Is a Backdoor Roth Strategy Right For You?

If you’re a high-net-worth individual or family, you’re likely grappling with the question, “Is a Backdoor Roth strategy right for me?” As a wealth management firm that works with HNW families, we understand your desire to make your money work for you in the most tax-efficient way possible, and a Backdoor Roth strategy may sound like a powerful tool to add to your wealth management arsenal. 

A Backdoor Roth can be a powerful tax strategy for retirees, even if your income is above the limit for direct Roth IRA contributions. In this article, we will cover the basics of this strategy, providing concise and comprehensible insights to help you determine if a Backdoor Roth strategy aligns with your financial goals.

*Please keep in mind that this is not an exhaustive guide and it is based on the current tax laws. It is important to consult with a certified tax professional or financial advisor before implementing any tax strategies.

What is a Backdoor Roth IRA?

A Backdoor Roth IRA is a financial strategy that high-net-worth families, both pre-and post-retirees, can use to get around income limits for Roth IRA contributions. The problem is this: if your income exceeds the limits set by the Internal Revenue Service (IRS), you’re not allowed to contribute directly to a Roth IRA.

This is where the “backdoor” strategy comes in. How does a Backdoor Roth work? You contribute to a Traditional IRA — which has no income limits — and then convert that to a Roth IRA. The process technically allows you to circumvent the income limits imposed by the IRS for direct contributions to a Roth IRA, which can be a significant advantage for effective wealth management, particularly if you anticipate being in a high tax bracket in retirement.

Roth IRA contribution and income limits

As mentioned above, Roth IRAs have an income limit for direct contributions that is based on your modified adjusted gross income (MAGI). As of 2023, the income limit is $138,000 for single filers and $218,000 for married couples filing jointly before phaseout limits start applying; but this could change in 2024. If your income exceeds beyond the phaseout limits you are not eligible to contribute directly to a Roth IRA. Contribution limits as of 2023, are $6,500 annually, or $7,500 if you’re 50 years of age or older.

However, there is no limit on how much you can convert from a Traditional IRA to a Roth IRA. This is what makes Roth Conversion and Backdoor Roth IRA strategies so appealing for high-income individuals and families.

To see whether your Roth IRA contributions will be affected by your MAGI, visit IRS.gov for specific details.

Potential benefits of the Backdoor Roth conversion strategy

One of the key aspects of a Roth IRA is that contributions are made with after-tax dollars, meaning you don’t get a tax break when you initially make the contribution. However, all future earnings and distributions stemming from the account are tax-free, as long as you follow the rules for qualified withdrawals.

A backdoor Roth strategy typically involves placing after-tax dollars into a pre-tax account (such as an IRA or 401(k)) and subsequently converting those after tax dollars into Roth contributions. These Roth conversions do not impact your contribution limits for a particular year, and avoid issues stemming from income limitations. 

The after-tax dollars that are used only get taxed once, upon making the initial contributions to the pre-tax plan; therefore upon conversion, they do not get taxed a second time. This is a great way to take advantage of a workplace plan’s total allowable savings, as opposed to the limitations set by personal contributions. 

For example, a 401(k) permits up to 66,000 to be saved within a given year; however personal contributions are limited to 22,500 (30,000 if 50+ years old). In the event an individual’s employer match, or profit share, does not push the total savings amount to 66,000; then an indivudal can make additional after-tax contributions up to the 66,000 limit (assuming it is permissible within the plan). Once the after-tax contributions are made to the plan, they will grow tax-deferred; and certain plans permit these after-tax contributions to be converted, or rolled over, into a Roth account. This means additional savings can be captured each year and benefit from tax free distributoins later in life. 

Additional benefits of a Backdoor Roth strategy include:

• Flexibility in retirement: Unlike traditional IRAs, which require you to start taking required minimum distributions (RMDs) at age 73, a Roth IRA has no RMD requirements, giving you more flexibility in retirement planning and potentially reducing your tax liability.
• Increased control over taxes in retirement: By having a mix of taxable, tax-deferred, and tax-free accounts — including a Backdoor Roth IRA — you can plan to have more control over your taxable income in retirement and can potentially reduce your overall tax burden.
• Potential for tax-free growth and withdrawals: As mentioned, the ultimate goal of a Backdoor Roth IRA is to take advantage of the potential for tax-free growth and withdrawals. This can be especially beneficial if you anticipate being in a higher tax bracket in retirement.

Potential risks to consider

This strategy does not come without its risks. When using the Backdoor Roth strategy, you need to be mindful of your other retirement strategies. If you have other IRAs, the IRS is going to look at the percentage of allocation between all of your IRAs, not just the Traditional IRA you converted. This means that even if only a small portion of your overall retirement savings is in a Traditional IRA, you may still owe taxes on a larger portion of the conversion.

Another risk to consider is the potential for changes to tax laws. While Roth IRAs have been around since 1998, there’s no guarantee that they will always remain tax-free. In fact, Congress could change the rules at any time, potentially resulting in you being taxed on your Roth IRA withdrawals in retirement.

Continue reading: What are considered the safest investments for retirement?

Will the Backdoor Roth IRA go away in 2024?

There is no way to predict the future and whether or not the Backdoor Roth IRA strategy will still be available in 2024. That said, Biden’s 2024 budget proposal aims to impose restrictions on the maximum allowable holdings in tax-advantaged retirement accounts, such as Mega Roths or Backdoor IRAs, for individuals earning over $400,000. However, it is widely believed that this proposal is unlikely to be approved.

That said, it is important to stay up-to-date on any potential changes to tax laws and consult with a professional financial advisor or tax professional who offers retirement planning services before making any decisions that could impact your retirement nest egg.

What is the difference between a regular Backdoor Roth and a Mega Backdoor Roth?

The regular Backdoor Roth strategy, as discussed above, involves converting pre-tax assets from a Traditional IRA to after-tax assets in a Roth IRA. However, there is also the Mega Backdoor Roth strategy which allows for even larger contributions to a Roth IRA.

With the Mega Backdoor Roth strategy, you contribute after-tax income directly to your employer-sponsored 401(k) plan and then roll those contributions over into a Roth IRA. This strategy is only available to individuals who have an employer-sponsored 401(k) plan that allows for after-tax contributions and in-service withdrawals.

While the Mega Backdoor Roth strategy can potentially allow for larger contributions, it also comes with its own set of rules and potential risks, so be sure to thoroughly research and consult with a professional before pursuing this strategy.  

Curious about whether a Backdoor Roth conversion strategy is right for you? Let’s talk.

A Backdoor Roth strategy may be a strategy you want to pursue if your modified adjusted gross income (MAGI) is over $400,000 and you are interested in the tax-free growth potential of a Roth IRA. However, every individual’s financial situation is unique and it’s important to consult with a professional to help you decide if converting to a Backdoor Roth IRA is the right move for you.

At Avidian Wealth Solutions, we offer personalized retirement income planning and retirement planning in Houston, Austin, Sugar Land, and The Woodlands specifically tailored for high-earning individuals and families. We can help analyze your current retirement savings and work with you to develop a comprehensive plan that incorporates strategies such as the Backdoor Roth IRA to help you work toward achieving your retirement goals.

Contact us today to schedule a consultation with one of our experienced financial advisors.  Together, we can create a customized plan that aims to put you on the path toward long-term financial success.

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