Roth IRAs come with some big tax benefits. But as a high-income earner, you know Roth IRAs aren’t for you.
Or are they?
One option you have as a high-income earner is an IRS-sanctioned loophole coined the backdoor Roth IRA. Let’s take a closer look at what it is, and if it might be right for you.
What Is a Backdoor Roth IRA?
A backdoor Roth IRA is an IRS-sanctioned loophole that lets high-income earners reap the benefits of contributing to a Roth even though they exceed the income limits for traditional Roth IRA contributions. Here is how it works.
Let’s say your income exceeds the legal limit for a traditional Roth IRA contribution, but you still want to fund an account. First, you will need to open a traditional IRA and fund it with non-deductible contributions. Then, you convert your non-deductible IRA balance 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 income limits for Roth IRA contributions, but you cannot avoid the annual contribution amount limits. This means that you can fund a maximum of $6,500 in 2023 (with $1,000 catch-up contributions if 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 dramatically increase your after-tax wealth; that is, the wealth you have after all taxes have been (or will be) paid. Unlike traditional retirement accounts, Roth IRAs aren’t subject to required minimum distributions (RMDs). This means you won’t be forced to start taking withdrawals—and paying income taxes on those withdrawals—when you reach age 73. 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 free of taxes if you wish to do so.
Knowledge Is Power
There are some things to be aware of when considering a backdoor Roth. For one, they 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 state taxes. If you live in a state that has an 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. Finally, this strategy is less effective if you have existing IRA balances that were made with pre-tax contributions.
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 is more nuanced and relates to whether or not taxes and penalties will be assessed if converted funds in a Roth IRA are distributed (or withdrawn) within five years of when they were each converted (each Roth IRA conversion has its own five-year clock in this context).
As with all tax-related matters, please consult a tax professional for tax advice that is specific to your situation. This article is not meant to be tax advice.
Is a Backdoor Roth IRA the Answer?
As with most financial matters, the answer is, “It depends.” Consulting your wealth advisor to discuss your particular circumstance is the best approach, especially if you have concerns about your current financial plan.
At Anderson Financial Strategies, we provide concierge financial services to help you manage your wealth, helping executives, business owners, and families prepare for retirement. In everything we do, our goal is to give relationship-based, premium financial guidance with rapidly responsive service. We want you to feel excited and confident about your future, and we’d love to help make that a reality for you. If you want to learn more about backdoor Roth IRAs or other options, please call us at 855-237-4545 to schedule an executive briefing to discuss your goals.
Shon Anderson is president and chief wealth strategist at Anderson Financial Strategies, LLC with over 15 years of experience. As a fiduciary, Shon’s mission is to provide his clients with quality financial expertise along with rapidly responsive service through an honest relationship. He specializes in providing family office-style services to help his clients organize and focus their financial life. Shon graduated from Wright State University with a bachelor’s degree in financial services and an MBA in finance. He is a CERTIFIED FINANCIAL PLANNER™ practitioner and holds the Chartered Financial Analyst® (CFA®) certification. His insights have been quoted in leading financial news publications such as CNBC, Yahoo Finance, Fox Business, Consumer Reports, Forbes, Bankrate.com, Investment News, and Kiplinger. Shon serves as an adjunct professor teaching personal finance courses at Wright State University, leads CFP® exam review courses for Keir Educational Resources, and is president of the CFA Society Dayton. Shon and his wife, Jessica, reside in Sugarcreek Township, Ohio, and are blessed with triplet daughters, Elizabeth, Bridgette, and Alexandra, along with their son, Jacob, and dog, Jack. Over the years, Shon has been involved in several volunteer organizations including the Wright State chapter of Delta Tau Delta as an alumni advisor and was a Big Brother in the Big Brothers/Big Sisters program. To learn more about Shon, connect with him on LinkedIn.