backdoor roth ira conversion

How To Do A Backdoor Roth IRA Contribution

Are you trying to plan for retirement? How about fully leveraging the benefits of Roth IRAs? If you’re like most medical and dental practice owners, you might be considered a high-income earner according to the IRS. This precludes you from making standard contributions to a Roth IRA account. 

As a way to bypass the income limitations, many doctors and dentists use a backdoor Roth IRA conversion strategy. We’ll get you started on how you can make a backdoor Roth IRA contribution and when this strategy might be beneficial. 

What is a Backdoor Roth IRA Contribution? 

A backdoor Roth IRA contribution allows individuals to make Roth IRA contributions despite being over IRS income limits. For the 2024 tax year, individuals with income over $161,000 and married taxpayers with income exceeding $240,000 are excluded from contributing to a Roth IRA. 

To bypass these limitations, medical and dental practice owners can make a Traditional IRA contribution and roll it over to a Roth IRA account. This means you can leverage the tax-free growth of Roth IRAs regardless of your income level. However, contributions are only allowed up to the IRA limit, which is $7,000 for taxpayers under the age of 50 and $8,000 for taxpayers over the age of 50 for the 2024 tax year.

How a Backdoor Roth IRA Contribution Works

Making a backdoor Roth IRA contribution from a Traditional IRA involves three steps:

  1. Make Traditional IRA Contribution – First, you need to make a contribution to a Traditional IRA account by April 15 of the following year. 
  2. Convert Contribution to Roth IRA – Next, you will need to convert your contribution to your Roth IRA. Having your Traditional IRA and Roth IRA with the same provider can make this process simple. You can either initiate the transaction on your end or contact your plan provider. 
  3. Report Transaction on Tax Return – Taking a distribution from a Traditional IRA will generally trigger the issuance of a 1099-R. Be sure you report the transaction on your return as a roll over. 

It’s important to be aware of the timing of your contributions. Any growth within your Traditional IRA account will be taxed at ordinary income rates. Let’s say you made a $5,000 contribution on January 31 and forgot to initiate the conversion. When you finally get around to converting the funds, your account value is at $5,200. In this scenario, you will need to pay tax on the $200 in growth if you choose to roll over the entire $5,200. 

Additionally, funds withdrawn from a Traditional IRA account need to be deposited within your Roth IRA account within 60 days. If you plan on receiving a check to deposit into your Roth IRA, carefully abide by the time requirements. To prevent any issues, many practice owners will use a trustee-to-trustee transfer, where the Traditional IRA provider sends the funds directly to your Roth IRA provider. 

Remember, these steps can vary based on your specific situation. As a result, it’s best to consult with your accountant and investment advisor. 

The Benefits of Backdoor Roth IRA Contributions

Backdoor Roth IRA contributions have a myriad of benefits for doctor and dental practice owners. The first advantage is flexibility. Roth IRAs allow you to withdraw your basis (your contributions) tax-free before retirement age (59 ½). This gives you flexibility if you plan on retiring early. 

Additionally, growth within your Roth IRA account is tax-free upon withdrawal, assuming you are of retirement age and meet the five-year rule. The five-year rule states that contributions must remain within your Roth IRA for at least five years. As long as you meet the five-year rule and do not withdraw any growth before retirement, your withdrawals will be tax-free.

Limitations of Backdoor Roth IRA Contributions

There are a few notable limitations to backdoor Roth IRA contributions. One of the main limitations is the five-year rule. If you are nearing retirement age or need access to your contributions within five years, a Roth IRA contribution might not be the best strategy. 

Another limitation is that there is no upfront tax benefit for making a backdoor Roth IRA contribution. IRAs are considered a self-sponsored plan, meaning the tax benefit is claimed on your individual income tax return. However, a deduction for IRA contributions is only available if you are below the income limit and make a contribution to a Traditional IRA account. Roth IRAs defer the tax benefit and leverage tax-free withdrawals during retirement.

Pro-Rata Rule

One of the common hangups when doing a backdoor Roth IRA contribution is not understanding the pro-rata rule. If you have any money sitting in your IRA, SEP IRA, and SIMPLE IRAs, it is important to note that the pro-rata rule treats all IRAs as one IRA. This is referred to as the Aggregation Rule. When you go to convert your non-deductible IRA contribution to a Roth IRA contribution, the sum of your pre-tax deductible contributions inside your IRA, SEP IRA, and SIMPLE IRAs are used to calculate your pro-rata share of deductible vs. nondeductible contribution basis. For example, if you make a $7,000 non-deductible IRA contribution on March 1st for 2024, and immediately convert that into a Roth IRA, but you have additional pre-tax contributions sitting inside of another IRA, SEP IRA, or SIMPLE IRA of $28,000, then only a portion of your backdoor Roth IRA contribution will be non-taxable: $7,000/($28,000+$7,000) = 20%. It is important to talk with your PBM advisor to avoid this.

Getting Started 

Does it sound like your retirement plan can benefit from a backdoor Roth IRA contribution? This strategy can be a great opportunity to bypass stringent income limitations while still saving for retirement. If you have questions about how to do a backdoor Roth IRA contribution, please contact us