The backdoor Roth is a popular way to save for retirement. It can insulate your retirement against changes in the tax code and provide more for your loved ones. However, this strategy is definitely not for everyone. What exactly is the backdoor Roth, and how does it work?
Okay, let’s start from the top—what is a backdoor Roth?
A backdoor Roth is a way to access the tax-free growth in a Roth IRA, even if your income is higher than the Roth contribution limits. This strategy is open to anyone with a Traditional IRA.
What’s so different about this backdoor Roth thing?
Unlike a Traditional IRA, which only delays taxes until you take out the funds, a Roth IRA lets you withdraw all funds tax free. In a Roth IRA, investors save after-tax money (which means they had to pay taxes on the money initially contributed), but in exchange they won’t pay another dime of taxes, even when they take out the money in retirement.
Unfortunately, the government limits Roth contributions to a certain income level. For 2017, married taxpayers with incomes over $196,000, or single taxpayers with incomes over $133,000, are barred from directly contributing to a Roth IRA.
This is where the backdoor Roth comes in. While there is a limit on Roth IRA contributions, anyone can turn a Traditional IRA into a Roth IRA. This means that you can make $200,000, $500,000, or $1,000,000 each year and still access the tax-free growth in a Roth IRA.
Before you get too excited, remember that the backdoor Roth isn’t actually a tax loophole. While all earnings come out tax free, you can only save after-tax dollars. This can be a significant roadblock for investors with a large Traditional IRA. The IRS will tax the full IRA balance in the year of conversion (and at the annoyingly higher ordinary income rates, too), which could result in a unexpectedly large IOU on tax day.
Who should consider a backdoor Roth?
A backdoor Roth can play an important role in any portfolio by giving you flexibility in retirement. No one knows what tax rates will be in the future. This is especially risky for retirees, who often live off of their investment portfolio. An unexpected tax hike can erode away the value of their savings, making retirement more expensive. Retirees can protect themselves by using accounts with different tax treatments. For example, a retiree may own a Traditional IRA (taxed as ordinary income), stocks held in a living trust (taxed as capital gains), and a Roth IRA (tax free). This way, the retiree is ready for whatever the Washington DC has in store.
Additionally, a backdoor Roth can be a key player in estate planning. Since taxes are already paid upfront, heirs can continue reaping the benefits of tax-free growth for years to come. Also, unlike Traditional IRAs, Roth IRAs don’t have a required amount you need to take out each year. Because many affluent individuals don’t need the extra income, the backdoor Roth lets them keep more in the account for kids and grand-kids.
What is the best time to do a backdoor conversion?
Sooner rather than later! The beauty of the Roth IRA is that withdrawals are tax free. The cost, however, is a large upfront tax bill. After that, the Roth IRA grows without any future taxes, boosting your after-tax investment returns. And, the longer investors wait before making withdrawals, the more the account can grow. It just keeps getting better and better!
A backdoor Roth conversion is especially tax-savvy in years with low taxes. A gap in employment or a large charitable gift might drop you into a lower tax bracket. Such a year is a great opportunity to Roth convert a large Traditional IRA to a Roth.
Who should consider not converting a Traditional IRA?
A backdoor Roth conversion is definitely not for everyone. Investors may want to consider not making a backdoor conversion in the following circumstances:
- When investors expect their income to fall. Earning an unusually generous commission or selling a property owned for a long time could inflate your income up to a higher-than-normal tax bracket. This makes a backdoor Roth conversion that much more expensive. Investors who expect their income to fall back down in the next few years may want to wait.
- When the investors have Traditional IRAs that they want to keep. In what is called the IRA Aggregation Rule, the IRS will lump together all Traditional IRA assets, even those held in separate accounts. Some investors have after-tax (non-deductible) contributions in their Traditional IRAs, which can be withdrawn or Roth converted without owing anything to the IRS. However, when investors try to convert only these non-taxable amounts, the IRS forces them to include a proportionate amount of after-tax and pre-tax amounts.
Some investors can avoid this IRA Aggregation Rule through the Escape Hatch. Some company retirement plans allow participants to “roll in” Traditional IRA assets. Investors with an “Escape Hatch” retirement plan can transfer untaxed money out of their Traditional IRA and then Roth convert only the remaining after-tax amounts. The entire process is completely tax-free—not bad!
Okay, sounds great but what’s the catch? Are there any pitfalls to be aware of?
Just as with anything else involving taxes, investors thinking about the backdoor Roth IRA need to follow all of the “ground rules” of the IRS. There are two common mistakes with this strategy: forgetting the IRA Aggregation Rule and breaking the Step Transaction Doctrine. As mentioned above, the IRA Aggregation Rule lumps all of your Traditional IRA assets together for tax purposes. Some investors with non-deductible IRA contributions try to Roth convert only that one piece to avoid taxes. However, they will have an unexpected tax surprise when filing the next year.
Additionally, investors might run afoul of the Step Transaction Doctrine. This doctrine states that separate transactions, done one after each other, are subject to a fine if they combine to violate a tax law. So, if an investor makes a Traditional IRA contribution and then immediately converts to a Roth IRA, the IRS sees this as making a direct Roth contribution. Again, this increases your risk of an unexpected tax penalty—never a good thing!
Is a backdoor Roth right for me?
If you’re considering a backdoor Roth, you might want to ask yourself these questions:
- Are you in an unusually low or high tax bracket this year? Do you expect your income to go up or down in the future?
- Will a portion of your portfolio offer tax-free income?
- Do you have a plan in place for giving to your heirs in a tax-efficient way?
- What is the full tax implication of completing the backdoor Roth conversion?
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor.
Ibis Capital and its affiliates do not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.
Investment advice offered through Stratos Wealth Partners, Ltd., a registered investment advisor.