- A backdoor Roth IRA is a completely legal strategy to avoid a Roth IRA's income limits.
- Backdoor Roth IRAs are really just a conversion, not a special type of retirement account.
- Opening a backdoor Roth IRA comes with important tax implications to consider.
Roth IRA accounts offer tax-free growth on earnings and tax-free withdrawals in retirement. But those perks come with a big asterisk: You can't contribute directly to one of the best Roth IRAs if you exceed IRS-imposed income limits.
However, high-income people still have a way into a Roth with a Roth IRA conversion. This is also known as a backdoor Roth IRA. This investment strategy is relatively easy to do but comes with some tax implications to be aware of.
What is a Roth IRA conversion?
Definition and overview of backdoor Roth IRAs
A Roth IRA conversion, or backdoor Roth IRA, is a retirement investment strategy that allows high-income taxpayers to capitalize on the benefits of a Roth account despite the annual income limit. But don't let the name mislead you. It's not as shady as it sounds.
A backdoor Roth IRA is not officially one of the best retirement plans, but rather a way for high-income taxpayers to fund a Roth IRA despite exceeding traditional income limits. Converting a traditional IRA to a Roth is entirely legal and sanctioned by the IRS.
Converting your IRA to a Roth IRA may take several years, depending on your account balance and how close you are to being pushed into the next income tax bracket. People younger than 50 can contribute up to $7,000 per year in 2024. Those 50 and older can contribute an additional $1,000 annually.
According to CFP Brian Fry, CFP and founder of Safe Landing Financial, a backdoor Roth IRA "is exactly what it's called, a backdoor solution, but I would say it's more mainstream than a backdoor or hidden thing."
Depending on your personal tax strategy, this could be a win-win situation, especially if you predict your tax rate will be higher in retirement.
Differences between traditional and Roth IRAs
Roth IRA accounts allow you to deposit money annually and pay income taxes the year the money is deposited. In contrast, a traditional IRA or 401(k) comes with an immediate tax advantage because you are not expected to pay associated income taxes on deposits until the money is withdrawn. However, when money is withdrawn, you owe taxes on both their earnings and initially invested money.
The big advantage Roth IRAs have over traditional IRAs is you pay taxes upfront. In exchange for that, the returns you accrue are tax-free, and you don't owe income taxes upon withdrawal.
Benefits of converting to a Roth IRA
Tax-free withdrawals
Roth IRAs are funded with after-tax dollars, offering the benefit of tax-free growth and withdrawals later in retirement. This is particularly beneficial for people who believe they will be in a higher tax-bracket during retirement compared to their working years.
Although you'll lose the initial tax benefit made available to through a traditional IRA, you could potentially pay less in taxes on gains by converting to a Roth for tax-free withdrawals. This is a great strategy for generating generational wealth for you and your beneficiaries.
No required minimum distributions (RMDs)
Unlike traditional IRAs, Roths don't have required minimum distributions (RMDs). So, if you want to keep your money growing in your IRA past age 73, consider converting into a Roth IRA. This allows your beneficiary to enjoy tax-free growth and withdrawals without bumping them into a higher tax bracket.
Estate-planning advantages
You can lower your estate tax with a Roth conversion as the initial taxation reduced the size of your estate so you don't exceed the current estate tax exemption. The estate tax exemption is $13.62 million per person ($27.22 million for couples) in 2024.
The estate tax exemption is set to decrease by nearly $7 million per person in 2026.
Steps to convert to a Roth IRA
1. Evaluate your current retirement accounts
After contributing to an existing traditional IRA, you can "rollover" or transfer the funds to a Roth IRA. You can also roll over money that's already in an existing IRA, and there's no maximum to how much you can roll over at once.
You can convert your IRA to a Roth through any of the best online brokerages and banks that offer IRAs. If your retirement plan is part of an employer's 401(k), the associated financial services company can also help you navigate the logistics.
2. Calculate the tax impact
Money in a traditional IRA comes with earnings that are taxed upon conversion to a Roth. Taxes are also incurred on any money the account earns in the time between contribution and account conversion. Despite initial taxation, a backdoor Roth IRA gives investors the future tax benefits that come with a regular Roth account.
Make sure to consider Roth IRA conversion tax implications before going through with the process.
3. Complete the conversion process
If you go with this strategy, it's best to do so ASAP, because the sooner you convert to a Roth IRA, the fewer taxes incurred on your earned income.
Tax implications of a Roth IRA conversion
Paying taxes on the conversion
A backdoor Roth IRA comes with the tax perks of a Roth IRA, meaning you will not owe further taxes when you eventually withdraw money post-retirement. However, when opening a backdoor Roth IRA, you are subject to paying taxes on the money transferred in that tax year.
Strategies to minimize tax burden
If you're considering opening a Roth IRA, you should also be mindful of your tax bracket, staying alert to the fact that withdrawing too much at once may push you into a higher income tax bracket.
Finally, withdrawing money from your IRA to pay taxes limits future investment growth, and individuals who withdraw under the age 59½ are subject to early withdrawal penalties.
Timing the conversion
Knowing when to convert to a Roth IRA is a key part of the Roth IRA conversion strategy. Ideally, you should convert funds to a Roth IRA when you're in a lower tax bracket and will not need access to the money for at least five years.
Individuals who will need to withdraw money in five years or less will not be able do so with a Roth IRA due to its five-year rule. Moreover, withdrawing early will subject you to taxes and a 10% penalty.
Should you convert to a Roth IRA?
While opening a backdoor Roth IRA is a solid option under some circumstances, it isn't for everyone.
Fry asks clients to consider the following questions when deciding to open a backdoor Roth IRA:
- "Where do I get the most value or the most tax-advantaged savings?"
- "Does it make sense to get the tax deduction today if I potentially qualify?"
- "Does it make sense to pay the taxes up front and have tax-free growth for potentially the rest of my life?"
"It's really just about comparing your taxes today versus down the road," Fry says, adding that "there's not any significant advantages. In the end, Uncle Sam always wins."
FAQs about converting to Roth IRA
A Roth IRA conversion involves moving funds from a traditional IRA or other retirement accounts into a Roth IRA. This allows for tax-free growth and withdrawals as well as no required minimum distributions (RMDs).
The amount of tax you will owe on a Roth IRA conversion depends on the amount converted and the current tax bracket. It's advisable to consult a tax professional if you are considering converting your traditional IRA to a Roth IRA.
There is not a limit to how much you can convert to a Roth IRA. However, you can only contribute up to the annual contribution limit each year. If you're under 50, the annual limit is $7,000 in 2024. Folks 50 and older can contribute up to $8,000 in 2024.
The best time to convert to a Roth IRA is when your income is lower, which could result in a lower tax bill on the conversion amount.
