By Boyce F. Lowery, CLU, ChFC
If you’ve spent any time researching retirement accounts, you’ve probably come across the very popular Roth IRA. People all across America are in love with Roth IRAs because they come with some major tax benefits: You pay taxes on your contributions up front, but then your investments grow 100% tax-free. When you start taking withdrawals in retirement, none of that money counts as taxable income. It’s a very attractive option for those who can qualify.
But here’s the bad news: Most high-income earners don’t qualify for a Roth IRA. As of 2021, you’re not eligible for contributing to a Roth IRA if you make at least $140,000 as a single filer or $208,000 as a married person filing jointly. (1)
This begs the question: How can you enjoy the sweet tax perks that come with a Roth IRA if your income is over these limits? Enter the backdoor Roth IRA.
What Is a Backdoor Roth IRA?
A backdoor Roth IRA is an IRS-sanctioned loophole that lets high-income earners convert some of their traditional IRA earnings into a Roth IRA. It’s also called a Roth IRA conversion.
Here’s how it works.
Let’s say your income exceeds the legal limit for a Roth IRA but you still want to fund an account. You have $200,000 in a traditional IRA, so you decide to take $35,000 of it and convert it to a Roth IRA. You pay taxes on the initial $35,000 up front, but after that, it grows tax-free into retirement.
Pros and Cons of a Backdoor Roth IRA
Backdoor Roth IRAs are an excellent financial planning tool, but there are a few drawbacks to watch out for. Let’s take a quick look at some of those now.
- Tax-free growth. Let’s say you take $35,000, pay taxes on that amount up front from separate funds, then invest the $35,000 in a backdoor Roth IRA, where it grows at 6% annually. In 20 years, you’d have roughly $77,000 in tax-free growth. (2) Not bad, right?
- Higher contribution limits. You typically can’t contribute more than $6,000 to a Roth IRA each year. (3) But with a backdoor Roth IRA, there’s no limit on how much you can roll over.
- No RMDs. 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 pay taxes on those withdrawals—when you turn age 72.
- Estate planning benefits. With no required RMDs, you’re free to let your Roth IRA account balance grow and build for as long as you’d like. Then you can pass it on to your heirs if you wish to do so.
- Could bump you into a higher tax bracket. If you convert too much at once, it could push you into a higher marginal tax bracket. For this reason, most people opt to do rollovers in years where they know their income will be lower than usual.
- Can’t be undone. Once initiated, backdoor Roth IRAs can’t be reversed. If you roll over money, then realize you owe more taxes than you thought, you can’t undo it. That’s why it’s best to get the expert eye of a professional who can ensure you do it right the first time.
- Beware transfer types. There are several ways you can roll money into a backdoor Roth IRA. If you opt to have the check sent to you—and it takes you more than 60 days to deposit it—it’ll count as a withdrawal and you’ll be on the hook for penalties and taxes.
- Potential state taxes. If you’re in a state that has income tax, you’ll likely pay 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. (4) It’s important to talk with a tax professional who can give you insights into what type of tax bill you could expect with a conversion.
Watch Out for Five-Year Rules
Backdoor Roth IRAs have two five-year rules you need to watch out for.
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. (5)
The second five-year rule states that each of your backdoor Roth IRA conversions counts as its own five-year period. (6) For example, if you do a conversion in 2021 and another in 2022, you’d have to wait until at least 2026 to access the first conversion and 2027 to access the second.
When a Backdoor Roth IRA May Be Right for You
You may want to explore the possibility of opening a backdoor Roth IRA if you…
- Make too much money to qualify for a regular Roth IRA
- Can afford to pay taxes on your rollover amount now in order to take advantage of future growth
- Want to minimize required minimum distributions (RMDs) when you reach age 72
When a Backdoor Roth IRA May Not Be Right for You
On that same note, a backdoor Roth IRA may not be the best move for you if you…
- Already qualify for a Roth IRA
- May start using funds within the next five years (because then you’d violate the two five-year rules)
- Don’t have enough idle cash to cover the conversion tax
Need Help Deciding if a Backdoor Roth IRA Is Right for You?
A backdoor Roth IRA is a great workaround if your income is too high to qualify for a Roth IRA. But as with all good things, there are some caveats to consider. If you convert too much, it can push you into a higher marginal tax bracket. If you do the wrong transfer type, you could end up paying penalties and taxes on your entire withdrawal.
Because of this, it’s best to work with an experienced professional who can help you execute your backdoor Roth IRA strategy in a way that avoids surprises. If you have earnings beyond the limit to contribute annually to a Roth IRA or wish to set aside higher amounts than a Roth IRA allows, we can explain how to achieve tax-free cash flow during your retirement years or sooner with no IRS contribution limits.
Suncrest Advisors is here to help. Call us at 888-827-0146 to get started.
Boyce Lowery is a 40-year veteran and established expert in the insurance industry. As the managing partner of Suncrest Advisors, he, his partner, and their associates all aim to provide financial security and peace of mind to business owners, executives and professionals, and high net-worth individuals across the United States. Along with more than four decades of experience, Boyce is a Chartered Life Underwriter® (the premier designation for insurance professionals signifying specialized knowledge in life insurance and estate planning) and a Chartered Financial Consultant® (known as the advanced financial planning designation). To learn more, visit https://suncrestadvisors.com/ or connect with Boyce on LinkedIn.