The Backdoor Roth IRA: A Strategy for Tax-Advantaged Growth

By: Scott Sturgeon, JD, MBA, CFP®

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When it comes to tax-efficient retirement savings, implementing a Backdoor Roth IRA strategy can be a great addition to an overall financial plan. While it may not be the most common strategy people implement, the Backdoor Roth IRA has gained popularity as a strategic approach for high-income individuals to benefit from tax-free growth. In this article, we’ll delve into the mechanics of Backdoor Roth IRA contributions, exploring their benefits, eligibility criteria, how to execute this tax-efficient strategy, and whether it makes sense for your financial situation.

1. Understanding Roth IRAs

Before diving into Backdoor Roth IRA contributions, let’s briefly go over what a Roth IRA actually is. A Roth IRA is a retirement savings & investment account that allows you to contribute after-tax dollars (i.e. money you’ve already paid taxes on). The key advantage of a Roth IRA lies in the tax treatment during retirement: qualified withdrawals are entirely tax-free. Moreover, Roth IRAs do not currently have Required Minimum Distributions (RMDs), allowing your investments to grow tax-free indefinitely, making them an attractive option for long-term financial planning.

2. The Limitations of Traditional Roth IRA Contributions

One significant limitation of contributing to a Roth IRA is the income eligibility threshold. This threshold means that higher income earners cannot contribute directly to a Roth IRA if their income exceeds a certain amount. As of 2023, individuals with a Modified Adjusted Gross Income (MAGI) above $153,000 and married couples filing jointly with a MAGI above $228,000 cannot contribute directly to a Roth IRA. This has made the Roth IRA inaccessible to high-income earners seeking its benefits, unless they get a little creative…

3. What is the Backdoor Roth IRA?

The Backdoor Roth IRA is a legal and strategic workaround for high-income earners to enjoy the advantages of a Roth IRA, despite the income limitations on direct contributions. It involves a three-step process:

Step 1: Make sure that no assets are held in Traditional IRA accounts when your initiate the strategy. If you currently have funds in a Traditional IRA, you can transfer the balance to a 401(k) or 403(b). The reasoning gets a little complicated, but suffice it to say this allows for the transaction to be more tax efficient & avoids the pro rata rule.

Step 2: Make a Non-Deductible Traditional IRA Contribution – Since there are no income limits for contributing to a Traditional IRA, high-income individuals can make a non-deductible contribution regardless of their earnings. This means they contribute after-tax dollars to the Traditional IRA.

Step 3: Convert the Traditional IRA to a Roth IRA –  After contributing to the Traditional IRA, you can convert the funds to a Roth IRA. The conversion process is crucial as it moves the money from the Traditional IRA (with potentially taxable growth) to the Roth IRA (with tax-free growth). Note that in doing so, you will need to make sure whoever files your taxes is aware you made the transaction as there are some specific tax forms you’ll want to file with your return.

4. Benefits of Backdoor Roth IRA Contributions

A. Tax-Free Growth: The primary advantage of the Backdoor Roth IRA is the potential for tax-free growth. By converting after-tax contributions to a Roth IRA, all future earnings and withdrawals in retirement can be tax-free if certain requirements are met.

B. Tax Diversification: When you’re retired and living off of your various investment accounts, the order in which you withdraw from those accounts can actually impact how much you’ll pay in taxes throughout your retirement. Having built a balance in your Roth IRA, you’re able to potentially introduce a tax-free source of income in retirement that can work in tandem with your other accounts to potentially reduce your tax bill. Having both pre-tax and after-tax retirement accounts provides tax diversification during retirement. This can be advantageous in managing your tax liability in different economic and tax environments.

C. No RMDs: Unlike Traditional IRAs, Roth IRAs do not require you to take Required Minimum Distributions (RMDs) during your lifetime. This allows you to maintain control over your funds and potentially pass on a tax-free inheritance to your beneficiaries.

5. Eligibility and Considerations

A. Existing Traditional IRA Balances: As previously noted, the Backdoor Roth IRA strategy can be less effective if you have significant pre-tax balances in existing Traditional IRAs, almost to the point of not making it worthwhile at all. This is because any conversion will trigger pro-rata taxes, making it less tax-efficient. If this is the case, consider rolling over your Traditional IRA balances into an employer-sponsored 401(k) if possible.

B. A Secondary Tax Strategy: While the Backdoor Roth IRA is a legitimate strategy, it is typically a secondary strategy to things like maxing out your workplace retirement plan like a 401(k), 403(b), or even a Health Savings Account (HSA). This is especially true for those who may be high income earners in some of their highest earning years where you’re trying to defer paying taxes on earnings now. In those instances though, once you’ve maxed out contributions to those types of tax-deferred accounts, ongoing Backdoor Roth IRA contributions can be hugely beneficial over the long term as an additional place to build tax advantaged retirement savings.

C. Advice & Guidance Before executing any tax or investing strategy, consider consulting with a wealth advisor to assess your individual financial situation and to understand the potential tax implications specific to your circumstances. Implementing a Backdoor Roth IRA takes a little more planning and coordination than other strategies, so having someone to assist with the logistics on an annual basis can be helpful.

Conclusion

Backdoor Roth IRA contributions offer a strategic path to tax-advantaged growth for high-income earners who would otherwise be restricted from direct Roth IRA contributions. By following the process of making non-deductible Traditional IRA contributions and converting them to a Roth IRA, individuals can access the tax advantages of a Roth account.

However, it’s crucial to consider existing retirement account balances and consult with a financial advisor to ensure this strategy aligns with your overall financial plan. By incorporating the Backdoor Roth IRA into your retirement strategy, you can enhance tax diversification and potentially enjoy tax-free growth in your golden years. Remember, planning for retirement is a long-term journey, and informed decisions today can lead to a more secure financial future tomorrow.

Curious to learn how working with a seasoned CFP® professional at Oread Wealth Partners can bring value to your unique financial situation? Let’s talk.

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