• Nate Baim, MBA, CFP®

The Backdoor Roth IRA Tax Strategy


The Backdoor Roth IRA Tax Strategy

For high earners, like you, who have contributed the maximum to tax-deferred accounts such as 401(k)s, additional savings that can grow tax-free may make sense even if those extra savings don't reduce taxes in the year you contribute. Furthermore, whether you have maxed your pre-tax accounts, you should have a portfolio that provides you with tax diversification. Tax diversification means holding assets in pre-tax, after-tax, and taxable accounts. You want to have these different kinds of accounts because we don't know:

  • What the tax laws will be in the future.

  • How your goals will change over the coming decades.

Due to income phaseouts, the after-tax bucket can be challenging for high earners to fund. Roth IRAs are not usually associated with high earners. Still, there is a way to provide the advantages of tax-free growth and tax-free withdrawals in retirement, even if you are over the income limits. An IRS loophole that allows for conversions means that even those who exceed the income limits for a Roth IRA can convert traditional IRA contributions into a Roth IRA.

Using a Backdoor Roth IRA strategy can be a powerful way to create additional retirement savings and diversify your tax exposure. But first, let's understand the Roth IRA.


The Advantages of a Roth IRA

Since you pay taxes on contributed funds to the Roth IRA, no further taxes are due if you make qualified withdrawals. Furthermore, once the funds are in the Roth IRA, your money grows tax-free.

Another critical advantage of a Roth IRA is that it is not subject to required minimum distributions (RMDs). With traditional IRAs, 401(k)s, 403(b)s, and other pre-tax accounts, the IRS requires you to withdraw a certain percentage of the balance once you reach age 72. These required withdrawals are called RMDs. With RMDs, you will have less control over when to remove funds from your accounts. Thus, it may force you into a situation where you are pushed into a higher income tax bracket to satisfy the RMD. And yeah, don't think about skipping the RMD; it will cost you a hefty penalty. The penalty is 50% of the RMD. Ouch.

However, the Roth IRA does not have RMDs. The Roth allows for more control over your income stream in retirement, helping you better manage your income. The flexibility helps you better manage your tax bracket. Ultimately this enables you to address better Social Security taxation or the Medicare Part B or D surcharge.


Roth IRA Benefits


What is a Backdoor Roth IRA?

A Backdoor Roth IRA is a tactic used by high-income earners to legally circumvent the income phaseouts associated with contributing to a Roth IRA. If your income is higher than the 2022 phaseouts listed below, then you are ineligible to make a direct contribution to a Roth IRA:

  • Filing Single: $129,000 - $144,000

  • Filing Married Jointly: $204,000-$214,000

And if you are in the phaseout, you may be able to make a pro-rata contribution. But why make a pro-rata contribution when you can use the Backdoor Roth to contribute the complete $6,000 limit ($7,000 if over age 50)? With a Backdoor Roth IRA, you can convert a traditional IRA (which doesn't have income limits) into a Roth IRA.


How Does It Work?

The process is simple, but there are issues you must carefully consider (more on that later). First, you open a non-deductible, traditional IRA, contribute up to the maximum amount of $6,000 ($7,000 for age 50 and older), and immediately convert the traditional IRA funds to a Roth. In this scenario, you contribute to the IRA with after-tax dollars, and no further taxes are due. However, those funds in the traditional IRA are allowed to sit in the account to grow. But I would not let those funds sit there to grow, it will complicate your tax work, and taxes will need to be paid on the growth when that money rolls to a Roth IRA.


Are you looking for a more detailed breakdown of the Backdoor Roth IRA process? Download this Backdoor Roth IRA flowchart, which helps you through the specific steps of completing a Backdoor Roth IRA.


Backdoor Roth IRA Flow Chart Download


The Key Item to Lookout For - The Pro-Rata Rule

If you have any pre-tax IRAs, then the tax rules get tricky. This rule applies to any SEP IRAs, SIMPLE IRAs, or traditional IRAs you may have. If you have any of these IRAs for which you've received a deduction, and there are earnings in the IRAs, then rules around taxation grow a bit more complicated. See, the IRS doesn't look at IRAs individually. No IRA stands alone. The IRS looks at them in aggregate. So, the IRS doesn't allow you to single out non-deductible contributions within a traditional IRA when doing a Roth conversion. To execute the Backdoor Roth IRA, you must consider if your situation requires you to follow the pro-rata rules.

Form 8606 outlines the math required to complete the calculation. But basically, you have to separate the fraction of after-tax vs. before-tax contributions for all your IRAs. And then you pay tax based upon this proportion when completing a conversion.

An option to avoid the pro-rata rule is to roll your IRAs to your 401(k) or 403(b). You can do this if your employer-sponsored plan allows it. Check the plan's documents to see if they allow IRA rollovers into the qualified plan. By eliminating all your IRAs and moving the funds to a 401(k), you've eliminated the need to figure out any tax due under the pro-rata rule. The pro-rata rule does not apply to 401(k)s or 403(b)s when making a Backdoor Roth Conversion.


Roth Conversion Considerations

There are a few things to consider before using the Backdoor Roth IRA strategy.


While you can withdraw contributions tax-free from a Roth IRA, converted assets to the Roth IRA are subject to the five-year rule. If the funds are not in the Roth IRA for five years, you may owe penalties. However, if you hold the converted assets in the Roth IRA for the minimum 5-year holding period, you will owe no taxes or penalties.


If you've maxed out your 401(k), the Backdoor Roth IRA can be an excellent strategy to consider. If you haven't, further investigate how appropriate a Backdoor Roth is for you. If you've not maxed out your pre-tax contributions before doing a Roth conversion, you should consider your current tax rate and what you believe your tax rate will be in the future. If you think your tax rates in retirement will be lower than right now, the conversion and tax-free aspect won't be as impactful. If you are currently in the highest tax brackets, you would likely be better off maxing out your pre-tax accounts. If you are not in the highest tax brackets but cannot make a direct Roth contribution, it may make sense to do a Backdoor Roth without first maxing your pre-tax accounts. But, if you have maxed out your pre-tax accounts, contributing to a backdoor Roth can be advantageous.


The Key Tax Document

A key document you must fill out at tax time to adequately capture your Backdoor Roth IRA is Form 8606 - Nondeductible IRAs. If you do not fill out this form correctly, it will be as if you did nothing, and you'll end up with some significant tax headaches. This form outlines the steps necessary to report the pro-rata tax, the nondeductible contributions to the traditional IRA, and the Roth IRA rollover.


The Backdoor Roth May Go Away

Several versions of the Build Back Better Bill included provisions that would have eliminated the Backdoor Roth strategy. However, the BBB Bill is currently dead in Congress and has not become law. But the signaling of the possible elimination of the tactic does mean individual investors need to stay apprised to changes in legislation and change their approach if new laws come into force which may impact their plan.


The Takeaway

Backdoor Roth IRAs can be a powerful tool and provide tax advantages that other retirement accounts don't. Having Roth IRAs as a part of your total portfolio can offer you tax diversification and more options as you progress toward your pursuit. However, many different factors play a role in deciding whether to do a backdoor Roth IRA. Talk with a financial planner about your specific situation and run the numbers before completing a conversion.


Are you trying to figure out if you should do a Backdoor Roth? At Pursuit Planning and Investments, LLC, I help you think through your options. I ultimately help you make the best decisions for yourself, your family, and your money. Feel free to place a commitment-free 30-minute meeting on my calendar. We can discuss your possible Roth Conversion and begin best optimizing your financial plan in that meeting.





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