The Backdoor Roth IRA

Courtney Jones, CFP®
Posted on 
October 7, 2021

Author  Courtney Jones, CFP®

The Backdoor Roth IRA

A Roth IRA can be an important tool to increase your portfolio long term returns, especially if you expect to have a lower tax bracket during retirement. But not everyone can invest in a Roth IRAs; the IRS limits the investment to people with income below a certain threshold.  However, there is an IRS loophole that allows for investment account conversions, the backdoor Roth IRA.

First, let’s look at the reasons why some investors may want to invest in Roth IRAs. Roth IRAs attract investors for two main reasons, their tax-free growth and withdrawals, and their lack of required minimum distributions (RMDs).

Roth IRAs are funded with after tax contributions, that is, you pay taxes on the funds before they are contributed to the Roth IRA and no further taxes are required when making qualified withdrawals, thus allowing for your investment to grow tax free. IRAs contributions, on the other hand, are funded with pretax dollars. You can deduct taxes of your contributions, but withdrawals are taxed on both contributions and earnings.

Another advantage of Roth IRAs is that the IRS does not require required minimum distributions from the account (as opposed to RMDs from IRAs). This can give you more control over the income stream in retirement, and more flexibility to ensure that your income stays under the levels that would trigger taxes on Social Security benefits or the Medicare Part B surcharge.

Both advantages make the Roth IRA a desirable investment vehicle for many professionals saving for retirement. If you have contributed the maximum to other tax deferred accounts such as 401ks, 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.

But as we mentioned before, not everyone can invest in a Roth IRA. The IRS limits the investment to people with income below a certain threshold.  In 2021, the income limits to contribute to a Roth IRA are $140,000 for single filers or $208,000 for those who are married and file jointly. This can leave many high-income investors unable to take advantage of the Roth IRA’s benefits.

However, there is a strategy to allow conversions from traditional IRAs to Roth IRAs. This strategy is commonly referred among investors as a backdoor Roth IRA. Those who exceed the income limits for a Roth IRA can use this strategy to convert traditional IRA contributions into 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.

The process is simple. 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 immediately convert to a Roth. In this scenario, the original amount is contributed to the IRA with after-tax dollars, and no further taxes are due. The term immediately is important. If instead of converting right away, the investment is allowed to sit 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.

The rules around the taxation can be a little tricky, especially if you have a traditional IRA funded for a few years, the investments have grown, or if you have deducted contributions. The IRS doesn’t allow an investor to single out non-deductible contributions within a traditional IRA when doing a Roth conversion.

Additionally, there are a few things to consider before using the backdoor Roth IRA strategy.  Withdrawals from a Roth IRA during the first five years after making the conversion or before age 59 ½ will incur penalties. Also, consider that 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.

In summary, backdoor Roth IRAs are a powerful tool when used correctly and can 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 always talk with a CPA or financial advisor at Credo Wealth Management about your specific situation and run the numbers before committing to a conversion.

The Backdoor Roth IRA

Courtney Jones, CFP®
Posted on 
October 7, 2021
The Backdoor Roth IRA

Author  Courtney Jones, CFP®

The Backdoor Roth IRA

A Roth IRA can be an important tool to increase your portfolio long term returns, especially if you expect to have a lower tax bracket during retirement. But not everyone can invest in a Roth IRAs; the IRS limits the investment to people with income below a certain threshold.  However, there is an IRS loophole that allows for investment account conversions, the backdoor Roth IRA.

First, let’s look at the reasons why some investors may want to invest in Roth IRAs. Roth IRAs attract investors for two main reasons, their tax-free growth and withdrawals, and their lack of required minimum distributions (RMDs).

Roth IRAs are funded with after tax contributions, that is, you pay taxes on the funds before they are contributed to the Roth IRA and no further taxes are required when making qualified withdrawals, thus allowing for your investment to grow tax free. IRAs contributions, on the other hand, are funded with pretax dollars. You can deduct taxes of your contributions, but withdrawals are taxed on both contributions and earnings.

Another advantage of Roth IRAs is that the IRS does not require required minimum distributions from the account (as opposed to RMDs from IRAs). This can give you more control over the income stream in retirement, and more flexibility to ensure that your income stays under the levels that would trigger taxes on Social Security benefits or the Medicare Part B surcharge.

Both advantages make the Roth IRA a desirable investment vehicle for many professionals saving for retirement. If you have contributed the maximum to other tax deferred accounts such as 401ks, 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.

But as we mentioned before, not everyone can invest in a Roth IRA. The IRS limits the investment to people with income below a certain threshold.  In 2021, the income limits to contribute to a Roth IRA are $140,000 for single filers or $208,000 for those who are married and file jointly. This can leave many high-income investors unable to take advantage of the Roth IRA’s benefits.

However, there is a strategy to allow conversions from traditional IRAs to Roth IRAs. This strategy is commonly referred among investors as a backdoor Roth IRA. Those who exceed the income limits for a Roth IRA can use this strategy to convert traditional IRA contributions into 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.

The process is simple. 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 immediately convert to a Roth. In this scenario, the original amount is contributed to the IRA with after-tax dollars, and no further taxes are due. The term immediately is important. If instead of converting right away, the investment is allowed to sit 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.

The rules around the taxation can be a little tricky, especially if you have a traditional IRA funded for a few years, the investments have grown, or if you have deducted contributions. The IRS doesn’t allow an investor to single out non-deductible contributions within a traditional IRA when doing a Roth conversion.

Additionally, there are a few things to consider before using the backdoor Roth IRA strategy.  Withdrawals from a Roth IRA during the first five years after making the conversion or before age 59 ½ will incur penalties. Also, consider that 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.

In summary, backdoor Roth IRAs are a powerful tool when used correctly and can 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 always talk with a CPA or financial advisor at Credo Wealth Management about your specific situation and run the numbers before committing to a conversion.

Registered Representative of Sanctuary Securities Inc. and Investment Advisor Representative of Sanctuary Advisors, LLC. Securities offered through Sanctuary Securities, Inc., Member FINRA, SIPC.  Advisory services offered through Sanctuary Advisors, LLC., an SEC Registered Investment Advisor. Credo Wealth Management is a DBA of Sanctuary Securities, Inc. and Sanctuary Advisors, LLC. This communication has not been reviewed for completeness or accuracy, does not necessarily reflect the views of Sanctuary Securities, Inc. or Sanctuary Advisors, LLC., and is not a recommendation or endorsement of any product, service, or issuer. For additional information, please refer to one of the following consumer websites: www.FINRA.org, www.SIPC.org.

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Securities offered through Sanctuary Securities, Member FINRA and SIPC. Advisory services offered through Sanctuary Advisors, LLC, an SEC registered investment advisor.