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Ever wondered about the mysterious backdoor Roth conversion? While seemingly complex, this retirement savings strategy can be quite useful if you fall into a specific bucket of savers. Let’s demystify the process.

How does a backdoor Roth conversion work?

The backdoor Roth conversion allows high earning individuals the opportunity to contribute to a Roth IRA, even if they otherwise exceed the income restrictions for this type of account.

Instead of contributing to a Roth directly, the process involves making a non-deductible contribution (money you have already paid taxes on) to a traditional IRA, then converting it over to a Roth IRA. You may also convert pre-tax traditional IRA funds to a Roth IRA. The tax implications are somewhat nuanced – more on that later.

Check the IRS website for additional information.

What are the benefits?

  • Potential for tax-free growth and withdrawals. One of the biggest advantages of a backdoor Roth conversion is the potential for tax-free growth on your investments in the account. Likewise, Roth IRAs offer tax-free withdrawals in retirement, so long as you meet the qualifying criteria.
  • No RMDs. Roth IRAs do not require minimum distributions during the account holder’s lifetime. You can potentially allow your investments to continue growing tax-free for as long as you would like, without being forced to take withdrawals at a certain age.
  • Estate planning options. Unlike traditional IRAs, Roth IRAs can provide a vehicle to pass an inheritance to your beneficiaries tax-free.

What are the drawbacks?

  • Tax consequences. Be prepared to pay taxes during the conversion process. When you convert pre-tax traditional IRA funds to a Roth IRA, you will pay taxes on the conversion, based on your earned income tax rate. The tax bill can be quite significant, depending on how much you convert and your current tax bracket. Make sure to discuss the potential tax liabilities with your CPA before utilizing this strategy.
  • Pro-rata rule. The IRS will determine what taxes are owed for the conversion, based on their pro-rata rule. It analyzes all your traditional IRA accounts as a whole and the tax implications for those funds, taking into account your traditional IRA balances, including any pre-tax contributions and earnings. You cannot pick and choose which bucket of funds to convert. The tax calculation can be complicated, and potentially limits the conversion benefits.
  • Tax law changes. The current tax treatment of Roth IRAs could change at any time. There is always a risk that the tax law could be modified, limiting or negating the potential benefits of a backdoor Roth conversion all together.

Does a backdoor Roth conversion make sense for you?

As with any financial decision, your specific situation dictates whether the backdoor Roth conversion is the right move. For many people looking for retirement account flexibility, the potential upsides may be well worth it. However, if you need the money sooner rather than later, do not have the cashflow to pay the taxes, or are pushed into a higher tax bracket through the process, the costs may outweigh any benefits.

Want to dive into more details? We can certainly help guide you along the way.