Unpacking The Backdoor Roth IRA - Is This Strategy Right For You?

A Roth IRA is one of the most powerful accounts you can own, as it offers tax-free growth and tax-free withdrawals in retirement.

You can only contribute $6,500 into your Roth for 2023 ($7,500 if you are 50+ years old) and if you are a high-income earner, chances are you make too much money to contribute to a Roth.

But did you know there is a strategy that allows you to bypass the income limits?

Introducing the "Backdoor Roth IRA".

This strategy is used by high-income earners to contribute to a Roth IRA account, even if they exceed the income limits.

Here's how it generally works:

• Make a non-deductible contribution to a Traditional IRA: There are no income limits for contributing to a Traditional IRA. High-income earners can make a non-deductible contribution (meaning you don't get a tax deduction for the contribution) to this account.
• Convert the Traditional IRA to a Roth IRA: After making the non-deductible contribution to the Traditional IRA, you call the company where your account is held and tell them you want to convert the funds to a Roth IRA.
• Pay taxes on the converted amount: Taxes with the Backdoor Roth IRA strategy can be small or nonexistent. You will want to do this conversion immediately after the original contribution into the Traditional IRA, so there may be minimal earnings, and the tax impact is often minimal.
• Enjoy the Fruits of Your Labor: Once the funds are in your Roth IRA, you enjoy the benefits of tax-free growth and tax-free withdrawals in retirement.

A few things to keep in mind:

This strategy is great for people who DON’T already have a traditional IRA account established. Why? Because when calculating the taxes due on conversion, you need to consider ALL of your traditional IRA assets and the ‘pro rata’ rule comes into play.

If you want to use this strategy, consider doing it early in the year. That way, you can bunch together your contributions. For example, if I perform this strategy in March 2024, I can contribute $6,500 for 2023 and $6,500 for 2024. This may make it worth your time if you are converting $13,000 as opposed to just $6,500.

You may read those steps above and think it’s a lot of work/confusing and I would agree with you. I truly believe people flock to this idea because of the word ‘backdoor’.

‘Let’s stick it to the man!!’

That’s why I stick to my philosophy of keeping this game simple.

Rather than doing the ‘backdoor Roth IRA’, consider other ways to create your tax exempt buckets:

• Contribute to a Roth IRA while you are below the income compensation limits. If you get married, and file taxes jointly, the compensation limits increase significantly so double check to see if you qualify.
• Review your retirement account through your employer and see if they offer a Roth 401k or 403b. THERE ARE NO COMPENSATION LIMITS TO A ROTH 401K/403B. Rather than doing only pre-tax or Roth contributions, why not do both? If you have a deferred compensation plan, see if Roth is an option. Once you leave the employer or officially retire, the balances within these buckets can be rolled into a Roth IRA.
• If your 401k plan allows, you may be able to do a mega backdoor Roth conversion. Some plans permit automatic Roth conversions, which means you can make after-tax contributions and have them automatically convert to Roth within your account. Check with your plan to see if this option is available to you.
• Like most retirement accounts, you typically can’t access the funds until 59 1/2. While the tax free growth is great, ensure you are providing yourself flexibility to cover the short-term and medium-term needs. An investment account is a great option here.

It’s all about giving yourself options and flexibility. By building up your tax-exempt bucket early, you are putting yourself in a great position to attack the future.

Disclosure: This material is for general information only and is not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results.

It's essential to consult with a financial advisor or tax professional before implementing a Backdoor Roth IRA strategy, as individual circumstances can vary, and tax rules may change over time. All indices are unmanaged and may not be invested into directly. All investing includes risks, including fluctuating prices and loss of principal.