By Colleen Weber, CFP^®, CPA

Many people believe taxes are a thing of the past once you hit retirement, but that couldn’t be further from the truth for most of us.

In fact, high-income earners often don’t qualify for the tax benefits that accompany common retirement strategies, like investing in a Roth IRA. 

Fortunately, there are a couple of ways to take advantage of Roth IRAs. This particular tactic provides an avenue for long-term savings and investment. 

Let’s explore this option further.

What Is a Backdoor Roth IRA?

A backdoor Roth IRA is an IRS-sanctioned loophole that lets high-income earners reap the benefits of a Roth without violating the income limits. 

There’s a reason Americans love Roth IRAs—they come with some major tax benefits. You pay taxes on your contributions up front, but then your investments grow 100% tax-free. Additionally, when you start taking withdrawals in retirement, none of that money counts as taxable income. It’s a very attractive option for those who can qualify. 

But that’s the problem—most high-income earners don’t qualify for a Roth IRA. As of 2023, you’re not eligible to contribute to a Roth IRA if you make at least $153,000 as an individual or $228,000 as a married couple.

This begs the question: How can you enjoy the sweet tax perks that come with a Roth IRA if your income is over these limits? The solution is the backdoor Roth. 

How Does a Backdoor Roth IRA Work?

Let’s say your income exceeds the legal limit for a Roth IRA, but you still want to fund an account. First, you will need to open a traditional IRA and fund it with non-deductible contributions. Then, you will immediately convert your non-deductible IRA to a Roth IRA and repeat this process each year in order to take advantage of tax-free growth. 

In this scenario, you can avoid the IRA income limits, but you cannot avoid the annual contribution limits. This means you can fund a maximum of $6,500 in 2023 ($7,500 if you’re over the age of 50) per year. This may seem small, but over time you can amass a sizable retirement savings, especially when combined with other tax-advantaged retirement vehicles. 

We can benefit from various tax-savings strategies during retirement. A backdoor Roth IRA is a useful wealth strategy that can save you thousands in taxes. But there’s even more to it than that.

Unlike traditional retirement accounts, backdoor Roth IRAs aren’t subject to required minimum distributions (RMDs). This means you won’t be forced to start taking withdrawals—and paying taxes on those withdrawals—when you reach age 73. 

This is yet another point in favor of backdoor Roths: estate planning benefits. With no required RMDs, you’re free to let your account balance grow and build for as long as you’d like. Then, you can pass it on to your heirs if you wish to do so. 

Considerations of a Backdoor Roth IRA

There are some things to be aware of when considering a backdoor Roth. 

Pro Rata Rule

Backdoor Roths only work if you have zero to very low traditional IRA assets. What happens if you have both pre-tax and non-deductible after-tax contributions in your traditional IRA? Unfortunately, you cannot choose to only transfer the after-tax contributions. This is because of the pro rata rule. 

Pro rata means that taxation is based on percentages or ratios. If 60% of all of your combined traditional IRA contributions were made pre-tax and 40% were made after-tax, then those are the percentages they use to determine the taxability of the conversion. No matter how much you convert or which specific IRAs it comes out of, 60% of the funds will be considered pre-tax (and therefore taxable) and 40% will be considered after-tax (and therefore tax-free). 

If you have a substantial amount of pre-tax savings, you may be able to utilize a “mega” backdoor Roth strategy instead. In this strategy, you would fund after-tax contributions to a Roth 401(k) that can grow tax-free if utilized properly. Most 401(k) plans don’t allow for this provision, but if it is available to you, reach out to us at Colleen Weber CPA, CFP to learn about this implementation strategy in greater detail.

Irreversible

Backdoor Roths are irreversible. That means if you converted too much at once and got pushed into a higher marginal tax bracket, you can’t take it back. But this can usually be avoided by keeping your conversion amounts to the annual contribution limits.

State Taxes

You will also need to consider those tricky state taxes. If you live in a state that has income tax like Minnesota, you’ll likely owe state taxes on your backdoor Roth conversion in addition to federal taxes. However, some states exempt part of your distribution if you’re over a certain age. 

5-Year Rule

Backdoor Roth IRAs also have two five-year rules to keep in mind. The first rule says that you must wait at least five years from your first contribution before you can make a penalty-free withdrawal from your Roth IRA—even if you’re over age 59½.

The second five-year rule states that each of your backdoor Roth conversions has its own five-year period. For example, if you do a conversion in 2023 and another in 2024, you’ll have to wait until at least 2028 to access the first conversion and 2029 to access the second. 

As with anything tax-related, consult a wealth advisor to position your money in a way that minimizes tax liability and maximizes growth. 

A Backdoor Roth IRA Could Be the Answer

The backdoor Roth IRA is a strategic financial move allowing individuals to grow wealth tax-free. By utilizing this method, individuals with higher incomes can contribute to a Roth IRA, even if they exceed the income limits. 

If you’re not working with a financial advisor to explore how a backdoor Roth IRA could significantly boost your tax-free savings potential, our team at Colleen Weber CPA, CFP is here to help. Contact us today to book a free introductory meeting online or call (952) 470-0750.

About Colleen

Colleen Weber is a fee-only financial advisor, CERTIFIED FINANCIAL PLANNER™ professional, and CPA with more than 20 years of financial planning experience. Providing comprehensive financial planning and wealth management, she specializes in serving clients nearing retirement, retirees, busy professionals, and women. She is passionate about developing financial plans that save clients on taxes and investment strategies that help them pursue their goals. Learn more about Colleen by connecting with her on LinkedIn or booking a complimentary phone call meeting.