Why High Earners Get Locked Out of Regular Roth Contributions
A common characteristic of high-income earners is that they are frequently looking for additional ways to put money away for retirement in tax-advantaged accounts. The question comes up often: we want to maximize what we are putting into a Roth IRA or Roth 401(k), so what are our options?
One thing people are sometimes unaware of is that if you make too much money in a calendar year, you may be prohibited from making a regular Roth IRA contribution. That is where the backdoor Roth concept can be very useful.
How a Backdoor Roth Contribution Works
A backdoor Roth is a two-step process. You make a non-deductible contribution to a traditional IRA, and then you convert that money over to a Roth IRA. The end result is money sitting in a Roth account, even though you were not eligible to contribute there directly.
What is critical in exploring this concept is knowing the specific steps you need to take in order to do it properly. Filing the right paperwork and tracking the basis of your non-deductible contribution matter, because mistakes here can create tax headaches later.
Watch Out for the Pro-Rata Rule
Another item that people are not aware of when it comes to this process: if you have money in any IRA that is pre-tax and has not been taxed yet, and you go through with a Roth conversion, you may trigger additional taxes through something called the pro-rata rule.
Before going ahead with a backdoor Roth contribution, it is important to coordinate with your accountant. What IRAs do you currently have? Is there any pre-tax money inside those accounts? Answering those questions up front will tell you whether the pro-rata rule will change the math on a conversion.
The Mega Backdoor Roth for 401(k) Savers
A second bucket that can be helpful for people looking to put more into a Roth account is the mega backdoor Roth. This strategy lets you put money into an after-tax account above and beyond the regular 401(k) contribution limits, and then move those dollars into a Roth, so you can stack as much as possible into an after-tax retirement account as you head toward retirement.
Does Your Employer’s Plan Allow It?
A few things need to line up before this works. First, if you are working for an employer, their plan may not allow for after-tax contributions. These are different from Roth contributions inside a 401(k), so it is important to confirm with your employer whether the plan permits them.
Second, you need to have enough W-2 income to make after-tax contributions above and beyond the typical maximum contribution limits in a 401(k). Without the earned income to support it, the strategy does not get off the ground.
Coordinate With Your Accountant Before You Act
It is important to circle back with your accountant and walk through the picture: here are the things I am thinking about, whether that is a backdoor Roth contribution or a mega backdoor Roth contribution. How is this going to affect my tax plan for the year? And is it going to be a good fit for me long term?
Both strategies can be powerful tools for high earners, but the details matter. A short conversation before you contribute or convert is usually the difference between a clean execution and an unexpected tax bill.
