When it comes to being eligible for certain types of retirement savings accounts, not all earners are created equal.
High-income individuals are shut out from contributing directly to a Roth IRA. But even if your income is more than the maximum allowed, there is a way to gain entry to this popular retirement savings vehicle by employing a strategy called a “backdoor” Roth.
Save more for retirement
What is a Roth IRA?
A Roth IRA is similar to a traditional individual retirement account, but you fund it with money that’s already been taxed — meaning there’s no upfront tax break. In 2019, you can save up to $6,000 each year, or $7,000 if you are 50 or older, in an IRA account.
For a Roth IRA, the key feature is that there’s no tax on funds when you withdraw them in retirement. What’s more, Roth IRAs are not subject to required minimum distributions after the holder turns 70-and-a-half.
The hitch: To qualify for a full Roth contribution, you cannot make more than $193,000 if married and filing jointly (those with incomes of up to $203,000 can make a reduced contribution) or $122,000 if single (those making up to $137,000 can make a partial contribution).
This limit puts high-earners on the backburner when it comes to reaping the tax advantages of these retirement accounts.
How do backdoor Roths work?
While income caps keep some individuals from contributing to a Roth, there are zero income restrictions on converting from a traditional IRA to a Roth IRA. That means high-income investors can make regular IRA contributions and then convert them to a Roth.
Converting to a Roth isn’t without penalty: You must pay taxes on any funds in other traditional IRA accounts you have that aren’t converted, according to the Internal Revenue Service (IRS)’s pro rata rule. You must figure the ratio of IRA funds that have never been taxed (in other words, deductible IRA contributions and earnings) to the total assets in all of your IRAs.
For example, let’s say you have $94,500 in traditional IRA assets and make a non-deductible IRA contribution of $5,500 this year with the intention of converting it to a Roth IRA. In this case, 94.5 percent of your total of $100,000 in IRA assets has not yet been taxed. That means that 94.5 percent of your $5,500 contribution, or $5,197.50, would be taxable upon conversion. If you opted to convert your entire $100,000, you’d owe taxes on $94,500.
Avoiding the pro rata rule
There is a way to work around the pro rata rule too — with a reverse rollover.
If your employer’s 401(k) plan allows you to roll IRA money into it, you can move your deductible IRA contributions and pre-tax earnings into the 401(k). This is a good move if your employer’s plan offers solid, low-cost investment options.
Then you can convert any remaining, non-deductible contributions you have made to your traditional IRA into a Roth IRA. In this case, you’d owe no taxes on the conversion and would secure a tax-free stream of income in retirement when you begin making withdrawals.
Andrew Westlin, CFP, a financial planner at Betterment, says this can be a great strategy — but it’s only effective if the plan’s sponsor allows rollovers and if the individual has been keeping tabs on their investments.
“You, as the investor, need to know how much non-deductible basis you have in your IRAs so we can accurately determine how much can be converted and how much needs to be rolled in,” Westlin says.
If you don’t, you could get hit with a major tax bill.
Why do a backdoor Roth IRA conversion?
The main reason why retirement accounts like traditional IRAs and Roth IRAs are appealing is because they provide tax benefits for individuals who use them. However, those tax benefits are only available to individuals below the income thresholds.
Those above the income thresholds are not permitted to make a tax-deductible traditional IRA contribution, meaning they won’t have the opportunity to lower their taxable income through retirement savings each year. Additionally, they can’t take advantage of Roth IRAs, meaning they aren’t able to have their retirement earnings grow tax-free.
This is why a backdoor Roth IRA conversion is appealing: It allows high-income earners to have a hand in retirement savings that come with tax benefits.
Aside from that, there are some other great benefits of backdoor Roth IRA conversions, including:
No required minimum distributions once you hit 70½
By not having to withdraw funds during retirement, that money has the chance to continue taking advantage of compound growth. This can be a great asset for someone who has multiple sources of income in retirement but wants to elongate part of it for as long as possible.
You can transfer the wealth tax-free
Money in a Roth IRA can be turned over to heirs tax-free, given that you owned it for more than five years. This makes it an attractive option for growing money tax-free and passing it along to loved ones without any tax penalties. Keep in mind, however, that the heirs will have mandatory annual withdrawals but they can stretch them out over a lifetime, giving some room for the money to continue to grow.
Setting up a backdoor Roth
You can do a backdoor Roth by converting a traditional IRA account to a Roth IRA account. To do this, contact your bank or brokerage to start the process.
Megan Gorman, a personal finance expert and founding partner of Chequers Financial Management, says consumers should contact a tax professional first before attempting a backdoor Roth on their own.
“It’s a great idea, but the aggregation rules and the rules regarding nondeductible versus deductible are complex, so it’s hard for investors who are do-it-yourself-investors to get it right,” Gorman says. “They are fraught with risk — if you do it wrong, you can hurt yourself tax-wise. Tax professionals are the ones who can really give this advice because they see the whole picture.”
How do taxes get triggered?
The main advantage of Roth IRAs is they allow individuals to pay taxes upfront, meaning in the future, they will have a source of tax-free income.
Since backdoor Roths work around income caps, they can be an appealing option for certain high-wealth individuals. Gorman warns, however, that they come with risks.
“In most instances it makes sense, but you have to make sure you don’t trigger any other tax consequences,” Gorman says.
If someone has multiple traditional IRAs and doesn’t convert them, they will be taxed. Another way: If the traditional IRA isn’t converted quickly and generates earnings, those earnings will be subject to tax.
Also, you can’t be over 70½ and complete a backdoor Roth IRA — after that age, you aren’t able to make traditional IRA contributions. Conversions have to be held five years before withdrawing.
If this strategy is potentially a good option for high-income earners, can’t the case be made that saving $6,000 at a time won’t do much in terms of their future? Dan Keady, chief financial planner at TIAA, says it’s a good strategy for building wealth — but shouldn’t be the only part of an individual’s plan.
“It’s a technique that works, but only works if someone were to do it over multiple years,” Keady says. “It’s a nice thing that can help, but it should not be the only part of the plan.”