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The backdoor Roth IRA: How to make it work for fou

The Roth IRA can offer some very unique tax advantages, but the gripe many people will have is, “I make too much money.”. If you are Single and make over $125k, Married Filing Jointly and over $198k, or Married Filing Separately and over just $10k, you may not be able to contribute. If your company offers a 401(k), they likely now have a Roth contribution option to go along with the traditional pre-tax method.



If you follow any of my writing or listen to The Kuderna Podcast, you have probably heard me say, “Investing is like a stool with three legs:  Market Risk, Liquidity, and Taxes”.  It bears worth repeating, as each one of these factors could either wreak havoc or greatly enhance your overall financial plan at a given point in time.  In the unforgiving world of finance, not knowing is not an excuse.  Each of these three metrics is present in every investment decision and it’s on you to know how to score it.  Today, we will focus on taxes.

There are ultimately three different forms of taxability when you put your money to work:  taxable, tax-deferred, and tax-free.  What does that mean?  Well, taxable essentially means your account or investment is taxed as you go.  These are the types of accounts that could generate a Form 1099 for you every year, disclosing investment income such as interest, dividends, and/or capital gains.  At the time of this writing, 2021, Qualified Dividends are taxed as long-term capital gains, traditionally more favorable than ordinary income tax rates.  Most interest is taxed as ordinary income, with some exceptions like municipal bond interest.  In regard to the actual buying and selling of investments, assets held for over 12 months receive the preferential long-term capital gains rate which peaks at 20%, whereas gains on assets held for less than 12 months are taxed as ordinary income.  These vehicles usually offer a higher level of liquidity (ability to access money), but as one could tell, paying taxes every year can chew away at any progress.

The second category of tax-deferred lives up to its name.  These are vehicles that defer or postpone the eventual tax liability.  Please note, it is deferred, not eliminated or saved, as can be often misquoted.  The most common incidence is in that of a Traditional 401(k), Individual Retirement Account (IRA), or similar “pre-tax” retirement account.  In these scenarios, contributions evade current income tax, but as the investments compound, so does the future unknown tax liability.  There are also liquidity restrictions present that can affect another leg of the investing stool, but we’ll defer that conversation unto another day.  Non-Qualified Annuities offer another method to take “post-tax” investments and defer taxes until a future time.  The caveat is, no one can accurately predict tax rates in an upcoming administration, let alone rates possibly decades away in retirement.

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The third major form of taxability is tax-free.  These are “post-tax” investments [except maybe in the case of a Health Savings Account (HSA)], in which principle and gains can be withdrawn without tax consequence, so long as abiding by certain restrictions.  Some popular vehicles in this category could be 529 Plans, Cash Value Life Insurance such as Whole Life, or Roth IRA’s.  Many investors may appreciate the idea of eliminating one of the biggest future unknowns of taxes, the luxury of looking at a statement in retirement and saying, “That number is all mine.”.  Whereas previously mentioned, several other account balances may still have Uncle Sam waiting for his share.

To the point of this article, the Roth IRA can offer some very unique tax advantages, but the gripe many people will have is, “I make too much money.”.  If you are Single and make over $125k, Married Filing Jointly and over $198k, or Married Filing Separately and over just $10k, you may not be able to contribute.  Now, before calling your congressman to complain, realize that if your company offers a 401(k), they likely now have a Roth contribution option to go along with the traditional pre-tax method, there are NO income limits on Roth contributions to workplace retirement plans!

But, if the Roth 401(k) is not an option, or you just want to put away even more money to grow tax-free, and you are making too much money for the Roth IRA, enter the “backdoor Roth IRA”.  This is not an actual type of account, but rather an IRS-sanctioned strategy for high-earners.  The process involves making a non-deductible contribution to a Traditional IRA (filing Form 8606), and then converting that balance into a Roth IRA.  The opportunity exists because there is no income limit for non-deductible contributions and no income limit for Roth Conversions.  Investors need to be extra careful if there have been any gains on that original non-deductible contribution, as those gains will be taxed on the way over, or if they have multiple IRA’s.  The IRS uses a pro-rata rule which essentially says you can’t cherry-pick the after-tax money out of your IRA to convert, but rather a portion of all pre-tax monies will be assumed to have been converted, triggering a tax consequence on the way over. Therefore, the simplest method involves having one Traditional IRA and one Roth IRA, making one annual non-deductible contribution to the Traditional IRA and converting it before any gains or interest accrue.

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It might seem like a headache, and it might sound like a lot of legwork to get the same outcome as your friend making less than the income limits, but these are the rules.  As you focus on each leg of the investment stool, a Roth IRA, or a backdoor Roth IRA, might be something to consider.

(Featured image by Karolina Grabowska via Pexels)

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Bryan M. Kuderna, CFP®, RICP®, LUTCF is the host of The Kuderna Podcast (available on all podcast apps or at, author of Millennial Millionaire, and founder of Kuderna Financial Team, a NJ-based financial services firm.