You might be familiar with the backdoor Roth IRA strategy.

In 2024, married couples who make more than $230,000 of modified adjusted gross income (MAGI) cannot directly contribute the full limit to their Roth IRAs. At $240,000, their contributions are phased out to $0. One thing to note is that this is modified adjusted gross income, not adjusted gross income (AGI). MAGI and AGI are the same for many taxpayers, but modified adjusted gross income adds back some deductions.

So, how do high-income families fund their Roth IRAs? Enter the backdoor Roth IRA strategy.

With a traditional IRA, investors at any income level can make contributions (even if the contributions aren’t tax deductible). 

So, investors with a MAGI over the limit can make after-tax contributions to a traditional IRA and then perform a conversion of those funds into a Roth IRA.

Here’s where things can get complicated. 

Suppose an investor has pre-tax money in a Traditional IRA. If that investor utilized the backdoor Roth IRA strategy, they would incur a pro-rata tax. The pro-rata tax is determined by the ratio of pre-tax contributions in all traditional IRAs to the total balance of all traditional IRAs.

Let’s consider a scenario where an investor has a $100,000 pre-tax in an IRA rolled over from a 401(k). Suppose this investor has a high income and wants to utilize the backdoor Roth IRA strategy. In that case, they plan to open a traditional IRA, contribute $7,000, and then convert that $7,000 to a Roth IRA. In total, they have $107,000 of IRA funds. 6.54% ($7,000) are after-tax, and 93.46% ($100,000) are pre-tax. Therefore, if they converted the $7,000 of after-tax contributions, 6.54% of the $7,000 would be tax-free, and 93.46% would be taxed.

Suppose their tax rate is 24%. This means they would pay $1,570.13 in taxes ($7000 x 93.46% pro-rata rate, x 24%). If they didn’t have a rollover IRA with pre-tax contributions, they would not owe this $1,570.13 tax. Essentially, the pro-rata tax imposes a double taxation on a portion of an investor’s Roth conversions.

So, what can you do if you have an IRA with pre-tax contributions and want to use the backdoor Roth IRA strategy? You have a few options:

Option 1: Perform a Roth Conversion on the Pre-Tax Funds

Eventually, you’ll have to pay taxes on these funds anyway. To go back to our example with a $100,000 rollover IRA, paying $24,000 in taxes to avoid paying $1,570.13 might not make sense. This could be a better fit under the following circumstances:

1. Your pre-tax IRA balance is minimal, and you can pay the taxes with non-retirement funds.

1. You’re expecting to be in a higher income bracket in the future, and you can pay the taxes with non-retirement funds now.

Option 2: Roll the Pre-Tax Contributions into an Employer-Sponsored Retirement Plan

Some 401(k)s and other employer-sponsored plans will allow you to roll a traditional IRA into them. This is great, but employer-sponsored plans can lack investment choices, have higher fees, and make future withdrawals and rollovers cumbersome. Furthermore, not everyone has access to an employer-sponsored retirement plan that allows them to roll money in.

Option 3: Roll the Pre-Tax Contributions into a Solo 401(k)

If you have any form of self-employment, you can set up a self-employed 401(k) often referred to as a solo 401(k). It is important to note that to maintain the solo 401(k), you must continue some form of self-employment. A solo 401(k) will also have some degree of overhead costs to maintain.

What are the advantages of a solo 401(k)? Compared to most workplace 401(k) plans, solo 401(k)’s offer more investment flexibility and can be set up to your liking. If you want a self-directed brokerage account option to invest in stocks directly, that can be accomplished with a solo 401(k). The other advantage is that even if you’re a W2 employee with a qualified retirement plan available, you can still have a solo 401(k). 

Now, the overall limits on qualified retirement plans still apply, but chances are if you’re a W2 employee, your employer is not maximizing your employer contributions to your 401(k). With a solo(k), you can contribute up to 25% of your self-employed income as an employer in addition to what you contribute as an employee. In 2024, the base limit for employee contributions to 401(k)s is $23,000, but the limit for employee and employer contributions is $69,000. So, individuals needing to utilize the backdoor Roth strategy to begin with and have a self-employed income of any sort might benefit from the extra tax-advantaged saving potential of a solo 401(k).