What Is A Backdoor Roth IRA? (And When It Makes Sense For You)

Planning your retirement saving strategy is a comprehensive task, especially when it involves complex strategies like backdoor Roth IRA contributions. With so many channels to choose from and varying rules like contribution limits, income thresholds, and tax liabilities, it can be difficult to keep it all straight. 

Many avid savers use individual retirement accounts (IRAs) to help fund their savings journey. Each type of IRA offers investors different opportunities. One that is attractive to many investors is a Roth IRA. 

A Roth IRA is a savings vehicle contributed to with after-tax dollars. What makes it so unique is that all qualified distributions aren’t taxed. With tax efficiency being a major factor in the efficacy of your retirement plan and cash flow, Roth IRAs are often a wonderful investment tool. 

But income thresholds keep many high earners from being able to regularly contribute to this account. Luckily, there is a way around those income limits with a process called a backdoor Roth IRA (Roth Conversion). 

What is a backdoor Roth IRA? How does it work and when does it make sense for you? Let’s find out. 

Backdoor Roth IRA Basics

A backdoor Roth IRA is a system that lets you transfer money from a traditional IRA into a Roth IRA. This process allows high-income earners to avoid the income rules for contributing to this account while still taking advantage of the account’s benefits. 

A backdoor Roth IRA is not an account like your 401(k) or traditional IRA, rather it is a strategy for high-income individuals to fund a Roth IRA. This strategy was put in place because once you reach a certain income limit, you are unable to open or fund the account. 

The income thresholds for 2020 are as follows: for those filing single it is $139,000 and for those married filing jointly it is $206,000. Once you surpass those modified adjusted gross income numbers, you can no longer regularly contribute to a Roth IRA. 

A backdoor Roth IRA opens up investors to this incredible wealth-building tool while remaining tax efficient. All IRAs have contribution limits, but in a conversion, you can surpass that limit ($6,000 or $7,000 if over 50 in 2020). Keep in mind that you can make multiple conversions per year so be sure to factor that into your plan.

But the conversion doesn’t stop there. Taxes play an integral role in this strategy, making it important to know how they will impact you. 

Your Tax Liability in a Roth Conversion

Think you can contribute pre-tax dollars into a traditional IRA then convert that money into a Roth and still get contributions tax free? Think again. The IRS has strict rules on the tax consequences of a Roth Conversion. 

There are a few different tax scenarios to be aware of. Most contributions to traditional IRAs are done with pre-tax dollars. Depending on your income, those dollars can either be deductible or non-deductible. 

If you are contributing money from a traditional IRA completely comprised of deductible (pre-tax dollars) assets, you are responsible for paying ordinary income tax on the total amount of those contributions including any amount that the contributions have earned. This tax requirement is triggered at the time of the conversion. 

If you are contributing money from your traditional IRA with all nondeductible contributions (after-tax dollars), you only pay taxes on any amount over your tax basis. But if you have a mix of both deductible and non-deductable contributions in your IRA, that is where things get a little more complicated. 

For contributions that are both deductible and non-deductable, the pro-rata rule comes into play. This rule uses the total value of all of your IRAs to come up with the taxes you owe. Let’s say you had $100,000 in total traditional IRA contributions from three sources (SEP-IRA, SIMPLE IRA, Traditional IRA) and $10,000 of that was non-deductible. You can’t just roll over the non-deductible portion as the IRS takes into account your total account balance to determine the amount of taxes you will pay. 

The tax consequences of Roth Conversions can be intense, making it important to understand both how much you want to roll over and what it will cost you to do so. 

When is a Backdoor Roth IRA Right for You?

There are a few things to keep in mind as you consider a backdoor Roth IRA. One of the main benefits of contributing to a Roth is the tax break in retirement. With contributions made from after-tax dollars, distributions aren’t taxed. This provides a huge tax incentive and is especially helpful for those who expect to be in a higher tax bracket in retirement than they are currently. 

Roth IRAs are also one of the only accounts not subject to required minimum distributions (RMDs) allowing them to be a wonderful wealth-building tool for yourself and also for beneficiaries in your estate plan. With a Traditional IRA, you have to start taking RMDs by 72 which limits how much you can contribute and when you have to start paying taxes. 

When you convert funds into a Roth IRA, you can’t take them out for at least 5 years without incurring a 10% early withdrawal penalty if you are younger than 50 ½. So if you need access to the money sooner, leaving it in a traditional IRA may be the better way to go. 

Be sure that you carefully weigh your options and tax consequences of a Roth conversion because once the money is converted, it can’t go back. 

The Arnold & Mote Team Can Help

We thrive serving people in every stage of life and view financial planning in a comprehensive, holistic way to meet you where you are and help get you where you want to be. Retirement planning is an important aspect of our firm and one we are passionate about. 

Saving for retirement is a long journey, and we want to be there by your side helping you navigate each step. Are you interested to know more about how a Roth Conversion could impact your savings strategy? Schedule a time to talk with us!

Let's Get Started

You'll get the most value from financial planning if your specific goals and needs match a firm's philosophy and services. Let's learn more about each other.

Ready to Get Started?