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What is a Backdoor Roth IRA?

April 01, 2022
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Mitch writes this blog for Resolute Wealth Management, LLC, and some of the content within this blog are opinions on financial products and/or securities that may not reflect the opinions of the firm or be applicable to everyone’s situation.  If you have questions about whether this content applies to your specific situation, please reach out to Mitch directly at mbodenmiller@resolutewm.com.

                One of the most confusing aspects of retirement saving strategies for most of us is the many options we can use in our personal retirement accounts.  Most employers offer easy retirement options through a 401(k), 403(b), deferred compensation plan, or other option.  Most individual savers are quite familiar with what an Individual Retirement Account (IRA) is.  However, there are several different ways to use these, and the different options can get quite confusing.  The “backdoor Roth IRA” has been in the news as a loophole that could be eliminated.  Its use in financial services is still quite common, as it is a very effective tax management strategy for high earners.  In order to understand that backdoor loophole, we will go over the more common IRA accounts, who typically considers a backdoor Roth IRA, and discuss some of the benefits and drawbacks to using the backdoor Roth loophole.

 All these account options are confusing.  What is the difference between them?

                There are LOTS of options when it comes to retirement saving.  Before we dig into the backdoor version of the Roth, it’s important we at least understand the basic options that most of us know and use.  When we save for retirement and put money into our accounts, we have two options available to us about how we do that, and it all boils down to when we want to pay the tax.  In a Traditional savings account, the money that we put away for saving is not taxed.  This happens automatically when we put it into an employer-sponsored account.  Our employer pays us, and before our federal, state, social security, and Medicare taxes come out, they contribute that money to the 401(k) (or whichever account you happen to be able to use).  For our individual retirement accounts, it’s not so clean.  We contribute to our IRA account, and when it comes time to pay our taxes, that money shows up as a deduction on our income.  For a Roth account, the only difference is that our contribution is taxed.  From an employer standpoint, they just tax our income, then contribute to the IRA from our taxed money.  On the IRA side, we just put the money into the account; no tax deductions or any current implications. 

Which one of these accounts should I be using?

                This is the most popular question I get asked by younger professionals and savers.  The answer is not simple and easy for everyone; they don’t fall into neat buckets.  However, this question CAN be answered.  Since the difference between the accounts boils down to how the money is taxed, we just look at the most efficient account from a tax perspective.  Simple, right?  I’m taxed on money I earn now, so if I just pay my taxes on the money I save, then I will have tax-free money whenever I want it when I go to retire!  For most of us, that simple thought process doesn’t work.  Let’s look one of my sample (and completely fictional) clients, Sue.  Sue is single, works as a nurse at a local hospital, and makes a modest income of $60,000/year.  How should she determine whether to put it into a traditional or Roth account?  Let’s assume she will draw Social Security as well as receive a great pension from the hospital for her years of service.  If these two sources provide her with a great income in retirement, she can supplement her retirement income with her savings.  If she chooses to put the money into a Roth, it has already been taxed at her current bracket of 22%.  So, when she reaches 59 ½, she can draw this money out penalty-free and tax-free.  If she would have placed in into a traditional account, the withdrawals would be taxed along with the income she receives from her pension and Social Security.  If this income pushes her into a higher tax bracket, then the Roth would be the more efficient account to use.  The most key takeaway here is that the more money you make while you are working, the higher tax bracket you are likely to fall in, and the more attractive the Roth could potentially be.

The Backdoor Roth

                The government quickly figured out that high-earning individuals have the ability to save a LOT of money for retirement, and would readily use the Roth IRA to pay tax on their contributions now in order to make their large account balances tax-free in retirement.  So, the government placed an income limit on individuals wanting to contribute to a Roth IRA.  For single individuals, that income limit is $144,000, and for married couples filing jointly, it is $214,000(1).  If you exceed these thresholds, you may not contribute to a Roth IRA account.  Yet, lots of these higher earners have them, and choose them as their retirement vehicles due to the tax-free advantages!  How is this possible?  They use a popular loophole called the “backdoor” Roth.  It seems very complicated, but in practice it’s not difficult to use.  Here’s the simplified version.

  • I make a full contribution to a Traditional IRA for the current tax year. So, in January of 2022, I put $6,000 in my Traditional IRA account, invest the money, and let it grow during the year.
  • Near the end of the year (November/December 2022), I convert the Traditional IRA account to a Roth IRA account. As long as it occurs in the current taxable year of the contribution (2022), it is a taxable event.  I would pay taxes on the money in the account (including and and all of the gains from the investments), and the resulting amount would be now invested in a Roth IRA, with all future gains tax-free.
  • Make sure that by December 31st, all traditional account balances are $0. This is called the “pro-rata” rule.  If you are converting to Roth, ALL assets that are held in individual accounts must be converted.  Larger IRA’s can be rolled into a 401(k) to avoid significant tax events.
  • Your tax professional will have you (and potentially your spouse) fill out an added tax form, Form 8606, reporting the rollover. Your tax preparer will very likely be familiar.  If you are a self-filer, common programs like TurboTax will ask you and help you prepare the form during tax season.
  • Every year, repeat the process. You can effectively continue this backdoor every year, opening an Traditional IRA, maxing the contribution, rolling into a Roth and paying the taxes at the end of the year.

This seems like a LOT of work.  Is it worth it?

                For high income individuals, this process is the single-best way to take some of their excess earnings and shelter them from taxes, allowing their investments to grow tax-free.  The reality is that they will be able to max out contributions to 401(k)’s, 403(b)’s, SIMPLE IRA’s, or other employer-sponsored retirement vehicles, as well as maxing out their IRA contributions.  The employer plan will be tax-deferred, meaning the earnings in those accounts will be taxed in retirement, and could mean a large tax bracket in retirement in return.  Individuals are required to take distributions from traditional accounts starting at 72, which forces those with large balances to start paying some potentially high tax bills on those tax-deferred assets.  Being able to convert IRA’s to Roth and pay taxes now shields some of their savings from this, and is one of the key tools in a financial professional’s toolbox when working with high income earners on a retirement strategy.  For those that have access to Roth IRA’s by falling under the income thresholds, this is the best vehicle to provide your retirement assets tax-free growth over a long time period, and the freedom to remove the assets at 59 ½ with no penalty is a great benefit as well.  One major drawback to the backdoor strategy is the fact that you are paying taxes on assets NOW, when you are in the high income tax bracket already.  If you are a high earner with a high-expense lifestyle and don’t have a propensity to save much, then in retirement when you have a lower amount of assets saved for retirement, all the backdoor option has assured is that you paid a high tax rate on converting assets, and now have a lower tax rate due to being forced to take smaller distributions. 

 

About the Author:

I work as a Financial Consultant with my partners Bob Montavon and Tom Schwab for Resolute Wealth Management, LLC.  After spending several successful years in business management working with clients in the retail and construction equipment industries, I transitioned into financial services to help make a greater impact on my client’s lives.  I work with clients from many different backgrounds, incomes, and situations.  By helping clients identify where they are and where they want to go, I serve as a fiduciary and trusted advisor to help them dodge roadblocks, adjust to different situations, and reach those goals.  I graduated from Wright State University in 2018 with a degree in Investment Finance, and completed my MBA work at The Ohio State University.  I currently hold the Chartered Financial Analyst (CFA®) designation, and serve as membership chair on the Board of Directors of the Dayton CFA Society.  In addition, I am a member of the Centerville Noon Optimists of Centerville, OH, a volunteer and social organization working to promote opportunities for local youths in the Centerville/Washington Township communities. 

Want to Reach Me?

Phone: 937-424-3269

Email: mbodenmiller@resolutewm.com

LinkedIn: https://www.linkedin.com/in/mbodenmiller/

Calendly: https://calendly.com/mitchbodenmiller

Sources:

1https://www.irs.gov/retirement-plans/plan-participant-employee/amount-of-roth-ira-contributions-that-you-can-make-for-2022, Roth IRA Income Limits, 2022