Want to contribute to a Roth IRA, but have an income that exceeds the limits? There’s another option. It’s called a backdoor Roth IRA, and it’s a way of converting funds from a traditional IRA to a Roth.
A Roth IRA is an individual retirement account that may provide investors with a tax-free income once they reach retirement. With a Roth IRA, investors save after-tax dollars, and their money generally grows tax-free. Roth IRAs also provide additional flexibility for withdrawals — once the account has been open for five years, contributions can generally be withdrawn without penalty.
But there’s a catch: Investors can only contribute to a Roth IRA if their income falls below a specific limit. If your income is too high for a Roth, you may want to consider a backdoor Roth IRA.
What Is a Backdoor Roth IRA?
If you aren’t eligible to contribute to a Roth IRA outright because you make too much, you can do so through a technique called a “backdoor Roth IRA.” This strategy involves contributing money to a traditional IRA and then converting it to a Roth IRA.
The government allows individuals to do this as long as, when they convert the account, they pay income tax on any contributions they previously deducted and any profits made. Unlike a standard Roth IRA, there is no income limit for doing the Roth conversion, nor is there a ceiling to how much can be converted.
How Does a Backdoor IRA Work?
This is how a backdoor IRA typically works: An individual opens a traditional IRA and makes non-deductible contributions. They then convert the account into a Roth IRA. The strategy is generally most helpful to those who earn a higher salary and are otherwise ineligible to contribute to a Roth IRA.
Example Scenario
For instance, let’s say a 34-year-old individual whose tax filing status is single and who makes $150,000 a year wants to open a Roth IRA. Their income is too high for them to be eligible for a Roth directly (more on this below), but they can use the “backdoor IRA” strategy. In order to do this, the individual would open a traditional IRA and contribute non-deductible funds to it. They then convert that money to a Roth IRA.
Income and Contribution Limits
In general, Roth IRAs have income limits. In 2024, a single person whose modified adjusted gross income (MAGI) is more than $161,000, or a married couple filing jointly with a MAGI more than $240,000, cannot contribute to a Roth IRA. For tax year 2023, a single filer whose MAGI is more than $153,000, or a married couple filing jointly with a MAGI over $228,000, cannot contribute to a Roth IRA.
There are also annual contribution limits for Roth IRAs. In 2024, an individual can contribute up to $7,000 in a Roth IRA (or up to $8,000 if they are 50 or older). For tax year 2023, an individual can contribute up to $6,500 in a Roth IRA (or up to $7,500 if they are 50 or older). Traditional IRAs have the same contribution limits as Roth IRAs.
How to Set Up and Execute a Backdoor Roth
Here’s how to initiate and complete a backdoor Roth IRA.
- Open a Traditional IRA. You could do this with SoFi Invest, for instance.
- Make a non-deductible contribution to the Traditional IRA.
- Open a Roth IRA, complete any paperwork that may be required for the conversion, and transfer the money into the Roth IRA.
Tax Impact of a Backdoor Roth
If you made non-deductible contributions to a traditional IRA that you then converted to a Roth IRA, you won’t owe taxes on the money because you’ve already paid taxes on it. However, if you made deductible contributions, you will need to pay taxes on the funds.
In addition, if some time elapsed between contributing to the traditional IRA and converting the money to a Roth IRA, and the contribution earned a profit, you will owe taxes on those earnings.
You might also owe state taxes on a Roth IRA conversion. Be sure to check the tax rules in your area.
Another thing to be aware of: A conversion can also move people into a higher tax bracket, so individuals may consider waiting to do a conversion when their income is lower than usual.
And finally, if an investor already has traditional IRAs, it may create a situation where the tax consequences outweigh the benefits. If an individual has money deducted in any IRA account, including SEP or SIMPLE IRAs, the government will assume a Roth conversion represents a portion or ratio of all the balances. For example, say the individual contributed $5,000 to an IRA that didn’t deduct and another $5,000 to an account that did deduct. If they converted $5,000 to a Roth IRA, the government would consider half of that conversion, or $2,500, taxable.
The tax rules involved with converting an IRA can be complicated. You may want to consult a tax professional.
Is a Backdoor Roth Right for Me?
It depends on your situation. Below are some of the benefits and downsides to a backdoor Roth IRA to help you determine if this strategy might be a good option for you.
Benefits
High earners who don’t qualify to contribute under current Roth IRA rules may opt for a backdoor Roth IRA.
As with a typical Roth IRA, a backdoor Roth may also be a good option when an investor expects their taxes to be lower now than in retirement. Investors who hope to avoid required minimum distributions (RMDs) when they reach age 73 might also consider doing a backdoor Roth.
Downsides
If an individual is eligible to contribute to a Roth IRA, it won’t make sense for them to do a backdoor conversion.
And because a conversion can also move people into a higher tax bracket, you may consider waiting to do a conversion in a year when your income is lower than usual.
For those individuals who already have traditional IRAs, the tax consequences of a backdoor Roth IRA might outweigh the benefits.
Finally, if you plan to use the converted funds within five years, a backdoor Roth may not be the best option. That’s because withdrawals before five years are subject to income tax and a 10% penalty.
Is a Backdoor Roth Still Allowed for 2023? For 2024?
Backdoor IRAs are still allowed for tax year 2023. And at this point, they are still allowed for 2024 as well.
There had been some discussion in previous years of possibly eliminating the backdoor Roth IRA, but as of yet, this has not happened.
The Takeaway
A backdoor Roth IRA may be worth considering if tax-free income during retirement is part of an investor’s financial plan, and the individual earns too much to contribute directly to a Roth.
In general, Roth IRAs may be a good option for younger investors who have low tax rates and people with a high income looking to reduce tax bills in retirement.
This article originally appeared on SoFi.com and was syndicated by MediaFeed.org.
Third-Party Brand Mentions: No brands, products, or companies mentioned are affiliated with SoFi, nor do they endorse or sponsor this article. Third-party trademarks referenced herein are property of their respective owners.
Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.
Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.
SoFi Invest®
INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE
SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below: Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.
Investment Risk: Diversification can help reduce some investment risk. It cannot guarantee profit, or fully protect in a down market.
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IRA Deduction and Contribution Limits For Taxes: Everything You Need Need to Know
Broadly speaking, individual retirement accounts, or IRAs, offer some sort of tax benefit — either during the year that contributions are made or when distributions take place after retiring. But not all retirement accounts are taxed the same.
With a traditional IRA, it’s possible for certain individuals to both invest for their future and reduce their present tax liability. For tax year 2023, the maximum IRA deduction is $6,500 for individuals younger than 50, and $7,500 for those 50 and older. For tax year 2024, the maximum IRA deduction is $7,000 for people younger than 50, and $8,000 for those 50 and older.
To maximize deductions in a given year, the first step is understanding how IRA tax deductions work. A good place to start is learning the differences between common retirement accounts — and their taxation. And since each financial situation is different, an individual may also want to speak with a tax professional about their specific situation.
Read on to learn more about IRA tax deductions, including how both traditional and Roth IRA accounts are taxed in the U.S.
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First, here’s a quick refresher on tax deductions for income taxes — the tax owed/paid on a person’s paycheck, bonuses, tips, and any other wages earned through work. “Taxable income” also includes interest earned on bank accounts and some types of investments.
Tax deductions are subtracted from a person’s total taxable income. After deductions, taxes are paid on the amount of taxable income that remains. Eligible deductions can allow qualifying individuals to reduce their overall tax liability to the Internal Revenue Service (IRS).
For example, Person X earns $70,000 per year. They qualify for a total of $10,000 in income tax deductions. When calculating their income tax liability, the allowable deductions would be subtracted from their income — leaving $60,000 in taxable income. Person X then would need to pay income taxes on the remaining $60,000 — not the $70,000 in income that they originally earned.
For the 2023 tax year, 22% is the highest federal income tax rate for a person earning $70,000. By deducting $10,000 from their taxable income, they are able to lower their federal total tax bill by $2,200, which is 22% of the $10,000 deduction. (There may be additional state income tax deductions.)
A tax deduction is not the same as a tax credit. Tax credits provide a dollar-for-dollar reduction on a person’s actual tax bill — not their taxable income. For example, a $3,000 tax credit would eliminate $3,000 in taxes owed.
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Traditional IRA tax deductions are quite simple. If a qualifying individual under age 50 contributes the maximum allowed to a traditional IRA in a year — $6,500 for the 2023 tax year and $7,000 for the 2023 tax year — they can deduct the full amount of their contribution from their taxable income.
That said, you are not eligible to claim your IRA deduction if you are:
- Single and covered by a workplace retirement account and your modified adjusted gross income (MAGI) is more than $83,000 for tax year 2023 ($87,000 or more for tax year 2024)
- Married filing jointly and covered by a work 401(k) plan and your MAGI is more than $136,000 for tax year 2023 ( more than $143,000 for tax year 2024)
- Married, only your spouse is covered by a work 401(k) plan, and your MAGI is more than $228,000 for tax year 2023 ($240,000 or more for tax year 2024).
It’s worth noting that you may claim a partial deduction, depending on your income if you are:
- Single and covered by a workplace retirement account and your adjusted gross income is more than $73,000 and less than $83,000 for tax year 2023 (more than $77,000 and less than $87,000 for tax year 2024)
- Married filing jointly and covered by a work 401(k) plan and your MAGI is more than $116,000 and less than $136,000 for tax year 2023 (more than $123,000 and less than $143,000 for tax year 2024)
- Married, only your spouse is covered by a work 401(k) plan, and your MAGI is more than $218,000 and less than $228,000 for tax year 2023 (more than $230,000 and less than $240,000 for tax year 2024).
401(k), 403(b), and other non-Roth workplace retirement plans work in a similar way (contributions to Roth IRAs are not tax deductible). For the 2023 tax year, the contribution maximum for a 401(k) is $22,500 with an additional $7,500 catchup contribution for employees 50 and older. For tax year 2024, the contribution maximum is $23,000 with an additional $7,500 catchup contribution for employees 50 and older. A person under 50 who contributes the full amount in 2023 could then deduct $22,500 from their taxable income ($23,000 in 2024), potentially lowering their tax bracket.
One common source of confusion: The tax deduction for an IRA will reduce the amount a person owes in federal and state income taxes, but will not circumvent payroll taxes, which fund Social Security and Medicare. Also known as Federal Insurance Contributions Act (FICA) taxes, these are assessed on a person’s gross income. Both the employer and the employee pay FICA taxes at a rate of 7.65% each.
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Traditional IRA, 401(k), and other non-Roth retirement accounts are deemed “tax-deferred.” Money that enters into one of these accounts is deducted from an eligible person’s total income tax bill. In this way, qualifying individuals do not pay income taxes on that invested income until later.
Because these taxes are simply deferred until a later time, the money in the account is usually taxed when it’s withdrawn.
Here’s an example of this: Having reached retirement age, a person chooses to withdraw $30,000 per year from a traditional IRA plan. As far as the IRS is concerned, this withdrawal is taxable income. The traditional IRA money will be taxed as the income.
So, what’s the point of deferring taxes? Generally speaking, people may be in a higher marginal tax bracket as a working person than they are as a retired person. Therefore, the idea is to defer taxes until a time when an individual may pay proportionally less in taxes.
Tax Brackets and IRA Deductions
Income tax brackets can work in a stair-step fashion. Each bracket reveals what a person owes at that level of income. Still, when a person is “in” a certain tax bracket, they do not pay that tax rate on their entire income.
For instance, in 2023, single filers pay a 12% federal income tax rate for the income earned between $11,001 and $44,725. Then, the tax rate “steps up,” and they pay a 22% tax on the income earned that falls in the range of $44,726 and $95,375. Even if a person is a high-earner and “in” the 37% tax bracket, they still pay the lower rates on their lower levels of income.
Why is this worth noting? Because tax deductions reduce a person’s taxable income at their highest marginal rate (their highest “stair-step”). Using 2023 tax rates, a person with $70,000 in taxable income would be taxed like this:
- 10% up to $11,000 ($59,000 remaining)
- 12% up to $44,725 ($14,275 remaining)
- 22% on the remaining $14,275
However, if that same person contributes the maximum to their tax-deferred retirement account, they would be taxed 22% on the top amount minus what’s deductible. In other words, they wouldn’t be taxed 22% on the full $14,275.
401(k) Withdrawals and Taxation
Now, let’s compare that with the taxation on a $30,000 withdrawal from a 401(k). Assuming 2023 income tax rates, a $12,000 withdrawal would be taxed at a 10% rate up to $11,000 and then a 12% rate for the remaining $19,000.
Taxes are assessed at a person’s “effective,” or average, tax rate. This is another reason that some folks prefer to defer their taxes until later, when they can pay a hypothetically lower effective tax rate on their withdrawals, rather than taxes at their highest marginal rate.
But, here’s why it’s not so simple: All of the above assumes that income tax rates remain the same over time. And, income tax rates (and eligible deductions) can change with federal legislation.
Still, plenty of earners opt to reduce their tax bill at their highest rate in the current year — and a tax deduction via an eligible retirement contribution can do just that.
For individual tax questions, it’s a good idea to consult a tax professional with questions about specific scenarios.
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Simply put, there are no tax deductions for Roth retirement accounts. Both Roth IRA and Roth 401(k) account contributions are not tax-deductible.
The trade-off is that Roth money is not taxed when it is withdrawn in retirement, as is the case with tax-deferred accounts like a 401(k) and traditional IRA. In fact, this is the primary difference between Roth and non-Roth retirement accounts. With Roth accounts, taxes are already paid on money that is contributed, whereas income taxes on a non-Roth 401k are deferred until later.
So, then, what are some advantages of a Roth retirement account? All retirement accounts provide an additional type of tax benefit as compared to a non-retirement investment account: There are no taxes on interest or capital gains, which is money earned via the sale of an investment.
Someone might choose a Roth over a tax-deferred retirement account because they prefer to pay the income taxes up front, instead of in retirement. For example, imagine a person who earned $30,000 this year. They pay a relatively low income tax rate, so they simply may prefer to pay the income taxes now. That way, the taxes are potentially less of a burden come retirement age.
Not everyone qualifies for a Roth IRA. There are limits to how much a person can earn. For a single filer, the ability to contribute to a Roth IRA for tax year 2023 begins to phase out when a person earns more than $138,00 ($146,000 for tax year 2024), and is completely phased out at an income level of $153,000 in 2023 ($161,000 for tax year 2024). For a person that is married and filing jointly, the phase-out begins at $218,000 in 2023 ($230,000 for tax year 2024), ending at $228,000 in 2023 ($240,000 for 2024).
designer491/istockphoto
The maximum amount a person is able to deduct from their taxes by contributing to a retirement account may correspond to an account’s contribution limits.
Here’s how much money can be put into an IRA for the 2023 tax year:
- Traditional IRA: $6,500 ($7,500 if age 50 or older), deductibility depends on whether the person is covered by a workplace retirement plan
- 401(k): $22,500 (additional $7,500 if age 50 or older)
- 403(b): $22,500 (additional $7,500 if age 50 or older)
- 457(b): $22,500 (additional $7,500 if age 50 or older)
- Thrift Savings Plan (TSP): $22,500 (additional $7,500 if age 50 or older)
- Simple IRA or 401(K): $15,500 (additional $3,500 if age 50 or older)
- SEP IRA: The lower of 25% of an employee’s income, or $66,000
- Solo 401(k): Either $22,500 or up to 100% of total earned income as employee, additional opportunity to contribute as the employer
Here are the maximum contributions for the 2024 tax year:
- Traditional IRA: $7,000 ($8,000 if age 50 or older), deductibility depends on whether the person is covered by a workplace retirement plan
- 401(k): $23,000 (additional $7,500 if age 50 or older)
- 403(b): $23,000 (additional $7,500 if age 50 or older)
- 457(b): $23,000 (additional $7,500 if age 50 or older)
- Thrift Savings Plan (TSP): $23,000 (additional $7,500 if age 50 or older)
- SEP IRA: The lower of 25% of an employee’s income, or $69,000
- Simple IRA or 401(K): $16,000 (additional $3,500 if age 50 or older)
The above lists are only meant as a guide and do not take into account all factors that could impact contribution or deduction limits — such as catch-up contributions. Anyone with questions about what accounts they qualify for should consult a tax professional.
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Different types of retirement accounts come with distinct tax benefits and, for eligible investors, IRA tax deductions. Opening a retirement account and contributing to certain tax-deferred accounts may affect how much a person owes in income taxes in a given year. Roth accounts may provide tax-free withdrawals later on.
This article originally appeared on SoFi.com and was syndicated by MediaFeed.org.
Third-Party Brand Mentions: No brands, products, or companies mentioned are affiliated with SoFi, nor do they endorse or sponsor this article. Third-party trademarks referenced herein are property of their respective owners.
Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.
Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.
SoFi Invest®
INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE
SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below: Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.
Disclaimer: The projections or other information regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results.
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