A Roth IRA may be the holy grail of personal finance. For those unfamiliar with the difference between Roth and traditional accounts, here is a brief synopsis and example to illustrate.
A traditional IRA or 401(k) is funded with (mostly) pre-tax funds, and the principal balance grows tax-deferred but is subject to unfavorable ordinary income tax rates upon eventual distribution. In order to avoid perpetual tax-deferment, there are mandatory liquidations (known as RMDs) for account owners older than age 70.5.
A Roth IRA, by contrast, is funded with post-tax funds and never taxed again. There are no distribution requirements to force taxable income. One way to view it is that any time money enters a Roth, it is taxed in the year of contribution, then never again. In other words, getting money into a Roth account is equivalent to setting it free from taxes forever.
Choosing Between a Roth IRA or Traditional IRA
Most conversations regarding Roth accounts involve choosing between Roth or traditional based on taxes, such as whether one should:
- Contribute to a Roth or traditional company plan (401(k), 403(b), etc.)
- Contribute to a Roth or traditional IRA
- Convert from a traditional IRA to a Roth IRA
The common thread for each above decision is there are additional taxes paid when choosing Roth vs. traditional, so tax rates should drive that analysis. If one’s tax rate in retirement is lower, than traditional contributions make sense.
Here is an example with two scenarios of an individual saving $10,000 for retirement. Assume our individual receives a $10,000 bonus they will invest for retirement at an annual 6% growth rate, and he is deciding between a Roth or traditional IRA. In one scenario, the tax rate during his working years is 25% and drops to 15% in retirement. The other scenario has opposite rates, with higher tax rates in retirement. (For related reading, see: Roth vs. Traditional IRA: Which Is Right for You?)
In the first scenario, the traditional account nets greater funds in retirement, where the opposite is true in the second scenario. Again, the only variable is tax rates. This obviously doesn’t favor any earner at the highest marginal tax bracket.
Using a Backdoor Roth IRA
Aside from tax rates, a high income prohibits many individuals from directly accessing Roth accounts. Any individual earning more than roughly $130,000 or married couple earning more than roughly $190,000 are significantly limited or flat-out prohibited from contributing to a Roth IRA account (although they can contribute to a work-sponsored account, which brings us back to the tax rates analysis above).
So, when conducting analysis, high earners often realize it doesn’t make financial sense to utilize a Roth based on tax rates and, even if it did, they are precluded from doing so based on the income limits. But there’s another way for high earners to achieve tax-efficient savings in Roth accounts, and it’s called, colloquially, the backdoor Roth. Here’s how it works:
Anyone with sufficient earned income can make a nondeductible contribution of $5,500 to a traditional IRA. This means they contribute post-tax money to a traditional account that grows tax deferred but is still subject to the burdensome tax and distribution requirements in retirement. Once they make that distribution, they have a “tax basis” in the account of $5,500, or whatever their contribution was. Any growth on that principal is tax deferred until distribution.
If the individual shortly thereafter converts the entire amount to a Roth, they would only pay taxes on growth between contribution and conversion, which is usually very small. If there is no growth, or very little growth, this is effectively the same as contributing directly to a Roth. (For related reading, see: Converting Traditional IRA Savings to a Roth IRA.)
And this can be done systematically every year. Why is this so good?
Let’s compare 20 years of a $5,500 contribution with 6% annual growth between a traditional and Roth IRA. After 20 years, both accounts have a pre-tax value of $202,231. If we assume the traditional IRA has a tax basis equal to the total contributions of $104,500 ($5,500 x 20), there is about $97,821 worth of investment growth taxable at an ordinary income rate of 25%. After taxes of $24,500, the post-tax value is roughly $178,000.
The Roth post-tax value, of course, is no different than the account balance.
Exceptional results are the aggregate of many small victories, and here is an example of that.
Some Precautions About Backdoor Roth IRAs
First, there’s a reason why this is called the backdoor Roth. It’s a bit of an end-around on the IRS rules that disallow Roth contributions from high earners. While you can be systematical about the process (contribute to traditional IRA and convert to Roth a short time thereafter), you certainly want to spread it out a bit to avoid the IRS step transaction doctrine. (For related reading, see: Avoid These Mistakes with Backdoor Roth IRAs.)
Second, keep in mind that if your funds are invested in the traditional IRA for some time before the conversion and there is any investment growth, that growth is taxed as ordinary income. In practice, this nets to a miniscule and almost negligible amount of tax, but make sure it doesn’t slip through the cracks. If you keep the funds invested long enough that there is some investment growth, this strategy still works despite some higher taxes. Those intra-year taxes could also be a buffer against IRS scrutiny. In any event, talk to your CPA.
When Does The Backdoor Roth IRA Strategy Not Work?
This strategy will not work for anyone who already has a traditional IRA with a low tax basis. That’s because of an IRS rule that bases the taxability of Roth conversions on the total taxable basis of IRA accounts. If, for example, you already had a $100,000 IRA with zero-tax basis and made a no-deductible contribution of $5,500, you can’t convert just the non-deductible portion.
Upon conversion of $5,500, the IRS would treat that as a partial conversion of all traditional IRA assets, which means $5,500/$105,500 would be 5.2% nontaxable, or in other words, 94.8% taxable. This totally undermines the strategy. For those with existing IRAs without tax basis, this strategy may not be for you.
(For more from this author, see: 3 Financial Planning Questions for 30-Somethings.)