By Michael Hathaway, CFP®, CFA®, AIF®
There’s a reason Americans love Roth IRAs—they come with some big tax benefits. But for some high-income earners, Roth IRAs might feel “out of reach”.
But are they?
As it turns out, there is a method that can allow high-income earners to utilize Roth IRAs. Let’s take a closer look at the ins and outs of the backdoor Roth IRA and how it could benefit you.
An IRS-Sanctioned Loophole
A backdoor Roth IRA is an IRS-sanctioned loophole that lets high-income earners reap the benefits of contributing to a Roth even though they exceed the income limits for traditional Roth IRA contributions. Here is how it works.
Let’s say your income exceeds the legal limit for a traditional Roth IRA contribution, 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 convert your non-deductible IRA balance 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 income limits for Roth IRA contributions, but you cannot avoid the annual contribution amount limits. This means that you can fund a maximum of $6,500 in 2023 (with $1,000 catch-up contributions if 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.
A backdoor Roth IRA is a useful wealth strategy that can dramatically increase your after-tax wealth; that is, the wealth you have after all taxes have been (or will be) paid. Unlike traditional retirement accounts, Roth IRAs aren’t subject to required minimum distributions (RMDs). This means you won’t be forced to start taking withdrawals—and paying income taxes on those withdrawals—when you reach age 72. 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 free of taxes if you wish to do so.
Knowledge Is Power
There are some things to be aware of when considering a backdoor Roth. For one, they 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. You will also need to consider state taxes. If you live in a state that has an income tax, 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. Finally, this strategy is less effective if you have existing IRA balances that were made with pre-tax contributions.
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 is more nuanced and relates to whether or not taxes and penalties will be assessed if converted funds in a Roth IRA are distributed (or withdrawn) within five years of when they were each converted (each Roth IRA conversion has its own five-year clock in this context).
As with all tax-related matters, please consult a tax professional for tax advice that is specific to your situation. This article is not meant to be tax advice.
Is a Backdoor Roth IRA the Answer?
You’ve worked hard for your money, so you want it to work hard for you when it’s invested. Minimizing (or eliminating) taxes on future growth is one way to accomplish this. If you make too much money to qualify for a regular Roth IRA and can afford to pay taxes now on your contributions, consider a backdoor Roth to increase your flexibility in retirement income planning, as well as optimize your future estate transfers. But remember, it’s always a good idea to consult a financial professional before making any significant moves. Epsilon Financial Group is here to help. Reach out to us by emailing me at Mike@wealthmatters.com or calingl (707) 428-5500 to get started.
Michael Hathaway is a fiduciary financial advisor at Epsilon Financial Group, Inc., an independent, fee-only wealth management firm. Mike has worked in the finance industry for more than 20 years and brings a wealth of knowledge and experience in sophisticated financial planning to help his clients make sound financial decisions. He is known for caring deeply for his clients’ well-being, being compassionate, and thinking creatively to help clients attain their financial goals. He prioritizes building long-term relationships and takes the time to listen, understand, and explain so that his clients feel confident in their financial plan. Mike is a CERTIFIED FINANCIAL PLANNERTM, Chartered Financial Analyst® (CFA®), and Accredited Investment Fiduciary® (AIF®) professional; he has a bachelor’s degree in cybernetics from UCLA and an MBA in finance and accounting from the University of Virginia. When he’s not working at Epsilon, you can find Mike enjoying anything related to exercise and fitness. He especially loves activities in the great outdoors, such as mountain biking, camping, hiking, and snowshoeing. In the fall of 2016, Mike successfully climbed to the top of Mount Whitney in a single day, the highest peak in the continental United States. To learn more about Mike, connect with him on LinkedIn.