What is a Backdoor Roth?
You won't find this product offered by financial institutions, because it doesn't exist. A backdoor Roth is a complicated, IRS-sanctioned method of converting a traditional IRA or 401(k) into a Roth IRA. It is a legal way to get around the income limitations put on Roth IRA contributions. While it may produce tax-free growth of the account, it DOES NOT avoid taxes all together. In fact, it can be quite costly in the year of conversion.
Why do it?
The major difference between a traditional IRA and a Roth IRA is the taxability of the earnings. Under a traditional plan the dollars you contribute are pre-tax. This means those dollars aren't taxed when you contribute to the plan, however, when you pull out the money in retirement, both the original dollar and its growth are taxed. Under a Roth plan the dollars are post tax. This means that you pay the tax on that dollar today and when you go to pull out the money in retirement, you don't need to pay any additional tax on that money.
When to do it?
Roth IRAs tend to make sense in the following situations:
Your income will be higher in the future
You expect tax rates to rise
Market conditions have your traditional IRA at a low valuation
Advantages of a Roth
Unlike traditional plans, Roth IRAs are not subject to required minimum distributions (RMDs). This means the account balances can see tax-deferred growth for as long as the account holder is alive. You can take out as much or as little as you want when you want, or leave it all for your heirs.
Downside to a Roth
The major downside to a Roth IRA, and the reason some do not have a Roth plan is that there is a income limitation on those plans. Taxpayers who earn over a certain amount aren’t eligible to open or fund Roth IRAs—under the regular rules, anyway. If your modified adjusted gross income is well into the six figures, the IRS starts phasing out the amount you can contribute; once your annual income gets above a certain threshold, you cannot participate at all. These limits, which vary depending on your taxpayer status (single, married filing jointly, etc.), are adjusted periodically for inflation. A traditional IRA on the other hand does not have an income limitation, so anyone and everyone can contribute.
Tax implications
Again, this isn't a tax avoidance scheme, but you can think of it as a way to frontload your taxes. You will need to pay tax on any money that is in your traditional IRA that has not been taxed. As an example, if you contribute $6,000 to your traditional IRA and then convert that money to a Roth IRA, you will owe taxes on that $6,000. You will also owe any money that it earns between the time you contributed to the traitional and when you convert to the Roth.
Most of the funds that you convert to a Roth will likely count as income in the year your convert. and could cause you to be in a higher tax bracket. However, you may not need to pay full taxes on that money, since a pro-rata rule may apply.
When should you NOT convert?
If the only way you can pay the taxes due is with money from your IRA withdrawal. Since you sacrifice future investment growth on that money, but there is also the risk that, if you’re under age 59½, you’ll owe the 10% early withdrawal penalty on that money used to pay the taxes.
You’ll need the money in five years or less. Money converted from an IRA to a Roth IRA falls under a Roth five-year rule: If you don’t wait five years to withdraw it, you could owe taxes and a 10% penalty.
The withdrawal from your IRA will push you into a higher income tax bracket. It’s generally a good idea to convert just enough that you’re not pushed into paying a higher tax rate that year.
Final Thoughts
Make sure you contact your financial advisor or other advisors before taking such a step. If you are converting your entire IRA there may be a huge tax implication. Also, while this step was once reversible (recharacterization) after 2017 it is no longer. So you should be sure that this is a step that makes sense for you, because you can't take it back. Market conditions can change rapidly and you should be cognizant of its implications.
As always if you have questions or need advice on your specific estate planning strategies call my office and I would be happy to talk.
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