The Roth IRA isn’t usually associated with high earners because of income contribution limits. There is a multi-step strategy that can be used to get money in a Roth. A Traditional IRA can be converted to a Roth IRA even for those who exceed the Roth contribution limits. If you’ve contributed the maximum to tax-deferred accounts such as 401(k)s, additional savings that can grow tax-free may make sense, even if they don’t reduce your taxes in the year in which you contribute.

Using a backdoor Roth IRA strategy can be a powerful way to create additional retirement savings. It can increase the spending flexibility in retirement. Let’s review what the process looks like and when it makes sense to use it.

The Advantages of a Roth IRA

Since you pay taxes on the funds before they are contributed to the Roth IRA, no further taxes are due on qualified withdrawals. Additionally, your money will grow tax-free.

Another advantage of investing in a Roth IRA is that it is not subject to required minimum distributions (RMDs). This allows for more control over the income stream in retirement, ensuring that income stays under the levels that would trigger taxes on Social Security benefits or the Medicare Part B surcharge.

Tax-free growth, withdrawals, no RMDs with Roth IRAs

What is a Backdoor Roth IRA?

A Backdoor Roth IRA is a term applied to opening a traditional IRA account and immediately converting it to a Roth IRA. It gives high earners who typically wouldn’t fall under the income qualifications the ability to save additional, tax-free funds for retirement.

In 2021, the income limits to contribute to a Roth IRA are $140,000 for single filers and $208,000 for married filing jointly. However, with a backdoor Roth IRA, you can convert your traditional IRA (no income contribution limits) into a Roth IRA to receive the tax-free growth it provides.

How Does the Conversion Work?

The process is straight-forward. You open a non-deductible, traditional IRA and contribute up to the maximum amount of $6,000 ($7,000 for age 50 and older), and then convert to a Roth. Since the contribution to the IRA is made with after-tax dollars and no tax deduction was taken, no further taxes are due on conversion. However, if it is invested in the traditional IRA account and it grows – taxes will need to be paid on the growth before it can be converted to a Roth IRA.

Process of converting from Traditional to Roth

The Watch Out

If you have a traditional IRA funded for a few years, your contributions have grown substantially, or you’ve deducted contributions – or all the above – the rules around the taxation can be a little tricky. The IRS doesn’t allow an investor to single out non-deductible contributions within a traditional IRA when doing a Roth conversion. This means any conversion will include a taxable portion. That doesn’t mean you shouldn’t do the conversion. Instead, examine the tax costs now verse potentially what they might look like in the future. 

The Drawbacks of Roth Conversions

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

First, your Roth IRA must be established for five years after making the conversion before taking any withdrawals, or you’ll incur penalties, and you can’t withdraw earnings penalty-free with the full tax benefits until age 59 1/2.

Also, if your tax bracket in retirement ends up being lower than it is right now, the conversion and tax-free aspect won’t be as impactful.

The Takeaway

Backdoor Roth IRAs are a powerful tool. They provide tax advantages that other retirement accounts can’t. However, many different factors play a role in deciding whether to do a backdoor Roth IRA, so it’s recommended to talk with a CPA or financial advisor about your specific situation and run the numbers before committing to a conversion.