• High-income investors may not be able to contribute to a Roth account or make tax-deductible contributions to a traditional individual retirement account.
• However, a strategy called the “backdoor Roth IRA” allows high-income individuals to access Roth accounts.
• Investors make non-deductible contributions to a traditional IRA and then convert those funds to a Roth account.

You might think that earning more would make it easier to increase your retirement savings. However, high-income earners may have difficulty accessing the tax benefits of individual retirement accounts.

U.S. tax law places income limits on the deductions associated with some tax-advantaged accounts, such as Roth and traditional (i.e., pre-tax) IRAs. These rules can pose a challenge for investors who have maxed out their annual contributions to their 401(k) plans and are looking for other tax-sheltered savings options.

But there is a workaround for the wealthy: the backdoor Roth IRA.

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Essentially, high-income earners who can’t contribute directly to a Roth IRA have a “backdoor” way to get one: They can contribute to a nondeductible IRA and then quickly convert it to a Roth. (More on that later.)

According to tax experts, Roth accounts are particularly attractive to investors because they offer benefits such as tax-free investment growth and retirement withdrawals.

“Roth IRAs are the gold standard,” said Ed Slott, a certified public accountant in Rockville Centre, New York.

IRA access and tax breaks could gradually phase out for high-income earners

The annual IRA contribution limit for 2024 is $7,000. Investors age 50 and older can save an additional $1,000 for a total of $8,000 this year.

Investors who save in a pre-tax IRA typically get a tax deduction for their contributions. However, they typically pay income taxes later on the earnings and withdrawals. Roth contributions don’t get the same upfront tax break: Investors fund a Roth IRA with after-tax money, but they typically don’t pay income taxes on the earnings or withdrawals in retirement.

However, many high-income earners cannot take full advantage of these tax-advantaged accounts.

For example, married couples filing a joint return can’t contribute to a Roth IRA in 2024 if their modified adjusted gross income is $240,000 or more. The income threshold for single filers is $161,000. (Eligibility begins to expire even before those dollar thresholds, reducing the amount investors can contribute.)

Similarly, income limits apply to deductions for IRA (pre-tax) (also known as “traditional”) accounts for people who also have access to an employee retirement plan, such as a 401(k).

For example, individual filers with 2024 income of $87,000 or more will not receive a tax break for contributions to a traditional individual retirement account (IRA) if they are covered by a workplace retirement plan.

The same goes for married couples filing jointly. For example, if your spouse participates in a 401(k) at work, you don’t get the deduction for IRA contributions if your joint income is $240,000 or more. If you’re the one who participates in a 401(k) at work, the limit is $143,000. (Again, you may only get a partial deduction below these dollar thresholds because of income phaseouts.)

The “Only Reason” to Save in a Nondeductible IRA

However, high-income earners can contribute to a nondeductible individual retirement account (IRA).

It’s a traditional IRA, but investors don’t get a tax deduction on their contributions; they fund the accounts with after-tax money. Investors are liable for income taxes on the growth later, after withdrawals.

Tax experts say the main advantage of these accounts is the ability to use a backdoor Roth IRA.

Slott explained that this only applies to investors who earn too much to contribute directly to a Roth IRA or make tax-deductible contributions to a traditional IRA.

Here’s the basic strategy: A high-income investor makes a nondeductible contribution to a traditional IRA, then quickly converts the funds to a Roth IRA.

“The only reason it would be worth it to set up (a nondeductible IRA) would be to set up a Roth account through the back door,” Slott said.

After making a nondeductible contribution, Slott recommends waiting about a month before converting the funds to a Roth IRA. That way, your IRA statement will reflect the nondeductible contribution in case the IRS ever requests proof, he said.

Some investors may also use a similar strategy in their 401(k) plan, the so-called mega backdoor Roth conversion. This involves moving after-tax 401(k) contributions to a Roth account. However, this strategy is not available to everyone.

“All high-earners should consider both a backdoor Roth IRA and a mega backdoor Roth IRA if they can’t set up a Roth IRA,” said Ted Jenkin, a certified financial planner and founder of Atlanta-based oXYGen Financial. He is also a member of the CNBC Financial Advisor Council.

When a Non-Deductible IRA Doesn’t Make Sense

According to financial advisors, a nondeductible IRA likely doesn’t make sense for investors who don’t intend to use a backdoor Roth strategy. In those cases, an investor would simply let the contributions remain in a nondeductible IRA.

For one thing, nondeductible contributions to an individual retirement account (IRA) can involve burdensome administrative and documentation requirements, Slott said.

“It’s a life sentence,” he said.

According to Arnold & Mote Wealth Management, based in Hiawatha, Iowa, taxpayers must file Form 8606 with the IRS each year to track their after-tax contributions to nondeductible IRAs. Withdrawals “add more complexity” to that administrative burden, it added.

Why Taxable Brokerage Accounts ‘Are Probably Better’

Without the backdoor Roth in play, most investors would be better off saving in a taxable brokerage account rather than a nondeductible IRA, advisers said. That’s because investors who use the former are likely to pay less tax on their gains over the long term.

Slott said taxable brokerage accounts “are probably better in many ways.”

Investors who hold assets such as stocks in a taxable brokerage account for more than a year generally pay a favorable tax rate on their gains compared to other income taxes.

These “long-term” capital gains tax rates — which only apply in the year investors sell their assets — are as high as 20% at the federal level. (High-income earners may also be required to pay a 3.8% “additional Medicare tax” on the gains.)

By comparison, the top income tax rate is 37%. Investors in nondeductible individual retirement accounts (IRAs) are typically subject to higher rates on earnings when they are withdrawn.

Advisors say that while investors with taxable brokerage accounts pay taxes on their dividend income each year, those taxes are usually not enough to offset the relative tax advantages of such accounts.

“The tax deferral of nondeductible IRAs can be an advantage for some,” says Arnold & Mote Wealth Management. “We believe, however, that this is quite rare.”

In addition, investors in taxable brokerage accounts can typically access their funds at any time without penalty, whereas IRAs are subject to tax penalties if gains are used before age 59½. (There are some exceptions for IRAs, however.)

Unlike traditional and nondeductible IRAs, taxable accounts do not have a requirement to make minimum distributions during the account holder’s lifetime.

“A taxable account gives you the flexibility to add and withdraw money with few limits, penalties or restrictions,” Judith Ward, a certified financial planner with T. Rowe Price, an asset manager, recently wrote.