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Why You May Want to Go Through the Back Door -- ROTH that is

Why You May Want to Go Through the Back Door -- ROTH that is

May 01, 2024

A “backdoor” Roth IRA is a strategy that allows high-income individuals to convert traditional IRA funds into a Roth IRA.  This is regardless of income limits that would otherwise prevent them from making direct Roth IRA contributions. This strategy involves making non-deductible contributions to a traditional IRA and then converting those funds into a Roth IRA.

How Does a Backdoor Roth IRA Work?

Here's a step-by-step breakdown of how a backdoor Roth IRA works:

  1. Make a Non-Deductible Contribution to a Traditional IRA: Since there are no income limits for contributing to a traditional IRA, high-income earners can make non-deductible contributions regardless of their income level.
  2. Convert Traditional IRA Funds to a Roth IRA: After making the non-deductible contribution to the traditional IRA, individuals can then convert those funds into a Roth IRA. This conversion is treated as a taxable event, but since the initial contribution was made with after-tax dollars, only the earnings (if any) are subject to taxation.
  3. Pay Taxes on Earnings: If there are any earnings in the traditional IRA before the conversion to a Roth IRA, those earnings will be subject to income tax in the year of the conversion. It's important to note that taxes on earnings can be minimized by timely converting the funds to a Roth IRA to prevent significant growth in the traditional IRA.

Benefits of a Backdoor Roth IRA:

  1. Tax-Free Growth: Like traditional Roth IRAs, backdoor Roth IRAs offer tax-free growth potential, allowing investments to grow without being subject to capital gains or dividend taxes.
  2. No Required Minimum Distributions (RMDs): Unlike traditional IRAs, Roth IRAs are not subject to required minimum distributions (RMDs) during the account holder's lifetime, offering more flexibility in retirement planning.
  3. Estate Planning Benefits: Roth IRAs can be passed on to heirs tax-free, providing potential estate planning advantages for individuals looking to leave a tax-efficient inheritance.

Considerations and Potential Drawbacks:

While backdoor Roth IRAs offer valuable benefits, there are some considerations and potential drawbacks to keep in mind:

  1. Pro-Rata Rule: The pro-rata rule stipulates that when converting traditional IRA funds to a Roth IRA, all funds in all traditional IRAs are considered, not just the funds being converted. This can complicate the tax implications of a conversion, especially if the individual holds other traditional IRA accounts with pre-tax contributions.
  2. Tax Implications: While contributions to a traditional IRA are made with after-tax dollars, any pre-tax contributions and earnings in traditional IRAs will be subject to income tax upon conversion to a Roth IRA. It's essential to consider the tax consequences before proceeding with a backdoor Roth IRA strategy.

Conclusion:

Backdoor Roth IRAs can be a valuable strategy for high-income individuals looking to take advantage of the benefits of Roth IRAs despite income limitations. By understanding how backdoor Roth IRAs work, the potential benefits they offer, and the considerations involved, individuals can make informed decisions about whether this strategy aligns with their financial goals and retirement planning objectives. As with any financial strategy, consulting with a qualified financial advisor or tax professional can provide personalized guidance based on individual circumstances.

Jayne W. Di Vincenzo CFP®, ChFC®, AIF®, CEP®

CEO | Wealth Advisor

Direct:       912-521-5005

Toll Free:  888-605-EDGE

Fax:           833-548-0855

www.FiduciaryEDGEAdv.com

33 Bull Street, Suite 505 | Savannah, GA 31401

 

  

Consult your tax advisor regarding your specific situation. This is not considered investment advice specific to any investor or situation.

 
Securities offered through Kestra Investment Services, LLC (Kestra IS), member FINRA/SIPC. Investment Advisory Services offered through Kestra Advisory Services, LLC (Kestra AS), an affiliate of Kestra IS. Fiduciary EDGE Advisors, LLC is not affiliated with Kestra IS or Kestra AS.