3 Backdoor Roth IRA Strategies to Consider Before 2024

It is time to decide how much you want to put in Roth IRA accounts in 2024 and choose from one or more of the three “backdoor Roth IRA” strategies.

The IRS recently announced that in 2024 the new contribution limit for one of the three backdoor Roth IRA strategies is $46,500.

After the 2020 election there was a lot of talk about shutting down the backdoor Roth IRA strategies. But the proposals died in Congress and haven’t been revived because of their unpopularity. The backdoor strategies are safe for you to exploit for at least another year and probably much longer.

Backdoor strategies are needed because of restrictions on Roth IRA contributions.

The first restriction is that taxpayers with adjusted gross incomes above certain levels aren’t allowed to contribute any amount directly to a Roth IRA.

In 2024, the Roth IRA contribution is phased out for married couples filing jointly when adjusted gross income is between $218,000 and $230,000. For single taxpayers, it is phased out when adjusted gross income is between $138,000 to $146,000. Taxpayers whose incomes exceed the phase-out levels aren’t allowed to make Roth IRA contributions.

Taxpayers who want to contribute to a Roth IRA but have too much income can use the original backdoor Roth IRA strategy, the IRA conversion.

Step one is to contribute to a traditional IRA. It probably won’t be deductible, because taxpayers with higher incomes who are covered by employer retirement plans also can’t take deductions for contributions to traditional IRAs. But they can make nondeductible contributions.

Step two is to wait for a while after the contribution and then convert the traditional IRA to a Roth IRA.

When the traditional IRA contribution wasn’t deductible, there’s no tax when the contribution is converted to a Roth IRA. It is already after-tax money. Any accumulated investment income and gains that are part of the conversion must be included in gross income.

After those two steps, a taxpayer who wasn’t eligible to contribute to a Roth IRA has a Roth IRA.

The IRS hasn’t issued rules or guidance on this backdoor Roth IRA. I recommend waiting a while after the contribution to the traditional IRA before doing the conversion because, if the actions are taken about the same time, the IRS could decide it doesn’t like the transaction. It might argue that the two transactions should be combined and considered an illegal Roth IRA contribution in disguise.

Because the IRS hasn’t issued guidance, there’s no safe harbor waiting period. But the longer you wait, the safer you are.

The conversion should be done directly by the IRA custodians without your taking possession of the balance. If you take possession, you must complete the rollover within 60 days. Also, you’re allowed only one 60-day rollover every 12 months. The limit could be a problem if you plan to do this every year or want to do a different 60-day conversion for other reasons. It is safer to have the custodians make the transfer directly.

The benefit of this backdoor Roth IRA strategy is limited when you already have one or more traditional IRAs with pre-tax money (deductible contributions).

IRS regulations don’t let you segregate nondeductible contributions and say you only are converting that money tax-free. Instead, you add all your traditional IRA balances and determine the percentage of the aggregate balance that consists of nondeductible contributions.

When you convert less than the aggregate traditional IRA balance, you are treated as converting a pro rata amount of the pre-tax and after-tax money that is in all the traditional IRAs, even when you convert the full amount of one IRA. So, if you already have a traditional IRA with pre-tax money in it, part of the conversion will be taxable.

The second restriction that makes people seek backdoor Roth IRA strategies is the annual limit on IRA contributions. Even when your income is below the phaseout range for contributions, the maximum IRA contribution is $7,000 in 2024, with an additional $1,000 catch-up contribution for taxpayers ages 50 and older.

The second backdoor Roth IRA strategy lets you dramatically increase the amount of money that can be put in a Roth IRA, so it sometimes is given names such as the Mega Roth IRA or Mega Backdoor Roth IRA strategy.

To use this strategy, you must be employed or self-employed and participate in a 401(k) plan that allows additional after-tax contributions to employees who maximized their pre-tax contributions. The pre-tax contribution limit is $23,000 in 2024, plus an additional $7,500 catch-up contribution for those 50 and older.

Though many people don’t know it, the tax code allows additional after-tax salary deferrals that exceed the pre-tax salary deferral limit. The additional deferral is included in your gross income and taxed, but once it is in the account, the income and gains on it compound tax deferred.

The maximum total contribution to a 401(k) for a worker is $69,000 in 2024, plus an additional $7,500 catch-up contribution for those 50 and older. The maximum includes pre-tax employee contributions, employer contributions and after-tax employee contributions.

Under the Mega Backdoor Roth IRA strategy, someone 50 or older can make after-tax salary deferrals of up to $46,500 in 2024 after maximizing pre-tax deferrals, assuming there are no employer contributions.

To maximize the benefits of the strategy, the 401(k) plan should allow “in-service distributions” without a showing of financial hardship.

An in-service distribution is one made while the employee still works for the employer. Generally, 401(k) distributions are allowed without a penalty only after a worker retires, moves to another employer, dies or becomes disabled. But the tax code allows in-service distributions for older workers, and many plans allow in-service distributions for active employees after age 55.

When your 401(k) plan has the two key provisions, you have after-tax salary deferrals made to your account. After after-tax deferrals have accumulated, direct the plan administrator to make an in-service distribution by rolling over the after-tax contributions to a Roth IRA. Have the rollover done directly between the plan administrator and the Roth IRA custodian.

Unlike the IRA rules, the 401(k) rules allow you to direct that only after-tax contributions be distributed when the account also has pre-tax contributions and investment returns.

The rollover of after-tax contributions is tax-free because the money already has been taxed. Once in the Roth IRA, the money is treated the same as any other Roth IRA money.

Most 401(k) plans limit the number of annual in-service distributions. Keep the strategy simple by doing in-service rollover distributions no more than once annually.

The plan still can be executed even if your own plan doesn’t allow in-service distributions. The difference is the after-tax contributions can’t be rolled over to the Roth IRA until after you separate from the service of the employer, such as by retiring.

You’re likely to have accumulated investment income and gains in the account. So, to avoid taxes, you’ll have to be sure only the after-tax amounts are rolled into the Roth IRA. Good recordkeeping by you and the 401(k)-plan administrator are key to making this strategy work.

The third backdoor Roth IRA strategy is to set up a tax-free account for your children or grandchildren. It is a good addition to your estate plan. Maybe you can’t set up a Roth IRA for yourself, but you might be able to for a grandchild.

Suppose you have a grandchild in high school or college who works during the summer or part-time during the school year.

The grandchild has earned income and is eligible to contribute to a Roth IRA. Of course, few people that age are going to take the relatively small amount of money they earn and contribute it to a retirement fund.

But anyone can make contributions to someone’s IRA, whether it’s a traditional or Roth IRA. The total contributions to IRAs for that individual can’t exceed the annual limit, and the owner of the IRA must have earned income at least equal to the contributions.

You can learn how much the grandchild is earning and contribute the lesser of that amount and the year’s IRA contribution limit ($7,000 in 2024) to a Roth IRA for that grandchild. The IRA can be set up by you, the grandchild, or the grandchild’s parents.

The contribution counts as part of your annual gift tax exclusion to that person, which is $17,000 for 2023 and probably will be $18,000 in 2024.

This strategy allows you to create a tax-free investment fund for the grandchild. You can make contributions to it each year the youngster has earned income.

The grandchild, of course, can wait and have that money plus the investment returns supplement his or her retirement. Or distributions can be made for any other purpose. Once the grandchild has had a Roth IRA open for more than five years, all distributions of income and principal are tax-free. So, the grandchild might be able to take taxfree distributions to pay for college or graduate school or help purchase a first home, among other possibilities.