital and personal finances. Whether your “pot of gold” is figurative or literal, these tactics will better enable you to maximize your wealth.
Today we’re looking at how taxpayers can maximize their retirement savings through a handy accounting maneuver known as the “backdoor Roth.”
Know Your Retirement Basics: IRA vs. 401(k), Traditional vs. Roth
The more money you save now, the better off you’ll be later… Right?
If only retirement were so simple. When you contribute to a 401(k), individual retirement account (IRA), or another retirement vehicle, the IRS expects you to pay taxes on the money you put away. The difference between a traditional retirement plan and a Roth account lies in the timing of those tax payments.
In a traditional 401(k) or IRA, you save now and pay later. More precisely, you deduct your contributions from your taxable income when you make those contributions. This means you avoid tax liability upfront, but need to hand over a big chunk to the IRS when you retire.
A Roth account flips the equation: you pay now and save later. Your contributions are taxed at the current tax rate, but you can withdraw everything tax-free when you retire.
For more information about the differences between retirement plans, read our article on the topic.
You Can’t Put Everything Away Now
Complicating matters further is the fact that the IRS limits how much you can contribute to a retirement account in a given year. If your income is above a certain level, you may be allowed to contribute only a reduced amount or nothing at all.
This is one reason some business owners participate in multiple retirement plans at once—for example, an IRA in conjunction with a one-participant 401(k). These limits are different for different kinds of plans and change every year.
To learn how much you’re allowed to contribute to your retirement plan in the current tax year, contact us.
Over the Limit? Enter the Backdoor Roth
High earner? Don’t let that stop you from maximizing your future wealth. Even if your income exceeds the eligibility limit, you can still contribute money to an IRA. This is one of the few examples of a true loophole in US tax law. It’s also relatively simple, provided you have a financial professional helping you out.
The strategy, known as a “backdoor Roth conversion,” involves two steps:
1. Make a non-deductible contribution to a traditional IRA and document the deposit on IRS Form 8606. Limits apply—check this IRS page for the maximum allowed contribution.
2. Process the conversion of the after-tax traditional IRA contribution to a Roth IRA.
Voila—you’ve managed to “sneak” a few thousand through the backdoor into your Roth IRA. Repeat these steps every year and you can build up some sizable tax-free retirement savings.
Okay, there are a couple of caveats. While the opportunity to circumvent the Roth IRA income eligibility limits may seem appealing, be aware that a backdoor Roth conversion may only be tax-free if you don’t have any other pre-tax traditional IRA money (including funds from rollover IRAs). If you do have other pre-tax IRA money, the conversion may be subject to pro-rata taxation.
Also, be aware that slightly different rules apply to conversions versus contributions.
Unless you’re an accountant, a backdoor Roth IRA conversion is one of those things you probably shouldn’t try yourself. An experienced tax and accounting partner can help with this and other tax savings strategies. Ask us about saving money on retirement.