As a high-income earner, you're likely familiar with the restrictions on contributing to a Roth IRA due to income limits. But did you know there's a way to bypass these restrictions legally? Enter the Backdoor Roth IRA, a tax-efficient strategy designed to help high-income earners like you take full advantage of tax-free growth in retirement.

In this article, we’ll walk you through the key steps of executing a Backdoor Roth, outline common pitfalls, and provide insights on how to ensure your conversion goes smoothly. At LA Wealth Management, we frequently help clients in partnership with their CPA to navigate this process to optimize their retirement savings.

Step-by-Step: How to Execute a Backdoor Roth IRA

1. Confirm Eligibility

Ensure that your income exceeds the Roth IRA contribution limits and that you or your spouse has earned income for the tax year. In 2024, the income phase-out for Roth IRA contributions is between $218,000 and $228,000 for married couples filing jointly.

2. Make a Non-Deductible Contribution to a Traditional IRA

Open a Traditional IRA, if you don't already have one, and make a non-deductible contribution. The contribution limit for 2024 is $6,500 if you are under 50, and $7,500 if you are over 50.

Tax Form Tip: This contribution should not be deducted on your tax return. On your Form 1040, Schedule 1, make sure that line 20 remains blank. This line is used for deductible IRA contributions, and a Backdoor Roth contribution is non-deductible.

3. Convert the Contribution to a Roth IRA

Once the contribution is made, promptly convert the funds from the traditional IRA to a Roth IRA. The sooner you do this, the better, as any growth in the traditional IRA between the contribution and conversion could be taxable.

Tax Form Tip: The conversion is reported on Form 8606, Part II. This form is essential to ensure that the IRS understands that your conversion is not fully taxable. Lines 16 and 17 of the 8606 report the full amount of the backdoor Roth conversion. If you follow the steps properly, the taxable amount will be $0 on Form 1040, Line 4b.

8686 part 1:

1040 line 4:

4. Avoid the Pro-Rata Rule

If you have other pre-tax IRA balances, such as a traditional, SEP, or SIMPLE IRA, the IRS applies the Pro-Rata rule. This means that the proportion of the conversion that is taxable will be based on the ratio of pre-tax to post-tax IRA balances.

Tax Form Tip: Form 8606, Lines 6-12 handle the reporting of pre-tax balances if the Pro-Rata rule applies. To avoid a larger tax bill, consider rolling existing pre-tax IRAs into an employer-sponsored 401(k) before performing the backdoor Roth conversion. 

Why You Need a Professional to Help You Through This Process

While the Backdoor Roth IRA is a powerful strategy, it involves several complex tax considerations and reporting requirements. Making even a small mistake, such as mishandling the conversion timing or misreporting the contribution on your tax forms, can lead to costly tax penalties or additional liabilities.

Here’s where it gets tricky:

• Pro-Rata Rule Confusion: If you have other pre-tax IRA accounts, the IRS Pro-Rata rule can complicate how much of your conversion is taxable. Without the right guidance, you might end up with an unexpected tax bill.

• Form 8606 Reporting: Filing Form 8606 correctly is essential for ensuring that your non-deductible contributions and conversions are reported properly. Missing or incorrect information can trigger IRS audits or tax liabilities.

• Custodian Reporting Issues: Many custodians do not clearly indicate that a conversion was a Backdoor Roth IRA on the Form 1099-R they send to the IRS. This can confuse tax preparers, especially if they’re unfamiliar with the process.

That’s why it’s best to work closely with both a professional tax preparer and your financial advisor. At LA Wealth Management, we help clients coordinate with their tax preparers to ensure every step is handled correctly and reported properly on the necessary tax forms. Your financial advisor can also help you understand the timing and amount of the conversion to maximize the benefits while minimizing any potential tax impact.

Why a Backdoor Roth IRA is Worth It for High-Income Earners

There are several key reasons why a Backdoor Roth IRA can be a valuable part of your retirement strategy:

• Tax-Free Growth: Once in a Roth IRA, your investments grow tax-free, and qualified withdrawals in retirement are also tax-free.

• No Required Minimum Distributions (RMDs): Unlike traditional IRAs, Roth IRAs are not subject to RMDs during the account owner’s lifetime, allowing your money to grow longer and pass on tax-free to heirs.

• Tax Diversification: Having a mix of tax-deferred and tax-free retirement accounts can give you more flexibility in managing taxes during retirement.

Final Thoughts

For high-income earners, the Backdoor Roth IRA is a valuable tool to maximize tax-free growth and diversify retirement savings. However, as with any financial strategy, careful planning and attention to detail are critical. Given the complexity of this process, we strongly recommend working with both a tax professional and your financial advisor to ensure that the Backdoor Roth conversion is executed correctly and reported properly on your tax return.

At LA Wealth Management, we’re here to help guide you through the process, ensuring your financial future is on the right path. If you’re considering a Backdoor Roth IRA or want to explore how it fits into your overall financial plan, reach out to us today for personalized advice.

Securities and Advisory services offered through GWN Securities, Inc., Member FINRA/SIPC, a Registered Investment Advisor. 11440 N. Jog Road, Palm Beach Gardens, FL 33418. (561) 472-2700. LA Wealth Management and GWN Securities, Inc. are separate companies.

Asset allocation and diversification do not guarantee a profit or protect against a loss in a declining market.

Information provided should not be considered as tax advice from GWN Securities, Inc. or it's representatives. Please consult with your tax professional.

A distribution from a Roth IRA is tax-free and penalty-free provided that the five-year aging requirement has been satisfied and one of the following conditions is met: age 59 1/2, death, disability