A Backstage Pass to Backdoor Roths
Our savviest clients at Phronesis Wealth Management are always looking for innovative strategies to help save money for the long haul.
This month, let’s talk about the backdoor Roth IRA, also known as a Roth IRA Conversion. What is it and how can it work for you?
The backdoor Roth IRA could help wealthier clients to sidestep some of the income limits of a traditional Roth IRA. A Roth IRA can be an attractive vehicle because it enables money to grow tax-free until it is time for retirement.
You see there are limits as to who can be eligible for Roth IRA contributions. In 2023 couples that make more than $228,000, or individuals that make more than $153,000, do not qualify to contribute to a Roth IRA.
A backdoor Roth IRA is completely legitimate and can change this equation.
Here are two steps:
- Add a non-deductible contribution into a traditional IRA. (Make sure to file the proper tax forms.)
- Convert your contribution within the traditional IRA to a Roth IRA. (We are more than happy to help with the paperwork as this can be complicated with the many types of allowed transfers for a conversion. Examples include a rollover, a trustee-to-trustee transfer, a same provider transfer, etc. Make sure to talk to your tax advisor or financial advisor for more clarification)
Is a Backdoor Roth IRA Worth It?
Roth IRA assets grow tax free. Unlike a traditional IRA that is tax deferred (you pay taxes when you withdraw funds) a Roth IRA grows tax-free forever. If you wait until you are 59.5 and five years after the Roth conversion/contribution, or use one of the other IRS qualified distributions, you can access this money without tax or penalty.
Keep in mind, if you decide to withdraw funds from your Roth IRA without using a qualified distribution there is a 10% penalty and ordinary income tax on the gains inside of the account provided you are not 59.5 and or have not held the account for 5 years. You always have access to funds you initially contributed to your account, but any gains can only be withdrawn under a qualified distribution to avoid taxes and penalty.
When clients invest, we look at three buckets: taxable, tax-free and tax deferred. The goal in many cases is to help our clients get as much into the tax-free bucket as possible.
Using a backdoor Roth could be a fantastic way for those who may earn above the income limits to take advantage of having tax-free growth. There are many ways to efficiently do this but there are some pitfalls to avoid. Most importantly the IRS does not allow you to segregate IRAs when completing a conversion. For some high-income earners this negates the main advantage of the Roth conversion. However, for most high-income earners a back door Roth IRA is feasible and could be beneficial.
We work with our clients to review this option every year. As tax rates go up Roth assets will only become more desired and valuable.
This can be a complicated topic and we would love to discuss it in more detail in our Severna Park office. So if you want to learn more about backdoor Roths send us an email at team@wearephronesis.com and we can schedule a conversation. You can also schedule a free introductory appointment directly with our online scheduler at https://go.oncehub.com/phronesis.
This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.
Traditional IRA account owners have considerations to make before performing a Roth IRA conversion. These primarily include income tax consequences on the converted amount in the year of conversion, withdrawal limitations from a Roth IRA, and income limitations for future contributions to a Roth IRA. In addition, if you are required to take a required minimum distribution (RMD) in the year you convert, you must do so before converting to a Roth IRA.
Sources:
TIME: https://time.com/nextadvisor/investing/roth-ira-vs-401k/