Backdoor Roth IRA and catch-up contributions: two ways to save more.

Navigating the complexities of individual retirement accounts (IRAs) for people who are nearing or are at retirement can be difficult. Not only are there a lot of rules, it can feel like the rules change or are modified as frequently as you change radio stations on your way to the grocery store.

If you are a high earner or someone with extra money to contribute to these accounts, backdoor Roth IRA and catch-up contributions are two great ways to bolster your retirement savings, protect what you have saved, and minimize your tax exposure. Let’s talk about what these tools are, how they work, and some recent changes that may affect you.

Backdoor Roth IRA contributions: a workaround that works.

Roth IRAs are individual retirement accounts that allow a person to set aside after-tax income. Currently, the amount of money you are allowed to contribute maxes out at $6,500 a year or $7,500 if you’re age 50 or older. However, for tax year 2023, if you are a high earner, single, and head of household filer making more than $153,000, or you make more than $228,000 and are married, filing jointly, you are not allowed to contribute to a Roth IRA at all. This is where the backdoor Roth IRA conversion comes into play.

A backdoor Roth IRA is a legal workaround allowed by the IRS that lets high earners over 50 years old indirectly contribute to a Roth IRA. This is done by setting up a traditional IRA with a custodian of your choice (your CommercePremier Banker can help you with this), and then immediately converting the traditional IRA to a Roth IRA. There is no limit on the amount of money you can convert from a traditional IRA to a Roth IRA, but keep in mind, you will be taxed on the total amount converted. Also, if you are younger than 59.5 years old, you will have to wait 5 years before you can take any distributions from your Roth IRA.

A Roth conversion has a number of advantages — especially for people nearing retirement. A few of those include:

1. Tax-Free Withdrawals During Retirement: Since tax has already been paid on the money going into your Roth IRA, there is no tax penalty when making qualified withdrawals.
2. No Required RMDs: A traditional IRA requires the account holder to start taking mandatory required minimum distributions (RMDs) starting at age 72. There are no RMDs for a Roth IRA during account holder’s lifetime.
3. Estate Planning Benefits: When someone passes away, IRAs can be passed on to beneficiaries. The rules surrounding a traditional IRA and how it is passed on can be complicated and could stick the beneficiary with a stiff tax bill (especially if the original account owner was 72 or older and had already started taking mandatory distributions). With a Roth IRA, the beneficiary can let the account grow for 10 years after the original owner passes away before they are required to take any distributions — and the distributions are tax free.
4. Long-Term Tax Savings: While you were working, you were likely in a higher tax bracket because of your income. In this case, contributing more pre-tax dollars to your IRA or 401(k) helped minimize your tax bill. After you stop working, you will likely fall into a lower tax bracket, so even though you are paying taxes on the total amount you are converting, when you do your backdoor Roth conversion, there is a good chance you are minimizing your tax liability.

For example, let’s say you were earning at a 28% tax bracket before retirement. Now that you are no longer working, you can make contributions that cap out at a 22% bracket and get that savings on tax.

Catch-Up contributions: beefing up retirement savings later in life.

Another way to maximize your retirement savings is through the use of “catch-up contributions” These are a type of retirement savings contribution that allows people age 50 or older to make additional contributions to 401(k) accounts and IRAs. They were created to help people who were slow to save earlier in their lives “catch up” by allowing them to put money into retirement accounts that exceeds typical contribution limits. For someone who is retired or nearing retirement, catch up contributions are a great way to bolster your retirement savings by socking even more money away into a higher-yielding IRA or 401(k). Additionally, since a catch-up contribution is putting more money into savings, it is also lowering your earnings, and therefore your tax liability.

As of 2023, the IRS increased the amount of “catch up” money an individual can contribute. For a traditional or Roth IRA, the annual contribution limit is $6,500. If you are over 50, your “catch up” contribution is an extra $1,000, bringing that total up to $7,500. If you started adding an extra $1,000 a year to an IRA with a return of 7%, you’d have almost $44,000 more in 20 years. So, the catch-up contribution may not sound like much, but it will add up over time. Another advantage of a catch-up contribution to a Roth IRA is that it can be made all the way up until the tax deadline of the current year, but still count toward the previous year. So, if the 2024 tax deadline is approaching, you can still put contributions toward 2023 if you have not already maxed out your 2023 contribution amount — even though it is already April of 2024.

For a 401(k), the catch-up contribution is even greater. Before age 50, the annual contribution limit is $22,500. For 2023, the catch-up contribution limit has been raised to $7,500. That is potentially an extra $30,000 a year you can defer tax on and tap into later in life — although you will eventually pay tax on it. The savings becomes even greater if you have an employer who is willing to match some or all of your contribution. Unlike the Roth IRA, catch-up contributions to a 401(k) must be made by the end of the current calendar year.

And recently, the IRS modified its requirements for high-income earners (over $145,000 a year) over 50. If you want to make catch-up contributions, you can still do that pre-tax by putting them in employer 401(k) or 403(b) accounts through 2025. However, after 2025, you will no longer be able to do this. At that point, all catch up contributions for high income earners 50+ will have to be made after tax into a Roth IRA and subject to Roth rules. This is where the backdoor Roth IRA conversion could come into play.

The more you save, the better.

The bottom line is this: Use the tools and programs available to save as much as you can whenever you can. Not only will it help you live a more comfortable life as a retiree, but it may also help preserve any wealth you hope to leave to your beneficiaries down the road. The landscape is tricky and the rules are complicated and numerous, but it’s worth taking the time to explore all of your options in order to hold on to and maximize the money you worked so hard for. Everyone’s situation is unique, and having a conversation with your financial planner and CPA is a good idea. And of course, your CommercePremier Banker is also available anytime to answer questions or point you in the right direction — so take advantage of that.