By Matt Gallagher
Your Finances
Matt Gallagher
While high-income earners are often ineligible to contribute to a Roth IRA due to income caps, there is an alternative option available. Known affectionately in the industry as the “backdoor Roth,” this strategy allows high-income earners to access the benefits associated with a Roth IRA. It is, in a sense, taking a backdoor route to a type of account that offers specific benefits for investors and retirees.
For people interested in long-term financial planning, the backdoor Roth provides the opportunity for tax-free distributions down the road. The trick is working with a professional who effectively advises you and accurately assesses risk, rewards, and other viable options based on your financial goals.
The backdoor Roth IRA is a strategy through which people access the unique benefits of the Roth IRA even if they earn above the stated income threshold. While high-income earners cannot make contributions to a Roth, they can make conversions.
To set up a backdoor Roth IRA, you’ll first start by funding a traditional IRA and then converting all or a portion of the balance to the Roth IRA. This strategy can also be used with 401(k)s that allow after-tax deferrals, known as the mega-backdoor conversion due to the larger contribution amounts allowed in 401(k)s with this feature. This after-tax deferral feature is not the same as 401(k) Roth deferrals and is not offered in all 401(k)s.
Upon the conversion (or at the time of your tax return filing), you will pay taxes on the money converted to the Roth account. You would not typically want to pay taxes out of the amount you wish to convert, as this will be considered a distribution. It would incur an early distribution penalty if you are under the age of 59-and-a-half. But once the conversion is complete, the money will grow tax-free.
Roth IRA benefits and rules include tax-free distributions after the age of 59-and-a-half; the ability to lock in today’s tax rate rather than risk a higher tax rate later; no income limit, as people at all income levels can do conversions; no restrictions on how much money can be converted to a Roth; no age restrictions; and unlike traditional IRAs, Roth IRAs don’t require mandatory withdrawals at age 72. This allows for the savings to grow and compound even after retirement.
Using this strategy does have tax implications for you right away. It will mean that you will have to pay taxes up front for the amount converted since it was not taxed upon investing it in the traditional IRA. If you use the mega backdoor conversion strategy, any contributed amount to the after-tax deferral bucket can be converted tax-free, but if there are any earnings on those contributions, those dollars will be taxed.
Because of the name, some people fear that a backdoor Roth IRA is a tax scheme or tax dodge. Not at all. Rather, this strategy is merely a way to choose to pay taxes on your account now rather than later. Like any financial decision, though, it depends heavily on your personal circumstances and financial goals.
The are a few things to keep in mind. The money converted will count as income for that year, so that might throw you into a higher tax bracket and affect your tax filing for the year. You should foresee that that money is there to stay for at least five years. If not, the backdoor IRA option might not be optimal because once converted, you must wait at least five years before withdrawals (some exclusions apply).
Also be aware that there is currently legislation being proposed that, if passed, could limit or disqualify high-income earners from transacting conversions after 2021.
Matt Gallagher is a partner and head of business development at TrinityPoint Wealth. He can be reached at 203-693-8519 or mgallagher@trinitypointwealth.com.