How Backdoor Roth Conversions Work

Investment Strategy | Roth IRA

 Plancorp Team By: Plancorp Team
How Backdoor Roth Conversions Work

Roth IRAs are an essential part of a diversified retirement plan. The most significant benefit of a Roth IRA is its potential to deliver massive tax savings over time.  

Because Roth IRAs are generally funded with after-tax dollars, the initial contributions and related gains you made will go back in your account, tax-free, at retirement. 

Additionally, there are no Required Minimum Distributions from Roth IRA accounts, which can be an attractive feature when tax planning in retirement.  

However, due to Roth IRA income limits, many investors think they're ineligible to take advantage of the benefits a Roth provides. Under current IRS regulations, only married couples who are making under $218,000 per year or single filers making less than $138,000 can contribute to a Roth in the conventional way.  

That's why backdoor Roth conversions have become an increasingly popular means for investors to stretch their retirement account dollars to the fullest. These tax-advantaged plans are also completely legitimate under current tax law. 

What Are Backdoor Roth IRA Contributions? 

In a traditional IRA, you generally contribute pre-tax dollars and, if under a certain income level, can file for a tax deduction on that same amount.  

When you start taking distributions from your traditional IRA at retirement, you will pay income tax on the amount. This amount will include both the contributions and the earnings within the account.  

Contributions to a Roth IRA, on the other hand, are made with after-tax dollars, meaning you already paid tax on these funds. As a result, any future payouts will be tax-free, including any investment gains.  

A backdoor Roth IRA conversion can be a solution for many high-income investors. Essentially, funds are taken from a traditional IRA account through a taxable distribution and then rolled into a Roth IRA account.  

This distribution will appear on your tax return in the year of conversion, so it is important to consider the ordinary tax that will be imposed on this conversion. However, individuals usually find this to be beneficial as most taxpayers find themselves to be in higher tax brackets at retirement. These benefits are further explained below.  

Funds will remain in the Roth IRA account until individuals choose to take qualified distributions. At that time, there will be no additional tax imposed on distributions, from earnings or contributions.  

When Are Backdoor Roth Conversions Beneficial? 

Because there can be tax implications, a backdoor Roth conversion may not be ideal in every situation.

Most traditional IRAs are funded with dollars that were never taxed, so a conversion to a Roth means you will have to pay taxes on those funds and any gains at that time. 

A Roth conversion is generally considered to be taxable income, so it could also push you into a higher tax bracket for the year. That’s why it’s important to know the amounts of pre-tax and after-tax money in your individual retirement account before you convert.  

These tax consequences may mean that the closer you are to retirement, the benefits of converting your traditional IRA to a Roth might diminish.  

Roth regulations also have a five-year rule, requiring you to wait that length of time to access your funds, or you could face an early withdrawal penalty. 

Despite these considerations, there are still several powerful tax benefits that may outweigh these concerns.  

The main benefit is that after the conversion, any investment gains are yours to keep, tax-free. And once you reach retirement age, Roth IRAs don’t force you to take the required minimum distributions.  

That’s extremely impactful, especially for high-income earners who may not need those funds at retirement. You can withdraw as much or as little as you need, or use the Roth as a vehicle to provide an inheritance to your heirs.  

Traditional IRA accounts have more stringent withdrawal rules for beneficiaries, which makes converting to Roth IRAs attractive to those worried about the types of assets they are leaving behind.  

What Are Mega Backdoor Roth Conversions? 

Because many high earners have 401(k) programs through their employers, a mega backdoor conversion has become a powerful way to take advantage of a Roth IRA’s benefits. 

While most investors are very familiar with 401(k)s as a way to invest pre-tax money for retirement, the mega backdoor conversion hinges on after-tax contributions to your 401(k).  

The majority of workers will only be able to contribute $22,500 each year in pre-tax dollars to their 401(k), but the IRS allows additional after-tax contributions up to $66,000.  

It’s important to check your employer’s plan, though, to understand how their company match works and how it can be affected by your additional contributions. 

Because your after-tax 401(k) contributions could be taxed again in retirement distributions, there's another critical second step in a mega backdoor Roth IRA conversion.  

First, you will make an after-tax contribution to your traditional 401(k) account. Then, these funds will be converted into a Roth 401(k) account or Roth IRA account, depending on which account is available through your employer’s plan.  

Some plans allow for automatic backdoor Roth conversions, so check with your employer to see if this is a feature available to you.   

A Roth 401(k) will alter the entire 401(k) plan to operate similarly to a Roth. If you’re able to go the Roth IRA route, you’ll be contributing after-tax dollars to your 401(k), and then periodically rolling over those converted funds to your Roth IRA. 

Can I Do Both Backdoor and Mega Roth Conversions? 

Because a mega backdoor conversion is done through a 401(k) and a standard backdoor comes from a traditional IRA account, it is possible to do both conversions at the same time.  

For high earners with a 401(k) plan, it provides multiple avenues to leverage tax-free growth in your retirement portfolio. 

Because a backdoor Roth IRA strategy requires multiple steps and can have a significant tax obligation involved, it’s best to consult a financial professional before moving forward if you believe that a backdoor or mega backdoor conversion is right for you. 

How Do I Begin Backdoor Roth Contributions? 

While it's relatively easy to open an IRA account at your brokerage and contribute to it, the conversion process and the associated income tax obligations can add increasing degrees of complexity.  

If you’re a high-earner with multiple IRA assets, you’re likely to have a financial advisor. But if you haven’t consulted a wealth management or tax professional, it’s highly advisable to do so prior to engaging in a backdoor or mega backdoor transaction.  

A financial professional can guide you toward the best strategy for retirement success. 

For many high-income earners, backdoor Roth conversions can set you up for massive retirement savings that will more than justify the expense of a financial advisor. 

Reach out today to learn more about how professional wealth manager can help.

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