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Take Advantage of a Backdoor Roth IRA: Tips on Growing Your Retirement Savings Tax-Free

By Sean Condon, CFP^®

“It’s the best motivation to save for retirement that we’ve seen in America.
Everybody should be in the Roth game if they can.”

-IRA expert and financial-industry speaker, Ed Slott

There is a reason Americans love Roth IRAs—they come with major tax benefits. Unlike traditional IRAs which provide tax-deferred growth (you pay the tax eventually), Roth IRA assets grow tax-free.   In addition, when you start taking Roth IRA withdrawals in retirement, none of that money counts as taxable income.  This can provide flexibility in retirement years, where the future state of tax rates is very uncertain. The Roth IRA protects you from paying future income taxes, and this protection also continues for your heirs.  It is an extremely attractive option for those who can qualify.

But that is the problem—most high-income earners do not qualify for a Roth IRA. As of 2023, you are not eligible to contribute to a Roth IRA if you make at least $153,000 as an individual or $228,000 as a married couple.  The solution is the backdoor Roth, a strategy that allows high-income earners to reap the benefits of a Roth without violating the income limits.

How Does a Backdoor Roth IRA Work?

While contributing to a Roth IRA is prohibited for high-income earners, anyone can make non-deductible contributions to a Traditional IRA. In addition, anyone who has funds in an IRA can “convert” the assets into a Roth IRA. Put together, high-income earners can sidestep the Roth income limitations by contributing to an IRA and then converting it to a Roth.

So as a first step, you will need to open a traditional IRA and fund it with non-deductible contributions (maximum of $6,500 in 2023; $7,500 if you are over the age of 50). Then, you will immediately convert your non-deductible IRA to a Roth IRA.  Repeat this process each year to take advantage of tax-free growth.

The $6,500 contribution limit may seem small, but over time you can amass sizable retirement savings, especially when combined with other tax-advantaged retirement vehicles.  If you’re looking for even more, business owners who can design their own retirement plan or those fortunate to have a flexible 401(k) at work might be eligible to implement the Roth Supercharge Strategy or maximize the benefit of a Roth conversion.

Even just an annual back-door Roth contribution can likely save you thousands of dollars in taxes over time.  Plus, unlike traditional retirement accounts, backdoor Roth IRAs are not subject to required minimum distributions (RMDs). This means you will not be forced to start taking withdrawals—and paying taxes on those withdrawals—when you reach age 73. This is an added estate planning benefit because with no RMDs, you are free to let your account balance grow and build for as long as you live.  Then, you can pass it on to your heirs if you wish to do so, and they can receive tax-free withdrawals for up to ten years.

Considerations of a Backdoor Roth IRA

There are some things to be aware of when considering a backdoor Roth.

Pro Rata Rule

The main obstacle preventing Backdoor Roth IRAs is whether you already own existing Traditional IRA accounts.  If you do have Traditional IRA’s, a backdoor Roth strategy is likely unworkable.  The reason is the pro-rata rule.  This rule forces all IRAs to be counted as one account, so a $6,500 Roth conversion will be considered as a partial conversion of all existing IRA assets, not as a standalone transaction.  For example, if you already own $65,000 in IRA assets, a $6,500 Roth conversion will be considered as 10% of your assets, and therefore just 10% of the conversion will be tax free (the remainder will be considered a taxable distribution – not the desired outcome).

Note the rule only aggregates IRA accounts, so 401(k)’s, spouse’s accounts, or other Roth accounts are not counted (SIMPLE and SEP IRA assets are included).

Irreversible

Roth conversions are irreversible. That means if you converted too much at once and got pushed into a higher marginal tax bracket, or later decide against the strategy, you cannot take it back. But this can usually be avoided by keeping your conversion amounts to the annual contribution limits.

5-Year Rule

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 states that each of your backdoor Roth conversions has its own five-year period. For example, if you do a conversion in 2023 and another in 2024, you will have to wait until at least 2028 to access the first conversion and 2029 to access the second.

As with anything tax-related, consult a wealth advisor to position your money in a way that minimizes tax liability and maximizes growth.

Is a Backdoor Roth IRA Right for You?

If you exceed the income limit for a Roth IRA, a backdoor Roth IRA can be an effective strategy to reduce your tax burden during retirement while taking advantage of future growth opportunities. At Windgate Wealth Management, we’re committed to helping you optimize your financial plan. Contact us today! You can reach us by calling (844) 377-4963 or emailing windgate@windgatewealth.com. You can also book an appointment online here.

Perritt Capital Management, Inc. is the registered investment advisor for Windgate Wealth Management accounts
All investments carry some level of risk, including the potential loss of principal invested.

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Chicago IL 60606
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