Backdoor Roth Conversion

Forbes Finance Council:

Backdoor Roth Conversion for High Income Earners- Is it right for me?

Retirement planning is stressful no matter how much you make throughout your working years. Whether you are an average earner or high income, taxes will take a toll on us all. And the name of the game is to mitigate those taxes upon retirement, so that you can keep what you worked for all of your working years. For high income earners, it can be a struggle to fund enough for retirement in traditional savings vehicles due to phase-outs, maximum contributions, and other convoluted regulations. Some common retirement accounts include the IRA, Roth IRA, SEP IRA, SIMPLE IRA, 401k, Profit-Sharing Plans, and Defined Benefit Plans to name a few; all which have their specific rules and regulations that follow. Some of these rules and regulations are so stringent that high income earners need to be creative while planning for their retirement, such as using the backdoor Roth conversion strategy. Though Backdoor Roth conversions have been around since 2010, they are still lesser known than some of their traditional planning counterparts. Before we dive into strategic planning, let’s introduce a few of the most common retirement accounts first, the traditional IRA and Roth IRA.

Traditional IRA

The traditional IRA is a retirement savings account that is tax-advantaged, meaning the contributions are tax deductible. The tax-deferred annual contribution limit for IRAs and Roth IRAs is $6,000 ($7,000 f you are over age 50). Though there are no restrictions on contributing to a traditional IRA based on your income, you will not be able to make the contributions deductible based on your income if you are making above $208k per year, filing jointly. For high income workers, or anyone for that matter, $6,000 per year will not be sufficient in saving for retirement. Let’s look at alternative traditional retirement vehicles.

Roth IRA

The Roth IRA allows you to make after-tax contributions for future tax-free withdrawals. However, again this is maxed out at $6,000 per year ($7,000 if you are over 50). This is ideal for those who expect to be in a high tax bracket once withdrawals begin. However, opposed to the traditional IRA, there are limits for contributing to Roth IRAs based on income. For married couples, the phase out is $198k-$208k. The Roth IRA would seemingly be out of the question for affluent individuals, but there is a way to take advantage of the Roth account to avoid unnecessary RMDs which may cause havoc come tax time due to increasing your income, therefore pushing you into a higher tax bracket. The answer could be a backdoor Roth conversion.

Backdoor Roth Conversion

I want to focus on the backdoor Roth conversion first, because our clients find this to be a very valuable tool which lets them, high income earners, to “get around” the normal income limits that prevent these clients from contributing to a Roth. There are no limits to this account, and anyone can convert to a Roth by simply rolling money from a traditional IRA to a Roth. The backdoor Roth is not a specific type of account, rather it is a complex strategy by converting a tax-deferred traditional IRA (or 401k) to a tax-free Roth IRA by paying the tax up front, to allow the Roth to grow tax-free once converted. The tax you will pay is on any principal and earnings of the traditional IRA. Note, the funds that you convert to a Roth IRA will count as income, which could, at that point, boost you into a higher tax bracket. For example, if you are filing as a single individual and convert $50,000, and your income is $150,000, your income will be considered $200,000. Be aware because now this has pushed you into the 32% rate, instead of the 24% rate.

Prior to converting your IRA by the backdoor method, you must ask yourself:

  1. Can I wait five years to take distributions? (You must wait to access funds unless you are over age 59.5 because these are not contributions, they are considered converted funds)
  2. Will this conversion boost me into a higher tax bracket?
  3. Will my taxable income be higher when I retire than what it is now?
  4. How will I pay for the conversion tax? (Note, use non-retirement funds)

The main takeaway here is that, if you are a high-income earner, and believe that taxes will rise in the future, and your taxable income will be higher after you retire, then the backdoor Roth conversion may be a viable option for you. This strategy is just one of the many intricate approaches that many individuals take advantage of when it comes to retirement. Due to their complex nature, always talk with your financial professional and tax adviser to consider the risks and rewards and if it makes sense for you.

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