What Is a Backdoor Roth IRA Conversion and Is It Right For Me?
Like it or not, taxes are a way of life. They fund great things like libraries, parks, and roads, but nobody wants to pay more than they must. We get questions like, “How can I minimize my income tax in retirement?” and one option is a Roth IRA. Roth IRAs are tax-advantaged retirement savings accounts that can be quite useful if you expect your tax obligations will rise as you get older. Because withdrawals from a Roth are tax- free, it’s especially attractive for high-earning households. Unfortunately, the US tax code prohibits individuals or households from contributing to a Roth IRA if they earn over a certain annual income, but there is an alternative. Backdoor Roth IRA Conversion What do you do if you can’t fund a Roth IRA because you earn over the income limit? Since traditional IRAs have no income limit, you may be able to open a traditional IRA. Then fund it with a nondeductible contribution in lieu of funding it with a normal deductible contribution thereby not claiming the tax deduction. It is then converted to a Roth IRA.
Becuase It can be complicated when you start to account for tax situations specific to your household, we recommend speaking with your financial advisor. The Pros The converted funds now held in the Roth IRA give you access to your funds tax free after age 59.5 with no required minimum distribution. You can pass it to your heirs (and unlike a traditional IRA, your heirs owe no taxes on an inherited Roth IRA). Also, there is no limit to the amount of money you can convert from a tax-deferred account to a Roth IRA. The Cons Because you haven’t yet paid taxes on the money in a traditional retirement account, when you convert to the Roth IRA the IRS views that as taxable income. So, you owe taxes on the amount you convert in the year you execute the conversion. For example, you’re in the 24% tax bracket and converted $100,000. That means you could owe $24,000 on top of your expected annual tax obligation.
There are other factors that can make a backdoor conversation complicated or messy. And remember, if you convert from a Traditional IRA, you must wait five years before you can withdraw funds. So, is it right for me? Ask yourself these five questions before speaking to your adivsor about initiating a Roth IRA conversation strategy: 1. Can I pay the taxes? Since traditional IRAs and other qualified retirement plans are tax-deferred, upon converting assets into a Roth IRA, you must pay income tax on the amount converted up front. 2. Am I Comfortable Increasing My Adjusted Gross Income (AGI)? A Roth IRA conversion will raise your income, thus increasing your AGI, which may move you
into a higher income tax bracket. Also, if you are retired, be mindful that Medicare Part B uses your two previous years’ income to calculate your monthly premium. As such, the conversion may increase your Part B payment for at least two years. 3. Will I Lose Eligibility For Specific Tax Write-Offs? Initiating a conversion may mean you lose deductions if your AGI increases. For example, the child tax credit and student loan interest deduction are determined by income. 4. Will I Need the Money Within Five Years? Roth IRAs typically offer penalty and tax-free withdrawals anytime on contributions. Still, investors must wait five years to access
Alera Group Wealth Services” is a brand name utilized by Alera Group, Inc and certain subsidiaries and affiliates (collectively “Alera”). Advisory Services offered through Alera Investment Advisors, LLC. Securities offered through Triad Advisors, LLC, Member FINRA & SIPC. Triad Advisors LLC is separately owned and other entities and/or marketing names, products or services referenced here are independent of Triad Advisors. Information provided by Alera should not be considered tax or legal advice. Should you require tax or legal information, please consult your tax advisor or attorney.
Personal Finance Quarterly | Spring 2023
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