You can sum up the appeal of a Roth IRA in three words: tax-free distributions. Potential earnings in a Roth IRA grow tax free as long as the owner abides by the Internal Revenue Service rules, and withdrawals are federally tax free (and state tax free in many states) once you reach age 59½ and have held the Roth IRA for at least five years.
Unfortunately, some people make too much money to contribute to one. In 2021, joint filers with modified adjusted gross incomes (MAGI) of $208,000 or more and single filers with MAGI of $140,000 will not be eligible to start or contribute to a Roth IRA.
There is, however, a way for high earners to bypass these limits: the “backdoor” Roth IRA strategy. This involves a little maneuvering, but may be of interest to certain investors.
Start with a Traditional IRA
The backdoor IRA strategy typically starts with the creation of a Traditional IRA. The contributions to this new IRA are usually non-deductible, because of the IRA owner’s high MAGI. This new traditional IRA is fully or partly funded, and, with a financial professional’s help, it is quickly converted to a Roth IRA, and any tax liability is paid. Since the IRA contribution is made with after-tax dollars, the initial contribution amount is not subject to federal taxes.
If your goal is to put as much money as possible into a Roth IRA, keep in mind that your total IRA contributions are limited to $6,000 per year ($7,000 if you're over 50). But you can contribute--and convert--the maximum amount year after year.
Speed matters
The longer it takes to convert the Traditional IRA into a Roth IRA, the greater the potential earnings of that Traditional IRA. Since any Traditional IRA earnings converted over to the Roth IRA represent taxable income, those earnings should be minimal if the transfer is completed shortly after opening the account.
Not so attractive if you already have a Traditional IRA
If you already have a Traditional IRA or Rollover IRA the tax benefits of the backdoor Roth strategy may not be nearly as attractive. That's because the IRS considers the value of contributions to all of your Traditional IRA accounts when determining how much you'll pay in taxes when you convert to a Roth IRA. The taxable portion of the converted amount will be based on the combined value of your deductible contributions to all of your IRAs. For example, if tax-deductible contributions comprised 80% of all your Traditional IRA money, 80% of the amount you converted to a Roth IRA would be considered taxable income. You can't "choose" to only count the after-tax contributions you make to a Traditional IRA.
Other benefits and considerations
In addition to the potential for tax-free retirement income, not to mention tax-exempt growth for the account, no mandatory annual withdrawals are required from Roth IRAs while the original owner lives. (Traditional IRA owners must start taking annual required minumum distributions at age 72, and these distributions are taxed as ordinary income.)
If you plan to pass on your remaining IRA assets to your children, converting to a Roth IRA can potentially lower their future tax burdens. Under the 2019 SECURE Act, most non-spouse beneficiaries of an inherited IRA are required to have the funds distributed to them by the end of the tenth calendar year following the year of the original owner’s death. Distributions from an inherited Traditional IRA would be counted as taxable income. Distributions from an inherited Roth IRA, however, would be tax-free.
Since any Roth IRA conversion is a taxable event, and these conversions cannot be undone, it’s important to fully consider the pros and cons before you act. A financial advisor can take you through this decision-making process. Should you decide to execute this back-door strategy, your advisor should be able to execute the conversion with greater speed and efficiency than you can do on your own.
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Chris Gullotti is a financial advisor and Partner located at Canby Financial Advisors, 161 Worcester Road, Framingham, MA 01701. He offers securities and advisory services as an Investment Adviser Representative of Commonwealth Financial Network®, Member FINRA/SIPC, a Registered Investment Adviser. He can be reached at 508.598.1082 or cgullotti@canbyfinancial.com.
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