Build Tax Free Wealth with Back Door Roth Strategy

Wealth Advisor

Ben Ruttenberg elaborates on the concept of a backdoor Roth IRA, a strategy that allows individuals whose incomes exceed the limits for direct Roth IRA contributions to still benefit from a Roth’s tax-free growth. He outlines the income thresholds for Roth IRA contributions in 2024 and explains that individuals or couples with higher incomes can first contribute to a traditional IRA, which has no income limits, and then convert these funds to a Roth IRA, essentially bypassing income restrictions. This extra step enables the funds to grow and be withdrawn tax-free under certain conditions. Ruttenberg also addresses the aggregation rule, a potential complication for those with existing traditional IRA balances, explaining that the entire balance must be considered during the conversion, which could result in unexpected tax implications. He advises strategies to mitigate this issue, such as rolling the traditional IRA balance into a pretax 401(k) or converting the entire traditional IRA balance to Roth, and recommends consulting a financial advisor to navigate this complex process effectively.

Video Transcript

Hey, my name is Ben Ruttenberg, and today we’re going to talk about a backdoor Roth Ira. We’re going to explain what it is, when it makes sense to complete, and then some other factors to consider as you’re. As you’re completing a backdoor Roth. So let’s just begin. A Roth IRA stands for individual retirement account. In 2024. The limit that you can contribute if you’re under the age of 50 is 7000. If you’re over the age of 50, it is 8000. So you can go open a Roth IRA in 2024, you can contribute 7000. Let’s assume we’re going to be under the age of 50. For this example, there are income limitations for contributing to a Roth IRA. So if you are a single filer, those income limits are between 146,160 1000.

 

So if you’re under this income limit, you can just open a Roth IRA, contribute 7000, no questions asked. If you’re married, filing jointly, that income limitation is between 230 and 240,000. So, again, if you’re under these limits, you can open a Roth IRA at Fidelity, Charles Schwab, Vanguard. Wherever you have your assets custodied, open a Roth IRA, fund it no problem. The issue and where the actual backdoor Roth Ira comes into play is, if you are over these income limits, let’s assume that you’re married, filing jointly. And let’s assume your household income is 500,000 between two spouses, you are over the income limit, and therefore, you cannot directly contribute to a Roth IRA.

 

So a totally legal loophole that is in the tax code that allows high income earners to contribute to a Roth IRA each year is to fund what’s called a backdoor Roth Ira accomplishes basically the same exact thing as a straight Roth IRa contribution would do with just an extra step. So in this case scenario, a high income earner, again, $500,000 of income, you would contribute $7,000 to a traditional IRA. So there is no income limits for any sort of contribution to a traditional IRA. And then the very next day, you would convert your traditional IRA to your Roth Ira. So it’s just an extra step. And then 7000 would be in your Roth IRA.

 

And then once it’s in the Roth, it grows tax free and distributes tax free, provided you don’t touch the account until you’re 59 and a half and you’ve had the account open for five years. So just that one extra step to get from the traditional IRA to the Roth, that essentially completes your backdoor Roth Ira. So we are big proponents of this. We’re huge fans of getting money into a Roth IRA for a lot of reasons. Like I just said, tax free growth, tax free distributions can help save you in Medicare costs and retirement. The more Roth assets you have, the lower your taxable income can be when you’re taking, again, huge benefits for Roth planning, having a mix of Roth and pre tax.

 

So one of the issues that we run into when we’re looking to fund backdoor Roth IRAs or we’re meeting someone that wants to fund a backdoor Roth IRa is a really important rule called aggregation. And this is something we really want to be aware of if and when we’re funding a backdoor Roth IRa. Aggregation states that if you have a traditional IRA balance, this entire balance needs to be zeroed out to make sure that you can fund a backdoor Roth IRA properly and tax efficiently. So what I mean by this is, let’s assume that someone has a traditional IRA of 100,000 and they fund a backdoor Roth IRA. So they contribute 7000 to their traditional IRA, which now has a balance of 107,000, and then they go to convert that 7000 into their Roth IRA.

 

The problem is when you go to convert your 7000 that you put in, it’s going to assume your entire balance is part of the conversion. So in this case, you go to convert 7000, but your balance is 107. That means that only 6.5% of the conversion will be actually reported as the 7000. So 93% of the conversion that you’re going to be reporting is actually from the traditional IRA balance, meaning that 6500 is going to be considered taxable. So you went in with the idea of, hey, I’m going to get 7000 into my traditional IRA, I’m going to convert it the next day, and this 7000 is now going to be growing into my Roth completely tax free for the rest of my life. Well, because we have this IRA balance here, the majority of that conversion is actually going to be considered taxable.

 

So it defeats the whole purpose of the backdoor Roth. So it’s really important that if you are looking to fund a backdoor Roth IRA and you have a traditional IRA balance, we could do one of a couple of things to clear aggregation. Number one, we could potentially roll this balance into your pretax 401k, if your plan allows, or if you have 1090 income, maybe this is a solo 401k. Or we can convert the entire balance to your Roth IRA, in which case that would zero out the traditional IRA balance, and you can then fund a backdoor Roth IRA, no problem. So if you’re looking to fund a backdoor Roth IRA or you have questions about how this is funded and how this applies to your financial plan, I do suggest reaching out to a financial advisor to discuss this further.

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