High-income households can use a so-called “backdoor Roth” to use a Roth IRA despite the program’s standard income restrictions. This can be an effective way to build a tax-free income stream for your retirement, and it’s a completely legal strategy.
Whether this method will lower your taxes depends greatly on your current tax rates and what you pay in retirement. For some high earners, a Roth IRA can even be a money loser if it means you spend more in taxes today than you will save in taxes in retirement.
Do you have questions about taxes and retirement planning? Talk to a financial advisor today.
What is a backdoor Roth?
A Roth IRA is a so-called after-tax retirement account. This means that you contribute to it with money on which you have already paid tax. Then, when you retire, you take completely tax-free withdrawals of both your contributions and any growth. The idea is that it is more expensive up front to build a Roth IRA compared to a pre-tax portfolio such as a traditional IRA or 401(k), but as a retiree you will save taxes on your portfolio at the highest value.
However, Roth IRAs also have income limits. For 2024, if you are single and earn less than $146,000, or married and earn less than $230,000, you can contribute up to $7,000 for that year. This contribution limit will begin to shrink and phase out until the final income caps of $161,000 and $240,000 for individual and joint filers, respectively. For high earners above these figures, this would lock you out of a Roth IRA.
The solution to this, however, is what is called a backdoor Roth. With this approach, you open a traditional IRA (which has no income limits) and a Roth IRA. You contribute money to the traditional IRA before taxes and then convert the money, either all at once or periodically, to your Roth IRA.
Because the IRS places no income limits on Roth rollovers, you can build a fully funded Roth IRA regardless of household income. Of course, you’ll need to be prepared to pay taxes on all that money upfront, so keep that in mind as well. You may also find it helpful to work with a financial advisor when planning a backdoor Roth.
Backdoor Roth conversion taxes and cooldowns
When you convert money to a Roth IRA, you must pay income taxes on the entire amount in the tax year in which you make the conversion. For example, moving $50,000 from your traditional IRA to your Roth IRA will add $50,000 to your taxable income that year, potentially moving you into higher tax brackets.
It’s important to properly manage your cash flow for this tax event. Unlike withdrawals from wallets, a conversion does not generate disposable funds that you can use to pay these taxes. You will need to have the money on hand.
Also keep the pro-rata rule in mind. If your IRA contains a combination of deductible and non-deductible contributions, you will pay taxes based on their share of your account. You can’t just voluntarily roll over all non-deductible contributions and avoid conversion taxes.
It’s not uncommon for households to convert their IRAs on a regular basis, such as every year or every few months. This can help maximize your tax-free gains, but conversion taxes will apply every time you roll over money. Current transfers can also help you get around the Roth IRA’s cooling-off period, known as the five-year rule.
Long-Term Tax Benefits of a Backdoor Roth
A Roth IRA offers several benefits. First, because you pay taxes on the funds upfront, this portfolio grows tax-free and you don’t pay taxes on your withdrawals. It also has no required minimum distributions (RMDs), giving you more flexibility in your financial planning.
High-income households may not find it helpful to save money with this vehicle. The more you earn, the easier it can be to end up paying more in conversion taxes than you actually save on income taxes in retirement.
The standard rule of thumb is that a Roth IRA is generally better if you expect to pay higher taxes in retirement than you currently do. On the other hand, a traditional IRA may be optimal if you expect your tax rates to decline in retirement. For example, suppose you pay an effective rate of 20% in taxes while working and have €50,000 to invest:
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Roth IRA: You pay €10,000 in taxes and invest the remaining €40,000
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Traditional IRA: You pay $0 in taxes and invest the entire $50,000
Now suppose your portfolio doubles in value by the time you retire. For taxes, you now pay an effective rate of 22% and withdraw all the money:
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Roth IRA: You pay $0 in taxes and keep $80,000
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Traditional IRA: You pay $22,000 in taxes and keep $78,000
This is where the rule of thumb comes from. The Roth would still give you $80,000, but the traditional IRA’s after-tax value would drop to $78,000.
In contrast, suppose your effective tax rate dropped to just 15% in retirement. The Roth would then generate the same $80,000, but the value of the traditional IRA would exceed it by $85,000 after taxes. Therefore, this decision always comes down to whether your tax rates will be higher or lower in retirement compared to your working life.
For a high-income household earning $300,000, it may be helpful to talk to a financial advisor. A backdoor Roth can help you lower your taxes, depending on your projected retirement income and current investment strategy, but chances are you’ll actually spend more than you save in the long run.
Tips for Making a Roth Conversion
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A financial advisor can help you draw up a comprehensive retirement plan. Finding a financial advisor does not have to be difficult. SmartAsset’s free tool matches you with up to three vetted financial advisors serving your area, and you can have a free introductory meeting with your advisors to decide which one you think is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
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Planning your retirement income can be a complicated and speculative process. But knowing your tax bracket is not. Once you know what you plan to withdraw, you can use an income tax calculator.
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Keep an emergency fund on hand in case you encounter unexpected expenses. An emergency fund should be liquid – in an account that is not at risk of significant fluctuations like the stock market. The trade-off is that the value of liquid cash can be eroded by inflation. But with a high-interest account, you can earn compound interest. Compare savings accounts from these banks.
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