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Investing

Wealthy investors rely on this retirement-saving loophole: What to know about backdoor Roth IRAs

A wealth advisor and tax expert weigh in on this popular backdoor maneuver high-income earners use.

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The Roth IRA is a so-called backdoor way for high-income households to save more for retirement.
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Many individuals turn to a Roth individual retirement account (IRA) to grow their money tax-free. With a Roth IRA, the account holder has already paid income tax on the money they contribute. From there, their funds grow tax-free and aren't subject to income taxes when they later want to withdraw.

Unlike a traditional IRA, however, a Roth IRA is generally closed off to high-income earners. Single filers with a modified adjusted gross income (MAGI) for 2021 equal to or above $140,000, or $208,000 for couples filing jointly, are shut off from directly contributing to Roth IRAs — but they can still take advantage of this special account by going through a 'backdoor.'

The backdoor Roth IRA is a strategy wealthy investors use to skirt around the usual income limits that apply to Roth IRA contributions.

"I do have several clients that utilize this strategy," says Faron Daugs, a CFP and wealth advisor at Harrison Wallace Financial Group. "It is an effective means of saving more money on a tax-free basis."

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How backdoor Roth IRAs work

The popular backdoor maneuver is quite simple: investors make contributions to their traditional IRA (a tax-deferred account) and then quickly convert the account to a Roth IRA (an after-tax account). For a nondeductible contribution to a traditional IRA, only earnings that are converted may be taxable, whereas income tax would be due on the entire conversion if it's a tax-deductible contribution to a traditional IRA, including any gains.

"There is not an immediate tax benefit to the person who is implementing the strategy," Daugs says. "It is a means of moving money into the Roth IRA position to take advantage of tax-free growth for the future."

What to know about backdoor Roth IRAs

The retirement-saving loophole may go away for some

The loophole is pretty well known, so much so that Democrats in the U.S. House of Representatives have proposed closing the backdoor Roth IRA strategy for individuals above certain incomes in a broader effort to fund a $3.5 trillion budget plan (this would be applicable to distributions, transfers and contributions made in taxable years beginning after Dec. 31, 2031).

This move, if approved, would create some challenges for high-earners as there are currently no income eligibility limits for nondeductible contributions to a traditional IRA or conversions to a Roth IRA. Should this pass, investors subject to the income limits would need to determine how much of their current traditional IRAs make sense to convert before these limits are imposed.

"This could result in a large income tax bill," Daugs says. "But we need to weigh the potential future tax-free growth of the converted amounts versus the tax bill due on those converted assets."

Backdoor Roth IRAs are worth it for most high-earners

Once the Roth IRA conversion is complete, the account holder has effectively funded a Roth IRA. The loophole makes it possible for anyone to invest and benefit from future tax-free growth and earnings.

"Even if you pay tax now at the top tax bracket (currently 37%, plus state taxes), this money will grow tax-free until retirement, when you are able to withdraw the funds and pay no tax," says Abby Donnellan, a CPA and senior tax strategist at Moneta Group.

Keep in mind that each Roth conversion you make is subject to the typical Roth IRA five-year rule. For those who make multiple conversions, the IRS demands that the oldest conversions get withdrawn first when applicable. (The order of Roth IRA withdrawals goes, from first to last, contributions, conversions, then earnings.) Those under age 59 and a half should avoid withdrawing within five years of their conversion, less they pay a 10% penalty fee (qualifying exceptions apply).

There are additional perks of a Roth retirement account that makes the backdoor strategy worth exploring for those who don't qualify to contribute directly:

  • No Roth conversion limits: Currently, there are no limits on the number of Roth conversions you can make nor on the dollar amounts you can convert from your tax-deferred traditional IRA. "If a taxpayer wants to, they can convert more of their current traditional IRAs; however, they should work closely with their financial advisors and CPAs to understand the full potential tax liability in doing a larger conversion," Daugs says.
  • No Required Minimum Distribution rules: These are also known as RMDs. Certain retirement plans, such as traditional IRAs and 401(k) plans, require you to withdraw a minimum amount of funds each year once reaching age 72, based on the balance in your account. "Some individuals don't need their RMDs to live on, and find it inconvenient to remove the funds from their IRA annually," Donnellan says. "[The backdoor Roth IRA strategy] gives those individuals the option to leave the funds, if that's what they would prefer."
  • Defer tax for future beneficiaries: If your heirs inherit your traditional IRA, they would be required to pay tax on any amounts that are withdrawn. With a Roth IRA, however, they can withdraw these funds and pay no tax. "Building up a Roth IRA can also be an effective means of transferring wealth tax efficiently as well," Daugs says.

Considering a Roth conversion? Check out Select's ranking of the top IRA and best Roth IRA accounts to get started. Charles Schwab ranks as the 'best overall' on both lists for offering an abundance of IRA types like traditional, Roth, Rollover, Inherited and Custodial IRAs, plus a Personal Choice Retirement Account® (PCRA). Schwab also has its own robo-advisor platforms and trading accounts so you can do all of your investing in one place.

Some robo-advisors will even also offer IRAs. Betterment has traditional, Roth and SEP IRAs. Plus, wealthy investors can take advantage of its premium plan (requires $100,000 minimum balance) that allows users to get unlimited access to a financial advisor.

Backdoor Roth IRAs aren't for everyone

Donnellan warns that large Roth IRA conversions aren't for everyone. "Depending on your age, tax bracket, balance in your account and beneficiary information, conversions may or may not be beneficial," she says.

Generally, you should only do a Roth conversion if you 1) have enough cash to cover your conversion taxes out of pocket (since no funds are withdrawn, only converted) and 2) know you will be in a higher tax bracket in retirement when your withdrawals are completely tax-free.

If you are worried about a large tax bill on your Roth conversion, consider moving fast. Opening a traditional IRA, making nondeductible contributions and then immediately converting those funds into a Roth means you avoid having to pay taxes on any earnings.

Before making a move, talk to your financial advisor to see if a Roth conversion makes sense for you.

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Editorial Note: Opinions, analyses, reviews or recommendations expressed in this article are those of the Select editorial staff’s alone, and have not been reviewed, approved or otherwise endorsed by any third party.