I'm Married And We Earn $250,000 Per Year Combined — This Exceeds The Roth IRA Limit But Can We Still Contribute Using A Backdoor Roth?

Married and finding yourself in the frustrating position of earning above the Roth IRA limit? Don’t worry, you’re not alone. Many people encounter this obstacle when seeking to maximize their retirement savings. The good news is that there’s a strategy known as the backdoor Roth IRA that could provide a solution. This approach allows high-income earners to make contributions to a Roth IRA, regardless of income limitations.

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Traditional Vs. Roth IRAs

Individual retirement accounts (IRAs) are designed to help people save for retirement. They offer tax advantages to encourage that behavior. A Traditional IRA gives taxpayers a reduction in their taxes in the year they contribute; a Roth IRA offers tax benefits in the future when the taxpayer is ready to withdraw the money. For example, if you contribute $1,000 to an IRA in 2024, you don't pay tax on that money in 2024, but when you withdraw in the future, it gets added to your taxable income in the future year. If you contribute $1,000 to a Roth IRA in 2024, you don't get a tax deduction in 2024, but when you withdraw that already-taxed money in the future, you don't have to add it to your taxable income that year.

 Here's a simple example.

*Not all of your Social Security may be subject to taxes, but in this simple example to show the difference between types of IRAs, let's assume it will.

To make the Roth deal even sweeter is the fact that the money you make in your investments isn't taxable when you withdraw — pretty much the only no-tax income a taxpayer can get away with. In the example above, if you invest in the stock market and that $1,000 turns into $5,000 and you withdraw it, you don't have to pay any tax on the $4,000 you earned over the years.

So why doesn't everyone contribute as much as they can to a Roth all the time? Roth IRA contributions are subject to maximum contribution limits and income limits. Also, you might benefit more from an actual tax deduction right now than you would from a tax deduction a hypothetical 25 years from now, when you might not be alive, earning as much in retirement as you are as a working person or having made money over the years in your investments. 

Understanding The Backdoor Roth IRA

So what if you have money in a Traditional IRA that you wish you had in a Roth because you expect to do well in the stock market in the future and think you'll be collecting high Social Security amounts, withdrawing from your substantial retirement funds and maybe enjoying a military or other pension? You could consider recharacterizing the money in a Traditional IRA to a Roth — known as a backdoor Roth.

The backdoor Roth IRA is not an official type of retirement account but a strategy that allows high-income earners to sidestep income limits for Roth IRA contributions. It involves converting Traditional IRA funds to a Roth IRA.

Consider the case of Kelly and Tim, a married couple filing jointly. With a combined annual income of $250,000, they exceed the Roth IRA income limits for 2024. Eager to take advantage of the tax-free growth offered by a Roth IRA, they explore the backdoor Roth IRA strategy.

Key Considerations For Married Couples

Income limits: In 2024, the income thresholds for Roth IRA contributions for married couples filing jointly have seen an upward adjustment. Couples with a modified adjusted gross income (MAGI) below $230,000 are eligible to make full contributions to a Roth IRA, up to the specified annual limit. As the MAGI increases to the range of $230,000 to $240,000, the eligibility for contributions begins to phase out, with the contribution limit decreasing progressively. However, for those whose MAGI exceeds $240,000, the opportunity for direct contributions to a Roth IRA is no longer available.

For couples like Kelly and Tim, whose combined income surpasses this upper limit, an alternative strategy comes into play: the backdoor Roth IRA. This approach allows them to circumvent the direct contribution limits, thereby providing a pathway to continue their retirement savings in a tax-efficient manner, despite their higher income bracket​.

Contribution limits: The standard IRA contribution limits still apply — $7,000 per person, or $8,000 if over 50. Even though Kelly and Tim’s income exceeds the direct Roth IRA contribution limit, they can still contribute to a Traditional IRA and then convert it to a Roth IRA, allowing them to take advantage of the tax-free growth potential of a Roth IRA.

Pro-rata rule: It’s important for Kelly and Tim to consider the pro-rata rule, especially if either of them has existing pretax dollars in a Traditional IRA. This rule could result in unexpected tax liabilities during the conversion process, so they should carefully evaluate their individual financial situations before proceeding with the backdoor Roth IRA strategy.

Separate accounts: To execute the backdoor Roth IRA strategy effectively, each spouse must have their own Traditional IRA to make nondeductible contributions before converting to their respective Roth IRAs. This ensures that the conversion process complies with the tax regulations and maximizes the benefits of the strategy for both individuals.

Executing The Backdoor Roth IRA

When executing the backdoor Roth IRA strategy, there are several crucial steps and considerations to ensure the process is effective and compliant with IRS regulations.

If you already have money in a Traditional IRA and want to convert it to a Roth, you'd follow these steps from the IRS:

Rollover: You receive a distribution from a traditional IRA and contribute it to a Roth IRA within 60 days after the distribution (the distribution check is payable to you).

Trustee-to-trustee transfer: You tell the financial institution holding your traditional IRA assets to transfer an amount directly to the trustee of your Roth IRA at a different financial institution (the distributing trustee may achieve this by issuing you a check payable to the new trustee).

Same trustee transfer: If your Traditional and Roth IRAs are maintained at the same financial institution, you can tell the trustee to transfer an amount from your Traditional IRA to your Roth IRA.

A conversion to a Roth IRA results in taxation of any untaxed amounts in the Traditional IRA. The conversion is reported on Form 8606, Nondeductible IRAs. 

If you are just starting the Roth IRA process because you're a high earner like Kelly and Tim, you'd follow these steps.

Initially, Kelly and Tim each open a Traditional IRA account. This is the first step in the process, where they will make their contributions.

Each of them contributes $7,000 — the maximum annual contribution limit for their age group in 2024 — to their respective Traditional IRAs. These contributions are nondeductible, meaning they don’t get a tax deduction for these contributions. This step is critical because their income level disqualifies them from making deductible contributions.

Subsequently, Kelly and Tim convert the entire balance from their Traditional IRAs to their Roth IRAs. It's generally recommended to do this step shortly after the contribution to minimize any earnings that could be taxable during the conversion.

Because their contributions to the Traditional IRAs are nondeductible, they don't face taxes on the contribution amount during the conversion. However, if there are any earnings in the Traditional IRA between the time of contribution and conversion, those earnings would be subject to income tax.

An essential aspect of their strategy is that they do not have any previous balances in their Traditional IRAs. This absence of pretax dollars in their IRAs is advantageous because it prevents the pro-rata rule from applying. The pro-rata rule could otherwise lead to a significant tax liability, as it requires a proportionate conversion of both pretax and after-tax dollars, resulting in taxes on the pretax portion.

They must report the nondeductible contributions and the conversion to a Roth IRA on their tax returns. This is done using Form 8606, which helps in tracking the basis of their IRAs to prevent double taxation in the future.

Benefits And Drawbacks

The primary benefit of this strategy is the ability to grow their retirement savings tax-free, despite their high income. However, it's important to be cautious about the timing of the conversion and any existing Traditional IRA funds to avoid unexpected tax implications.

Consulting An Expert

Given the complexities of the backdoor Roth IRA strategy, financial advisers and tax professionals become indispensable. These experts provide personalized financial advice tailored to an individual’s overall financial situation, retirement goals and other investment considerations. They are adept at navigating intricate tax laws and can offer strategies to minimize tax liabilities, ensuring that the backdoor Roth IRA strategy is executed in the most tax-efficient manner.

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Jeannine Mancini has written about personal finance and investment for the past 13 years in a variety of publications including Zacks, The Nest and eHow. She is not a licensed financial adviser and the content herein is for information purposes only and is not, and does not constitute or intend to constitute, investment advice or any investment service. While Mancini believes that the information contained herein is reliable and derived from reliable sources, there is no representation, warranty or undertaking, stated or implied, as to the accuracy or completeness of the information.