Roth IRAs and Roth 401(k)s are useful retirement savings vehicles that offer tax breaks on the back end. Roth 401(k)s are rare and must be set up by an employer, but a Roth IRA can be set up by anyone under a certain income level. To be eligible to open a Roth IRA, you’ll need to have a modified adjusted gross income (MAGI) under $140,000 if you’re a single filer or $208,000 if you file jointly. Roth IRAs are off-limits to wealthier would-be contributors since the tax breaks on high earners would be too great.
Of course, there’s a way around those income rules, but you’ll need to follow a few procedures and stay on the up-and-up with the IRS. A backdoor Roth IRA is a method for wealthier people to access the tax benefits of the usual Roth vehicle. However, before going this route, it’s important to know backdoor Roth IRA pros and cons.
If you need assistance with your finances, work with a professional financial advisor from Good Life Financial Advisors of Mt. Pleasant. We’re ready to help create a personalized plan for your specific needs.
What is a Backdoor Roth IRA?
A backdoor Roth IRA might sound like a sneaky way to get tax breaks without the IRS knowing. However, it’s completely legal and the IRS even has a form for those who wish to use one. A backdoor Roth IRA is simply a traditional IRA that’s converted into a Roth IRA at a later date. Until 2010, high earners couldn’t partake in any Roth benefits, but changes to the system now allow traditional to Roth IRA conversions without income considerations.
To use a backdoor Roth IRA, you’ll simply need to open and fund a traditional IRA and convert that account into a Roth IRA. If you already have a traditional IRA, converting to a Roth IRA is a simple process, especially if you open the Roth at the same institution. If you haven’t started a traditional IRA, you can contribute $6,000 annually and convert that amount into a Roth each year.
Benefits of Utilizing a Backdoor Roth IRA
Here are some benefits to using a backdoor Roth IRA:
- High earners can skirt the income limits placed on the more formal type of Roth IRA and benefit from tax-free investment growth. If you have a substantial nest egg and worry about taxes eating into your retirement money, a backdoor Roth IRA allows you to possess at least one investment account free from taxation.
- A Roth IRA is also far more liquid than a traditional IRA. Under current regulations, a traditional IRA or 401(k) can only be tapped before age 59.5 in certain situations, such as medical expenses or a first-time home purchase. The investment gains from a Roth IRA can’t be touched until age 59.5, but your basis can be withdrawn without penalty.
- A Roth IRA isn’t subject to required minimum distributions, or RMDs. Traditional IRA account holders must begin taking money out of their accounts at age 72. Roth IRA account holders are under no such obligation.
Drawbacks of Utilizing a Backdoor Roth IRA
Here are some drawbacks to using a backdoor Roth IRA:
- A backdoor Roth IRA isn’t a method of negating taxes, you’re just choosing to pay them now instead of later. But, of course, that means you need to pay the IRS now and you can’t use money from your IRA without suffering a penalty. If you contributed $5,000 to a traditional IRA and want to convert to a Roth, you’ll need to pay taxes on the $5,000 basis plus any investment gains. Make sure to have money set aside to pay the IRS when doing a backdoor Roth conversion.
- A distribution is taxable income. Converting money from a traditional IRA to a Roth IRA means removing money from one account and placing it in another. That’s a distribution! Since a distribution is taxable income, it could send you into a higher tax bracket for the year. For example, if you have a MAGI of $160,000 (22% tax bracket) and want to do a $30,000 Roth conversion, you’ll have a new MAGI of $190,000. Nearly $20,000 of your funds will be hit with the 24% rate instead of 22%.
- Future tax rates are uncertain, as are our future returns on investments. A backdoor Roth IRA is a bet that taxes now will be more manageable than taxes in the future, but that might not be the case.
Work With an Experienced Financial Advisor
It’s important to know backdoor Roth IRA pros and cons before converting your account. If you think opening a backdoor Roth IRA might be in your best interests, consult with a professional advisor from Good Life Financial Advisors of Mount Pleasant before making any decisions. A backdoor Roth IRA isn’t always the best course of action, especially if you don’t have ample cash to pay the upfront tax bill. Remember, you aren’t avoiding taxation, just the income limits on the Roth IRA. Your advisor can help you decide if this type of account is right for you.
The opinions voiced are for general information only and are not intended to provide specific advice or recommendations for any individual.
Traditional IRA account owners have considerations to make before performing a Roth RIA 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.