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What is a Backdoor Roth IRA Conversion?

September 15, 2022

Like it or not, taxes are a way of life. They fund great things like roads, libraries and parks, but nobody wants to pay more than they absolutely have to. We often get questions like, “How can I balance my tax obligations with my financial goals?” and one possible option is a Roth RIA. Roth IRAs are tax-advantaged retirement savings accounts that can be quite useful if you expect your tax obligations will rise as you get older.

Because withdrawals from a Roth are tax-free, it’s an especially attractive option for high-earning households. Unfortunately, the US tax code prohibits individuals or households from contributing to a Roth IRA if they earn over a certain annual income. But there IS a workaround (creatively known as a “backdoor Roth conversion” among tax and financial professionals).

How does a backdoor Roth conversion work?

Problem: you can’t open/fund a Roth IRA because you earn over the income limit (specified in the low- to-mid-six figures, depending on your filing status).

Solution: because traditional IRAs have no income limit, you would open a traditional IRA and then (here’s the tricky part) instead of funding it with a normal deductible contribution, you would fund it with a nondeductible contribution (meaning you won’t claim the deduction on your taxes). You then convert the traditional IRA into a Roth IRA.

That’s the idea in a nutshell, but be aware that it can be complicated, especially when you start to account for tax situations specific to your household.

What are the pros?

The converted funds now held in the Roth IRA give you access to your funds tax free after age 59.5 with no required minimum distribution. You can even pass it to your heirs (and unlike a traditional IRA, your heirs owe no taxes on an inherited Roth IRA).

Also, under current regulations, there is no limit to the amount of money you can convert from a tax-deferred account to a Roth IRA.

What are the cons?

Because you haven’t yet paid taxes on the money in a traditional retirement account, when you convert it to the Roth IRA the IRS views that as taxable income. So, you owe taxes on the amount you convert in the year you execute the conversion. For example, suppose you’re in the 24% tax bracket and converted $100,000. That means you could owe $24,000 on top of your expected annual tax obligation. Ouch.

There are other factors that can make a backdoor conversation complicated or messy, especially if the account you’ll be converting contains funds from different sources. And remember, if you convert from a Traditional IRA, you have to wait five years before you can withdraw funds.

Last word.

A backdoor Roth conversion can make a lot of sense for high-earning individuals and households seeking to access tax-advantaged funds in retirement. However, tax implications can be tricky to calculate, so it’s important to carefully weigh the potential costs relative to the anticipated benefits. Contact your tax professional if a Roth conversion might be right for you. If you have additional questions, call our office – we’re here to help.