Due to their built-in tax advantages, Individual Retirement Accounts (IRAs) are a popular component of retirement plans and can play a substantial role in lasting wealth. There are several types of IRAs you can choose from, each with its own advantages and disadvantages.

Traditional IRA

What is it?

A Traditional IRA is a personal retirement vehicle that shelters earned income from taxation and defers taxes until funds are withdrawn.

The following are important facts you should know about Traditional IRAs:

  • For both 2024 and 2025, eligible individuals may contribute up to $7,000 to an IRA and deduct this amount from their current taxable income, subject to phaseout rules. Individuals age 50 or older can make an additional “catch-up contribution” of $1,000.
  • There are no age requirements for making contributions to an IRA as long as you have earned income or are the spouse of someone with enough earned income to cover the contribution.
  • An IRA cannot be a joint account.
  • You may not borrow from an IRA. However, there is a rule that allows you to withdraw funds from your IRA and redeposit them into another IRA or qualified retirement account within 60 days without incurring taxes or penalties.
  • Prohibited investments include life insurance and antiques/collectibles.
  • If you withdraw funds prior to age 59½, you will be subject to a 10% penalty unless the distribution is related to an IRS exception, some of which include death, disability, and qualified higher education expenses. All withdrawals/distributions from IRAs are taxed as ordinary income in the year received.
  • In 2024 and 2025, the age for taking Required Minimum Distributions (RMDs) is 73.
  • The contribution due date is generally the tax filing deadline of April 15.
  • Excess contributions result in a penalty of 6% excise tax each year the excess amount is not withdrawn.
  • If you participate in a qualified company-sponsored retirement plan, 403(b) plan, Simplified Employee Pension (SEP) plan, or Savings Incentive Match Plan for Employees (SIMPLE) IRA, you are considered an “active participant.” Federal, state, and local government plans are also taken into account, but not 457 plans. When Single taxpayers and both Married-Filing-Jointly (MFJ) spouses are not active participants, Traditional IRA contributions are fully deductible, regardless of the taxpayer’s Modified Adjusted Gross Income (MAGI). For active participants, the 2025 deduction for Traditional IRA contributions is limited (or eliminated) when a taxpayer’s MAGI reaches phaseout levels of $79,000–$89,000 for Single taxpayers, and $126,000–$146,000 for MFJ taxpayers. When an MFJ couple only has one spouse who is an active participant, the non-participant spouse will have the deduction phased out at MAGI levels between $236,000–$246,000.
  • Earned income does NOT include earnings and profits from property (i.e., rental income, interest income, dividend income, investment income), pension or annuity income, compensation payments postponed from a previous year, or foreign earned income.
  • The IRS requires that all deductible and non-deductible Traditional IRAs be aggregated together. This means they are treated as one Traditional IRA for the purpose of calculating the cost basis of a distribution. Even if the nondeductible Traditional IRA contributions are separated into different IRAs from the deductible Traditional IRA contributions, the aggregation rule still applies for both accounts, because they will be treated as one.

Roth IRA

What is it?

A Roth IRA is a personal retirement vehicle that does NOT shelter earned income from being taxed, but allows investment earnings to grow tax free, assuming distributions are qualified.

The following are important facts you should know about Roth IRAs:

  • Only taxpayers with income below certain thresholds may contribute to a Roth IRA. In 2025, contributions are phased out based on MAGI between $236,000–$246,000 for MFJ and $150,000–$165,000 for Single.
  • There are no age restrictions on contributions to a Roth IRA.
  • For 2024 and 2025, the non-deductible contribution can be up to $7,000 per person. Individuals age 50 or older can make an additional “catch-up contribution” of $1,000.
  • Contributions cannot exceed earned income.
  • The contribution due date is generally the tax filing deadline of April 15.
  • Other than the 60-day rule, loans are not permitted.
  • Joint accounts are not permitted.
  • Prohibited investments include life insurance and antiques/collectibles.
  • Excess contributions result in a penalty of 6% excise tax each year the excess amount is not withdrawn.
  • For a non-qualified distribution, the first part of the distribution will be a return of the original contribution, followed by funds that may have resulted from a Roth IRA conversion. Earnings are withdrawn last.
  • RMD rules do not apply to Roth IRAs during the original owner’s life.
  • A qualified distribution is tax free. It must be made after holding the account for at least five years, and also meet any of the following conditions:
    • occurs after the owner turns age 59½
    • occurs upon the owner’s death
    • are attributable to the owner becoming disabled
    • used for a first-time home purchase (lifetime cap of $10,000)
  • Distributions taken before age 59½ where investment earnings are taxable but not subject to a 10% early withdrawal penalty, must be made after holding the account for at least five years, and be for any of the following:
    • higher education expenses
    • unreimbursed medical expenses over 7.5% of AGI
    • medical insurance premiums while unemployed
    • substantially equal periodic payments
  • Other distributions taken before age 59½ result in a 10% early withdrawal penalty plus a tax on investment earnings, even if the account is held for at least five years.
  • Distributions taken before holding the account for at least five years where investment earnings are taxable, but not subject to a 10% early withdrawal penalty, can be taken under any of the following circumstances:
    • after the owner turns age 59½
    • upon the owner’s death
    • if the owner becomes disabled
    • for a first-time home purchase (lifetime cap of $10,000)
    • for higher education expenses
    • for unreimbursed medical expenses over 7.5% of AGI
    • for medical insurance premiums while unemployed
    • for substantially equal periodic payments
  • Other distributions taken before age 59½ and before holding the account for at least five years will result in a 10% early withdrawal penalty plus a tax on investment earnings.

Inherited IRA

What is it?

An Inherited IRA is opened when an individual inherits an IRA or company-sponsored retirement plan upon the original owner’s death. Rules on the inheritance of this account differ depending on the circumstance and type of beneficiary, which can either be an Eligible Designated Beneficiary (EDB) or a Designated Beneficiary (DB).

EDBs include the original owner’s spouse, someone who is disabled or chronically ill, individuals not more than 10 years younger than the original IRA owner, and children of the original IRA owner who have not reached majority age. If you do not meet the requirements to be considered an EDB, and the original account owner passed away after 2019, you will be considered a DB.

The following are important facts you should know about Inherited IRAs:

Inherited Traditional IRA

  • Withdrawals from an Inherited Traditional IRA generally are taxable as regular income at the beneficiary’s current income tax rate.
  • A spousal beneficiary can take a lump-sum distribution.
  • A spousal beneficiary can roll over the assets from the original owner’s Traditional IRA or company-sponsored retirement plan to his or her own Traditional IRA and defer RMDs until age 73.
  • A spousal beneficiary can establish an Inherited Traditional IRA account:
    • If the original owner of a Traditional IRA was already receiving RMDs at the time of death, the spousal beneficiary must begin taking annual RMDs over his or her life expectancy beginning no later than 12/31 of the year following the original account owner's passing. Annual distributions are spread over the spousal beneficiary’s single life expectancy, or the original account owner's remaining life expectancy, whichever is longer.
    • If the original owner of a Traditional IRA was not already receiving RMDs at the time of death, the spousal beneficiary has a couple of options. Using the life expectancy method, RMDs must begin no later than 12/31 of the year the original account owner would have reached age 73, and annual distributions are spread over the spousal beneficiary’s single life expectancy. Using the 10-year method, all assets need to be fully distributed by 12/31 of the tenth year after the year in which the original account owner passed.
  • A non-spouse DB may not make additional contributions, transfer funds into an existing Traditional IRA account in his or her own name, or leave assets in the original Traditional IRA.
  • Unless a non-spouse DB elects to take a lump-sum distribution, he or she must set up a new Inherited Traditional IRA account:
    • If the original account owner was not already taking RMDs at the time of death, a non-spouse DB must fully withdraw all assets from the Inherited IRA by 12/31 of the tenth year after the year in which the original account owner passed.
    • If the original account owner was already receiving RMDs at the time of death, the non-spouse DB must continue taking RMDs during the 10-year period.
  • A non-spouse EDB can take a lump-sum distribution, or:
    • If the original owner of a Traditional IRA was already receiving RMDs at the time of death, the non-spouse EDB must begin taking RMDs by 12/31 of the year after the original owner’s death. Annual distributions are spread over the non-spouse EDB’s single life expectancy, or the original account owner's remaining life expectancy, whichever is longer. However, if the non-spouse EDB is the minor child of the original account owner, the life expectancy method of distribution is no longer available when the child turns 21. At that time, the distribution option is required to switch to the 10-year method and all remaining assets need to be distributed by the end of the tenth year after the minor turns 21.
    • If the original owner of a Traditional IRA was not already receiving RMDs at the time of passing, the non-spouse EDB has a couple of options. The first option is using the life expectancy method, where RMDs must begin no later than 12/31 of the year after the original account owner’s passing, and annual distributions are spread over the non-spouse EDB’s single life expectancy. However, again, if the non-spouse EDB is the minor child of the original account owner, the life expectancy method of distribution is no longer available when the child turns 21. At that time, the distribution option is required to switch to the 10-year method and all remaining assets need to be distributed by the end of the tenth year after the minor turns 21. The second option is for the non-spouse EDB to simply use the 10-year method, where all assets need to be fully distributed by 12/31 of the tenth year after the year in which the original account owner passed.

Inherited Roth IRA

  • Unlike the original Roth IRA owner, an Inherited Roth IRA beneficiary must take RMDs from the account.
  • Spousal beneficiaries may transfer the assets from the original owner’s Roth IRA to their own Roth IRA. The spouse will be subject to the same distribution rules as the original owner and will not be taxed if the five-year Roth IRA rule has been met.
  • A spouse can open an Inherited Roth IRA under the life expectancy method, where the spouse must take RMDs stretched over his or her life expectancy. Distributions are not taxed if the five-year Roth IRA rule has been met, and the surviving spouse can postpone distributions until the original account owner would have attained age 73 or 12/31 of the year following the year of passing, whichever is later.
  • A spouse can open an Inherited Roth IRA under the 10-year method, where the spouse can receive distributions in increments over time, but the Inherited Roth IRA account must be fully distributed by 12/31 of the tenth year after the original owner passed away. Distributions are not taxed if the five-year Roth IRA rule has been met.
  • A spouse can take one lump-sum distribution. Distributions are not taxed if the five-year Roth IRA rule has been met.
  • A non-spouse DB may not make additional contributions, transfer funds into an existing Roth IRA account in his or her own name, or leave assets in the original Roth IRA.
  • Unless a non-spouse DB elects to take a lump-sum distribution, he or she must set up a new Inherited Roth IRA account and fully withdraw all the assets by the end of the tenth year after the original account owner passed away. Either way, the distributions are tax free if the five-year Roth IRA rule has been met.
  • A non-spouse EDB can take one lump sum distribution, or:
    • Open an Inherited Roth IRA under the life expectancy method, where distributions must begin no later than 12/31 of the year following the year of the original account owner’s death. Distributions are spread over the non-spouse EDB's single life expectancy. However, if the non-spouse beneficiary is the minor child of the original account owner, the life expectancy method of distribution is no longer available when the child turns 21. At that time, the distribution option is required to switch to the 10-year method and all remaining assets need to be distributed by the end of the tenth year after the minor turns 21.
    • Open an Inherited Roth IRA under the 10-year method, where the non-spouse EDB can receive distributions in increments over time, but the Inherited Roth IRA account must be fully distributed by 12/31 of the tenth year after the original owner passed away. Distributions are not taxed if the five-year Roth IRA rule has been met.

Simplified Employee Pension Plan (SEP) IRA

What is it?

From the employer’s perspective, a Simplified Employee Pension Plan (SEP) IRA combines simplicity of design with a high degree of flexibility. It’s an employer-sponsored individual retirement account where all contributions are made solely by the employer on a discretionary basis, and no employees may defer their own income. In 2025, the limits of employer contributions are the lesser of 25% of compensation (covered compensation is limited to $350,000), or $70,000.

A SEP IRA is generally meant for a small-business employer seeking to make discretionary contributions and an alternative to a qualified 401(k)/Profit-Sharing Plan that is easier and less expensive to install and administer. SEP IRAs may be established by C corporations, S corporations, Partnerships, LLCs, and Sole Proprietorships. They must cover all employees who are at least age 21 and who have worked for the employer during three of the preceding five calendar years. Part-time employment counts in determining service. If you are an employee and change jobs, you may take the funds in your SEP IRA with you.

Other important facts you should know about SEP IRAs:

  • Other than the 60-day rule, loans are not permitted.
  • Joint accounts are not permitted and each participating employee maintains an IRA.
  • Prohibited investments include life insurance and antiques/collectibles.
  • Employer contributions are always fully vested and are not forfeitable.
  • An employer may deduct contributions to a SEP plan up to the contribution limit.
  • If an employer maintains a SEP plan and also maintains a regular qualified plan (i.e., 401(k), Profit-Sharing Plan), contributions to the SEP plan reduce the amount that can be deducted for contributions to the regular qualified plan.
  • A 10% excise tax is assessed on excess employer contributions.
  • Participation in a SEP plan counts as active participant status for purposes of determining the deductibility of separate Traditional IRA contributions.

Savings Incentive Match Plan for Employees (SIMPLE) IRA

What is it?

Savings Incentive Match Plan for Employees (SIMPLE) IRAs allow employees to make elective contributions as a percentage of compensation. In 2025, the maximum contribution is $16,500. In addition, individuals who have attained the age of 50 may make additional catch-up contributions of up to $3,500. If you are age 60-63 by December 31, 2025, you’ll have a higher catch-up limit, which is $5,250 (the greater of $5,000 or 150% of the regular age 50 catch-up contribution limit for SIMPLE IRA plans in 2025).

SIMPLE IRAs are meant for employers with 100 or fewer employees who earned at least $5,000 during the preceding year and who do not maintain another employer-sponsored retirement plan.

Important facts about SIMPLE IRAs include:

  • A self-employed person can establish a SIMPLE IRA.
  • Other than the 60-day rule, loans are not permitted.
  • Joint accounts are not permitted and each participating employee maintains an IRA.
  • Prohibited investments include life insurance and antiques/collectibles.
  • Employers cannot maintain another qualified plan, SEP IRA, or 403(b) plan, but qualified employers can maintain a 457 plan and also have a SIMPLE IRA.
  • SIMPLE IRAs are not subject to nondiscrimination rules generally applicable to qualified plans.
  • Employers must make contributions to the SIMPLE IRA based on one of the following options:
    • Match dollar for dollar up to 3% of employee’s compensation.
    • Make a nonelective contribution of 2% of each eligible employee’s compensation.
    • Employers with 26-100 employees may offer a 4% match or 3% nonelective contribution.
  • All contributions are immediately and fully vested to the employee.
  • Up to $350,000 in compensation can be taken into account in 2025 for purposes of the nonelective contribution.
  • After-tax contributions are not allowed.
  • Contributions made by employees are excludable from their gross income and are subject to payroll taxes.
  • Contributions by the employer reduce taxable income if made by the tax return due date (including extensions) and are subject to payroll taxes.
  • SIMPLE IRA withdrawals made within two years of initial participation are subject to a 25% premature distribution penalty tax (rather than 10%). However, certain exceptions to the penalty apply under Internal Revenue Code (IRC) Section 72(t). After the first two years, the early withdrawal penalty for a SIMPLE IRA reverts to a 10% penalty.
  • Distributions from a SIMPLE IRA may be rolled over to another SIMPLE IRA, but may not be rolled over to any other type of plan during the first two years of participation. Other plans, except Roth accounts, may not be rolled over to SIMPLEs until the participant's first two years have passed.

IRA Rollover

An IRA rollover allows for the transfer of assets from an employer-sponsored retirement account to a Traditional IRA, maintaining the tax-deferred status of those assets until they’re withdrawn. IRA rollovers are reported on tax returns as non-taxable transactions.

Eligible rollover distributions must be either transferred to the IRA via a direct transfer or rollover by you, the participant. A direct transfer is an eligible rollover that is paid directly to a rollover IRA for the benefit of you and is not subject to a mandatory withholding of 20%. If you receive a distribution and the tax on the distribution is to be deferred, the rollover must be made within 60 days of receipt of your distribution and follow IRS rules. Any taxable eligible rollover distribution paid from an employer-sponsored retirement plan is subject to a mandatory income tax withholding of 20% even if you intend to roll it over later. If the distribution is subsequently rolled over, you must add funds from other sources equal to the amount withheld or the withheld amount itself is subject to current taxation and a possible early withdrawal penalty.

Only one rollover from an IRA to another (or the same) IRA in any 12-month period is permitted, regardless of the number of IRAs you own. Trustee-to-trustee direct transfers between IRAs are not limited. Rollovers from Traditional IRAs to Roth IRAs (conversions) are also not limited.

Company plans you can roll over into your own Traditional IRA include qualified retirement plans (i.e., 401(k), 403(b), Profit-Sharing Plans), Tax-Sheltered Annuities (TSAs), 457 Plans (NOT non-governmental), SIMPLE IRAs (after two years of participation), and SEP IRAs.

Assets can be rolled over from an old company-sponsored plan after employment has ceased at that company. If you are over the age of 59½, there is a good chance you can roll over assets into a Traditional IRA, even while still employed at the company. In addition, you can still contribute to the company-sponsored plan and receive all the same benefits. Check with your employer and/or retirement benefits administrator to ask if they allow “In-Service Rollovers.”

Like most things in life, there are pros and cons to an IRA rollover.

You may roll over your assets to an IRA because:

  • You are dissatisfied with the company plan’s investment performance and fee structure.
  • Investment selections in the company plan are limited and you prefer access to more options so that you can create a personalized investment strategy.
  • You want quicker and simpler access to your funds without having to go through the company.
  • Funds rolled over from a qualified company plan to a Traditional IRA are still protected from creditors in accordance with the Employee Retirement Income Security Act of 1974 (ERISA).

You may consider leaving your assets in your company-sponsored plan because:

  • It has an inexpensive fee structure with broad investment options.
  • You already receive ongoing fiduciary financial planning, education, update calls, and personalized advice from the company plan advisor.

Roth IRA Conversion

What is a Roth IRA conversion?

Utilizing both a Roth IRA conversion and a back-door Roth IRA can be great ways to hedge against potential future tax rate increases from fiscal policy.

A Roth IRA conversion is a financial strategy in which you may convert funds that are already in your Traditional IRA, 401(k), or other tax-deferred retirement account into a Roth IRA. This conversion allows you to enjoy tax-free growth of investments, tax-free withdrawals assuming it’s a qualified distribution, and no RMDs which allows you to leave your Roth IRA assets untouched for as long as you wish.

Additionally, a Roth IRA conversion can be a useful estate planning tool. Since Roth IRAs do not have RMDs during your lifetime, the assets can continue to grow tax free and be passed on to your heirs tax free as well. This can be a significant benefit if you want to leave a legacy and minimize the tax burden for your loved ones.

Roth IRA Conversion Pros:

  • Contributions and earnings grow tax free.
  • There are no RMD requirements.
  • Beneficiaries can withdraw funds tax free assuming the five-year rule is met.
  • Those normally ineligible for a Roth IRA can use a conversion to create a Roth IRA and have tax-free growth.
  • It can be beneficial if tax rates are expected to increase in the future.

Roth IRA Conversion Cons:

  • Taxes are paid on the conversion when it occurs.
  • An individual must wait at least five years to take a tax-free withdrawal from the Roth IRA, even if he or she is age 59½ or older.
  • If taxes are higher now than they will be in the future, an individual may not benefit from a conversion.

The amount you convert from your tax-deferred retirement account to your Roth IRA will be added to your taxable income for that year, then grow tax free assuming you take a qualified distribution. Therefore, Roth IRA conversions should be done strategically, preferably with the assistance of a professional advisor and/or accountant, so you may save as much of your hard-earned money as possible instead of paying the IRS more than you have to. From a tax perspective, it rarely makes sense to convert the entire amount in your tax-deferred retirement account to a Roth IRA all at once, especially if there is a large amount.

When assisting with a Roth IRA conversion, I generally like to initiate the process around October or November. By this time each year, Clients typically have a solid idea of what their annual income will be, which allows us to determine their federal and state income tax brackets. From there, I can make the simple calculation of how much more income can be added before they’re bumped into the next tax bracket.

We also have to take into consideration the Medicare tax increase they’ll be assessed if their wages exceed $200,000 ($250,000 MFJ) in a calendar year. If you already earn above this amount prior to doing a Roth IRA conversion, it’s not as important to consider. But if you earn less and want to avoid the unpleasant surprise of paying extra tax, you should factor this into your Roth IRA conversion.

The third item I like to consider is the Client’s ability to pay the taxes owed from a Roth IRA conversion out-of-pocket, rather than withholding the taxes and only putting the after-tax amount into the Roth IRA. If you wanted to convert $20,000 from your Traditional IRA to a Roth IRA and you chose to withhold federal and state tax (assume 24% federal and 5% state), you would end up with $14,200 in your Roth IRA. But if you choose to move the full $20,000 into the Roth IRA and pay the taxes from, say, your savings or checking account, then you will have a higher starting point for tax-free growth ($20,000 vs. $14,200).

While it’s optimal to take advantage of larger Roth IRA conversions in years when your MAGI and tax brackets are lower than usual, don’t rule out these conversions even if you’re in the top tax bracket now.

Sample Client Analysis for a Roth IRA Conversion

Dr. Sample, age 54, is a medical professional in the 37% federal and 12.3% California state tax brackets. He does not want to move states in retirement. He has concerns that, because the United States has over $34 trillion in national debt, tax brackets will be higher when he needs to start taking RMDs. He wants to reduce the amount of taxes he needs to pay in retirement as much as possible, so he wanted to know if he should convert his Traditional IRA account, valued at $1.8 million into a Roth IRA, and the best way to do it. According to current fiscal policy, because he was born after 1960 and it will be after 2033 when he begins taking RMDs, his RMD age will be 75.

An analysis was completed for him assuming four different methods, all with a 7% annual rate of return:

  • Converting $100,000 per year to a Roth IRA and paying taxes out-of-pocket from money in his savings/checking accounts or earned income during the year.

  • Converting $100,000 per year to a Roth IRA, withholding taxes, and depositing the net amount into the Roth IRA.
  • Converting the full Traditional IRA to a Roth IRA all at once and withholding taxes.
  • Not doing a Roth IRA conversion at all, leaving his Traditional IRA as is.

The results were as follows:

  • Method 1:
    • Value of his Traditional IRA at the end of age 74 which is eligible for RMDs is $2,652,438.36.
    • Value of his Roth IRA at the end of age 74 is $4,800,573.92.
    • Total value of both the Traditional IRA and Roth IRA is $7,453,012.27.
  • Method 2:
    • Value of his Traditional IRA at the end of age 74 which is eligible for RMDs is $2,652,438.36.
    • Value of his Roth IRA at the end of age 74 is $2,366,682.94.
    • Total value of both the Traditional IRA and Roth IRA is $5,019,121.30.
  • Method 3:
    • There are no funds left in his Traditional IRA.
    • Value of his Roth IRA at the end of age 74 is $3,726,506.14.
  • Method 4:
    • Value of his Traditional IRA at the end of age 74 which is eligible for RMDs is $7,453,012.27.
    • There are no funds in a Roth IRA.

In this case, Method 1 was the best choice since Dr. Sample said he was able to pay the taxes owed from the Roth IRA conversion using his earned income and money in his savings account. He should have almost $5 million that will be tax free, assuming he takes qualified distributions. In addition, he’ll still have just over $2.6 million in his Traditional IRA and just under $7.5 million total between his Traditional and Roth IRAs.

Using Method 2, he would have less than $2.5 million in his Roth IRA and just over $5 million total between his Traditional and Roth IRAs. Method 3 would cost him half the value of his Traditional IRA in the first year if he did his Roth IRA conversion this way, and he should end up with just over $3.7 million in his Roth IRA. If Method 4 is used, then just under $7.5 million should be eligible for RMDs.

There are no limits to how many Roth IRA conversions you can do, and no income limitations. You have until December 31 to complete a Roth IRA conversion for the same year.

Dr. Sample decided on Method 1 and will still have a considerable balance in his Traditional IRA, so how should he maximize his savings when taking RMDs from this account? The key is to take it one year at a time. In the earlier years of taking RMDs, if he finds he is in a lower tax bracket than he expected or lower than he will be in future years, it would be a good practice to take more than the minimum to take advantage of a lower tax rate. How much more than the minimum? That will depend on tax brackets and the Medicare income threshold at the time, which should be taken into consideration each year.

The IRS calculates RMDs by taking the value of his Traditional IRA as of December 31 of the previous year and dividing it by an “age factor” which represents life expectancy. Each year, that age factor decreases, usually resulting in a larger distribution depending on the Traditional IRA value. So, in his first year of RMDs using Method 1, Dr. Sample will need to withdraw at least $107,822.70 ($2,652,438.36 / 24.6). In the first year, he will be able to wait until April 15 to take the RMD for the previous year, but each RMD thereafter must be taken by December 31 of the same year the RMD is due.

Back-Door Roth IRA

What is a Back-Door Roth IRA?

A back-door Roth IRA is a strategy you can use if you want to take advantage of tax-free growth and your income exceeds the Roth IRA income limits set by the IRS for annual contributions. You have until April 15 of the following year when you file your taxes to make a back-door Roth IRA contribution for the previous year.

As mentioned earlier, if you’re not an active participant in a company-sponsored retirement plan, you may contribute to a Traditional IRA regardless of your income and receive a deduction from your taxable income in the amount you contributed. The maximum amount still applies, meaning, you cannot exceed a contribution of $7,000 in 2024 and 2025 ($8,000 if you are age 50 or older) to a Traditional IRA. Once your funds have been deposited into your Traditional IRA, you may then convert those funds to a Roth IRA. Again, the amount you convert from your Traditional IRA to your Roth IRA will be added to your taxable income for the year, then grow tax free assuming you take a qualified distribution.

Now, even if you are an active participant in a company-sponsored plan and exceed the Roth IRA income limits, you may still contribute to a Traditional IRA. Under this circumstance, you will not receive a deduction in your taxable income for the year. Assuming you convert these funds to a Roth IRA right away before there is any growth in earnings, you will not owe any further taxes, because you never received a tax deduction for the Traditional IRA contribution. However, you must be aware of the pro rata tax rule, which comes into play when you have both pre-tax (deductible) and after-tax (non-deductible) contributions in any of your Traditional IRAs. The IRS requires that you consider all IRAs as one to determine the taxable portion of a conversion or distribution.

For example, as a high-income earner, suppose you have $95,000 in pre-tax funds in various Traditional IRAs, and you add $5,000 of non-deductible contributions to another Traditional IRA with the intention of converting it to a Roth IRA.

  • Total IRA Balance: $100,000 (where 95% of this is pre-tax and 5% is after-tax).
  • Conversion Amount: Say you convert $5,000 to a Roth IRA.
  • Taxable Amount on Conversion: Since 95% of your total IRA balance is pre-tax funds, 95% of any conversion amount will be considered taxable. Therefore, you would be taxed on $4,750 (95% of $5,000) of the $5,000 conversion.

This calculation shows the importance of considering all Traditional IRA funds when attempting a back-door Roth IRA if you have existing pre-tax IRA balances, as you may incur larger taxable income than anticipated. One strategy to help minimize pro rata taxes involves rolling over any pre-tax IRA funds into a qualified company-sponsored plan like a 401(k) before executing a back-door Roth conversion, potentially reducing or eliminating pre-tax funds in the IRA and minimizing taxes owed. Consulting with a tax professional is highly recommended to effectively navigate these rules.

References:

  1. IRAs. https://www.irs.gov/retirement-plans/individual-retirement-arrangements-iras
  2. IRS Publication 590-A. https://www.irs.gov/publications/p590a
  3. The Complete Guide to Individual Retirement Accounts (IRAs). https://www.palmcm.com/the-complete-guide-to-individual-retirement-accounts-iras/
  4. What Is A Traditional IRA? https://www.fidelity.com/retirement-ira/traditional-ira
  5. Roth IRA. https://www.schwab.com/ira/roth-ira
  6. Roth IRA Withdrawal Rules. https://www.investopedia.com/roth-ira-withdrawal-rules-4769951
  7. Retirement Topics - Beneficiary – Inherited IRAs. https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-beneficiary
  8. Other IRAs. https://www.schwab.com/ira/inherited-and-custodial-ira
  9. Simplified Employee Pension (SEP) Plan. https://www.irs.gov/retirement-plans/plan-sponsor/simplified-employee-pension-plan-sep
  10. What Is a Simplified Employee Pension Plan? How SEP IRAs Work https://www.nerdwallet.com/article/investing/what-is-a-sep-ira
  11. SIMPLE IRA Plan. https://www.irs.gov/retirement-plans/plan-sponsor/simple-ira-plan
  12. SIMPLE IRA. https://www.schwab.com/small-business-retirement-plans/simple-ira
  13. Rollover Chart. https://www.irs.gov/pub/irs-tege/rollover_chart.pdf
  14. IRA Rollover: Overview, Types, Special Considerations. https://www.investopedia.com/terms/i/ira-rollover.asp
  15. Roth IRA Conversion Rules. https://www.investopedia.com/roth-ira-conversion-rules-4770480
  16. Roth IRA Conversion. https://smartasset.com/retirement/roth-ira-conversion
  17. Backdoor Roth IRA. https://corporatefinanceinstitute.com/resources/wealth-management/backdoor-roth-ira/
  18. A Guide to the Pro-Rata Rule and Roth IRAs. https://smartasset.com/retirement/a-guide-to-the-pro-rata-rule-and-roth-iras