The Benefits of a Backdoor Roth IRA

An IRS-approved tool to high-income earners save for retirement and enjoy tax-free earnings.

While it may be somewhat misleading in name, a “backdoor Roth IRA” is not an illegal retirement funding scheme. Instead, it’s a smart (IRS-approved!) way for high-income earners who cannot contribute directly to a Roth IRA account to put away additional savings for retirement and enjoy the earnings tax free.

Learn more about the value of backdoor Roth IRAs for high-income earners, below.

The scenario is familiar. The New Year has passed, and tax season is approaching fast. You want to know how you can lower the taxes on your income tax return and you’ve heard (from a friend who heard it from a friend) that contributing to an IRA before April 15 will do just that.

Unfortunately, after speaking with your trusted advisor (AKA your accountant), you learn your income is too high to receive a tax deduction for such a contribution.

Could a Roth IRA be the answer?

Roth IRA contributions allow a taxpayer to receive a tax benefit later in life, when (generally) distributions from the Roth IRA (both the contributions and the earnings) are tax-free. Problem solved, right? Not so fast. If your modified adjusted gross income is close to or above $140,000 as a single filer or $208,000 married filing joint for 2021, you’ll find you can only make a partial Roth IRA contribution or none at all.

While a standard Roth IRA contribution is not on the table, you do have another option to help you achieve those tax-free savings. Enter, a backdoor Roth IRA. While its name might sound questionable, a backdoor Roth IRA (as it is often referred), is an IRS-approved method for high-income earners to fund a Roth IRA.

Introducing the Backdoor Roth IRA

The concept itself is simple. The most common way to accomplish a backdoor Roth IRA is to contribute to a traditional IRA, convert it to a Roth IRA and bingo. You have made a backdoor Roth IRA contribution. So, what’s the catch?

Very few things in our US Tax Code are simple and a backdoor Roth IRA is certainly not one of them. If you already have an existing IRA account (Traditional, SEP or Simple) set up and received a tax deduction for it or accumulated earnings, converting to a Roth IRA can increase your tax liability.

The IRS uses a pro-rata percentage to tax your conversion to a Roth IRA. To keep the math simple, if your Traditional IRA is $54,000 (remember this $54,000 was tax-deductible contributions and accumulated earnings) and you make a $6,000 contribution, you have a 90/10 ratio of old money to new. When you go to make your backdoor contribution, 90% of that contribution will be viewed as old money and will be considered taxable to the IRS.

A backdoor Roth IRA contribution can be a nifty way to put away additional savings for your retirement and enjoy the earnings tax-free. Since you must contribute to a Traditional IRA first, the limit on this contribution for 2021 is $6,000 per person ($7,000 if you are age 50 or older) – meaning your spouse may make their own contribution as well. In addition, you may convert as much of your existing non-Roth IRA funds as you wish, though this could significantly increase your tax bill. Keep in mind, withdrawals cannot be taken before 59 ½ years of age (and within five years of your first contribution) or you may incur a 10% early withdrawal penalty. Exceptions to this penalty are first-time home buyer, college expenses, birth or adoption, and Coronavirus-related expenses.

Another bonus to funding a Roth IRA is that it does not have required minimum distributions. Therefore, if you choose to leave the money in the account for an heir, you can extend tax-free growth to the next generation. However, once the beneficiary transfers the assets into an inherited Roth IRA, they are required to take distributions to avoid penalties.

We strongly encourage consulting a tax professional before facilitating a backdoor Roth contribution. Our team of wealth management and tax experts at Maner Costerisan can help you understand the pros and cons of making a backdoor Roth contribution, ensuring you make the right move for today and your financial future.