What is a “Backdoor” Roth IRA?
When it comes to retirement savings, there are several different types of accounts that you can contribute to help you reach your goals. Each account has different types of tax advantages and restrictions, and they are intended to help mitigate the headwinds of taxes while your account grows year after year. While the Roth IRA is a retirement account intended for middle to lower-wage earners, that doesn’t mean higher-wage earners are completely out in the cold from using the Roth. There’s a backdoor.
What is a Roth IRA?
The Roth IRA is an Individual Retirement Account that allows you to contribute after-tax money up to $7,000 each year, or $8,000 if you are over 50. Once you contribute to the account, the investments' earnings will grow tax-free, and all distributions made after the age of 59 ½ can also be made tax-free. Even better, there are no required minimum distributions (RMD), so the Roth IRA has become a great tool for estate planning purposes. Too good to be true? Well, there is a catch.
To be eligible to contribute to the Roth IRA, you must make less than $240,000 per year (Married Filing Jointly, 2024) or $161,000 per year (Single Filer, 2024). For many, this isn’t a problem, but for high earners, this constraint prohibits them from regularly contributing to this tax-advantaged retirement savings account.
While the Roth IRA has income limits on the contributions, there are no transfer restrictions. These transfers are also called “rollovers," where money from one IRA account is moved and transferred to another. This means there is a legal loophole that allows everyone to use the Roth IRA. You simply use the “back door”.
What is a “Back Door” Roth IRA?
The Roth IRA “back door” is simply a “qualified rollover contribution” from a Traditional IRA to the Roth IRA account. Sound complicated? The process can be completed in 5 easy steps.
Step 1: If you haven’t already, open both a Roth IRA and a Traditional IRA account with your preferred brokerage firm. You cannot perform this roll-over transfer from a company-sponsored 401k or 403b.
Step 2: Make a “post-tax” contribution to your Traditional IRA. If you do not make a post-tax contribution, or you have existing contributions in your Traditional IRA that you previously received a tax deduction, then you will be taxed as part of this transfer process since you cannot direct which contributions get rolled over. This is called the “pro rata” rule.
Step 3: Initiate the rollover from your Traditional IRA to your Roth IRA.
Step 4: Pay your tax if you owe taxes on this transfer. It’s not wise to wait until you file your taxes to pay a large tax bill, typically greater than $1,000. The IRS expects you to pay your taxes at the time of the taxable event, like paying sales tax at the time of purchase.
Step 5: Confirm the money has been transferred to your Roth IRA and invest the money. If you need help making investment decisions, seek assistance from a Certified Kingdom Advisor who can help you design a portfolio for your situation.
When does it make sense to use the Back Door Roth IRA?
First, if you are a high-wage earner, the backdoor method is a great way to get into the benefits of a Roth IRA. But regardless of your income level, if you find that all your IRA savings are in a Traditional IRA, it might be worth considering the back door method to diversify your tax burden in retirement. Why is tax diversification important? Historically, taxes continue to increase over time. By paying your tax now on the lump sum, you are “locking in” that tax rate for the remainder of your life.
Second, because the Roth IRA does not have Required Minimum Distributions, the Roth IRA can be an effective way to transfer wealth from one generation to another. Of course, everyone’s situation is unique – consult your CPA or financial advisor for how best to utilize the Roth IRA with your estate plans.
When should I get help using the Roth IRA Back Door?
While the rollover process is relatively straightforward, everyone’s financial situation is unique. For that reason, it is wise to seek the counsel of your CPA and your financial advisor before using the Roth IRA back door method. You can find a list of trusted CPAs and Financial Advisors on the Certified Kingdom Advisor’s website. You can also find more information about these and other restrictions on the IRS website:
Rollovers of Retirement Plan and IRA Distributions | Internal Revenue Service (irs.gov)
This “loophole” may not be around for long, as it continues to get scrutiny in the halls of Congress in Washington, DC. If you are considering a back-door Roth to take advantage of the long-term benefits of this account, seek the help of your CPA or CFP financial professional to develop a plan.
About the author: Nate Sargent serves as a financial counselor in the Greenwood, Indiana area. Nate holds an MBA from Colorado State University and a Certificate in Financial Planning from the Ron Blue Institute at Indiana Wesleyan University. Nate also holds an Electrical Engineering degree from Purdue University and has been in the aerospace industry for over 25 years.
