Taxes don’t go away in retirement. But there may be a way to lessen their impact on your retirement savings. In this article, we’ll cover the ins and outs of the backdoor Roth IRA and explain how it could benefit you. One of the biggest financial mistakes we see is not saving enough for retirement, and this strategy is just one way to help steer clear of that risk.
A backdoor Roth IRA is an IRS-sanctioned loophole that lets high-income earners reap the benefits of a Roth without violating the income limits.
There’s a reason Americans love Roth IRAs—they come with some major tax benefits. You pay taxes on your contributions up front, but then your investments grow 100% tax-free. Additionally, when you start taking withdrawals in retirement, none of that money counts as taxable income. It’s a very attractive option for those who can qualify.
But that’s the problem—most high-income earners don’t qualify for a Roth IRA. As of 2023, you’re not eligible to contribute to a Roth IRA if you make at least $153,000 as an individual or $228,000 as a married couple.
This begs the question: How can you enjoy the sweet tax perks that come with a Roth IRA if your income is over these limits? The answer may be the backdoor Roth.
Let’s say your income exceeds the legal limit for a Roth IRA, but you still want to fund an account. First, you will need to open a traditional IRA (it also needs to be your only traditional IRA) and fund it with non-deductible contributions. Then, you will immediately convert your non-deductible IRA to a Roth IRA and repeat this process each year in order to take advantage of tax-free growth.
In this scenario, you can avoid the IRA income limits, but you cannot avoid the annual contribution limits. This means that you can fund a maximum of $6,500 in 2023 ($7,500 if you’re over the age of 50) per year. This may seem small, but over time you can amass a sizable retirement savings, especially when combined with other tax-advantaged retirement vehicles.
A backdoor Roth IRA is a useful wealth strategy that can save you thousands in taxes. But there’s even more to it than that.
Unlike traditional retirement accounts, backdoor Roth IRAs aren’t subject to required minimum distributions (RMDs). This means you won’t be forced to start taking withdrawals—and paying taxes on those withdrawals—when you reach age 73 (the IRS changed the starting age from 72 to 73 this year).
This is yet another point in favor of backdoor Roths: estate planning benefits. With no required RMDs, you’re free to let your account balance grow and build for as long as you’d like. Then, you can pass it on to your heirs if you wish to do so.
There are some things to be aware of when considering a backdoor Roth.
The tax benefits of a backdoor Roth may be a benefit if you have zero to very low pre-tax traditional IRA assets. What happens if you have both pre-tax and non-deductible after-tax contributions in your traditional IRA? Unfortunately, you cannot choose to only transfer the after-tax contributions. This is because of the pro rata rule.
Pro rata means that taxation is based on percentages or ratios. If 60% of all your combined traditional IRA contributions were made pre-tax and 40% were made after-tax, then those are the percentages they use to determine the taxability of the conversion. No matter how much you convert or which specific IRAs it comes out of, 60% of the funds will be considered pre-tax (and therefore taxable) and 40% will be considered after-tax (and therefore tax-free).
In addition, you may be able to utilize a Mega Backdoor Roth strategy through your workplace qualified retirement plan if you have the financial flexibility to contribute beyond the annual IRS limits. In this strategy, you would fund after-tax contributions into your 401(k) that can grow tax-free as long as you have an in-plan Roth conversion option. Most 401(k) plans don’t allow for this provision, but if it’s available to you, reach out to us at WAG to learn more about this implementation strategy as you can do both mega backdoor and regular backdoor Roth contributions in the same year
Backdoor Roths are irreversible. That means if you converted too much at once and got pushed into a higher marginal tax bracket, you can’t take it back. But this can usually be avoided by keeping your conversion amounts to the annual contribution limits.
You will also need to consider those tricky state taxes. If you live in a state that has income tax, you’ll likely owe state taxes on your backdoor Roth conversion in addition to federal taxes. However, some states exempt part of your distribution if you’re over a certain age.
Backdoor Roth IRAs also have two five-year rules to keep in mind. The first rule says that you must wait at least five years from your first contribution before you can make a penalty-free withdrawal from your Roth IRA—even if you’re over age 59½.
The second five-year rule states that each of your backdoor Roth conversions has its own five-year period. For example, if you do a conversion in 2023 and another in 2024, you’ll have to wait until at least 2028 to access the first conversion and 2029 to access the second.
As with anything tax-related, consult a wealth advisor to position your money in a way that minimizes tax liability and maximizes growth.
A backdoor Roth IRA is just one of the many complex financial planning tools you can use to save money on taxes and prepare for retirement. At Wealth Advocate Group, we specialize in helping successful professionals plan for life’s many financial milestones, including retirement. We serve as your wealth advocate as we provide advice in the best interest of our clients to help them pursue their dreams.
Ready to learn more? Call 440-505-5704 or email jbrown@Wadvocate.com to schedule an appointment.
John Brown is a wealth advisor at Wealth Advocate Group, LLC, an independent, fee-based wealth management company. With over 10 years of experience in the financial industry and a background in accounting, John provides sophisticated and specialized services to his senior executive clients who need the expertise of someone well-versed in concentrated securities and restricted stock strategies, as well as the risk and tax burdens that come along with their compensation. John has a bachelor’s degree in accounting and financial management from Hillsdale College and is a CERTIFIED FINANCIAL PLANNER® professional. John is known for his thorough approach, often asking questions and bringing up details his clients have not considered. He strives to address every piece of his clients’ financial picture to make sure they are on the path toward their goals and financial confidence. In his spare time, John and his wife, Christina, enjoy traveling and staying active. You can often find him spending quality time with his friends and family. To learn more about John, connect with him on LinkedIn.
The opinions voiced in this article are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which strategies or investments may be suitable for you, consult the appropriate qualified professional prior to making a decision.
This information is not intended to be a substitute for specific individualized tax or legal advice. We suggest that you discuss your specific situation with a qualified tax or legal advisor. Wealth Advocate Group, LLC and LPL Financial do not offer tax advice or strategies.
Traditional IRA account owners have considerations to make before performing a Roth IRA conversion. These primarily include income tax consequences on the converted amount in the year of conversion, withdrawal limitations from a Roth IRA, and income limitations for future contributions to a Roth IRA. In addition, if you are required to take a required minimum distribution (RMD) in the year you convert, you must do so before converting to a Roth IRA.
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