By Matthew Gaude & Shawn McGuire
Benjamin Franklin is quoted as saying there is nothing certain in this world other than death and taxes. He couldn’t have been more accurate. Starting with our first income-producing job and throughout retirement, we are required to pay taxes on our wages. While the amount varies depending on how much we earn and our filing status, there’s no avoiding this responsibility. But there is a way to lessen its impact on your retirement savings.
In this article, we’ll cover the ins and outs of the backdoor Roth IRA and explain how it could benefit you, as well as introduce the lesser-known strategy of the mega backdoor Roth IRA.
What Is a Backdoor Roth IRA?
A backdoor Roth IRA is an IRS-sanctioned loophole that lets high-income earners reap the benefits of a Roth without violating the income limits.
There’s a reason Americans love Roth IRAs—they come with some major tax benefits. You pay taxes on your contributions up front, but then your investments grow 100% tax-free. Additionally, when you start taking withdrawals in retirement, none of that money counts as taxable income. It’s a very attractive option for those who can qualify.
But that’s the problem—most high-income earners don’t qualify for a Roth IRA. As of 2023, you’re not eligible to contribute to a Roth IRA if you make at least $153,000 as an individual or $228,000 as a married couple.
This begs the question: How can you enjoy the sweet tax perks that come with a Roth IRA if your income is over these limits? The solution is the backdoor Roth.
How Does a Backdoor Roth IRA Work?
Let’s say your income exceeds the legal limit for a Roth IRA, but you still want to fund an account. First, you will need to open a traditional IRA and fund it with non-deductible contributions. Then, you will immediately convert your non-deductible IRA to a Roth IRA and repeat this process each year in order to take advantage of tax-free growth.
In this scenario, you can avoid the IRA income limits, but you cannot avoid the annual contribution limits. This means you can fund a maximum of $6,500 in 2023 ($7,500 if you’re over the age of 50) per year. This may seem small, but over time you can amass a sizable retirement savings, especially when combined with other tax-advantaged retirement vehicles.
A backdoor Roth IRA is a useful wealth strategy that can save you thousands in taxes. But there’s even more to it than that.
Unlike traditional retirement accounts, backdoor Roth IRAs aren’t subject to required minimum distributions (RMDs). This means you won’t be forced to start taking withdrawals—and paying taxes on those withdrawals—when you reach age 73.
This is yet another point in favor of backdoor Roths: estate planning benefits. With no required RMDs, you’re free to let your account balance grow and build for as long as you’d like. Then, you can pass it on to your heirs if you wish to do so.
Important Update to Roth IRA Catch-Up Contributions
The IRS has delayed the implementation of a new rule regarding catch-up contributions until 2026. The rule states that individuals who earned over $145K in Social Security wages in the previous year must make any catch-up contributions in their workplace retirement plans (like a 401(k), 403(b), and 457(b)) as an after-tax Roth contribution, and will not have the option to make them as pre-tax contributions. People over the age of 50 are eligible to make catch-up contributions, and everyone will have that ability going forward, regardless of their income.
Considerations of a Backdoor Roth IRA
There are some things to be aware of when considering a backdoor Roth.
Pro Rata Rule
Backdoor Roths only work if you have zero to very low traditional IRA assets. What happens if you have both pre-tax and non-deductible after-tax contributions in your traditional IRA? Unfortunately, you cannot choose to only transfer the after-tax contributions. This is because of the pro rata rule.
Pro rata means that taxation is based on percentages or ratios. If 60% of all of your combined traditional IRA contributions were made pre-tax and 40% were made after-tax, then those are the percentages they use to determine the taxability of the conversion. No matter how much you convert or which specific IRAs it comes out of, 60% of the funds will be considered pre-tax (and therefore taxable) and 40% will be considered after-tax (and therefore tax-free).
The Mega Backdoor Roth
If you have a substantial amount of pre-tax savings, you may be able to utilize a “mega” backdoor Roth strategy instead. In this strategy, you would fund after-tax contributions to a Roth 401(k) that can grow tax-free if utilized properly. Most 401(k) plans don’t allow for this provision, but if it is available to you, reach out to us to learn about this implementation strategy in greater detail.
The mega backdoor Roth is a savings strategy that allows you to circumvent the 2023 $6,500 annual contribution limit for Roth IRAs ($7,500 if over the age of 50), and instead use the after-tax contribution limit for employer 401(k) plans, which is $66,000 in 2023 ($73,500 if over the age of 50). This strategy utilizes the same basic principle of indirectly funding a Roth account, but you would use a 401(k) as the first step in the process instead of a traditional IRA.
Irreversible
Backdoor Roths are irreversible. That means if you converted too much at once and got pushed into a higher marginal tax bracket, you can’t take it back. But this can usually be avoided by keeping your conversion amounts to the annual contribution limits.
State Taxes
You will also need to consider those tricky state taxes. If you live in a state that has income tax, you’ll likely owe state taxes on your backdoor Roth conversion in addition to federal taxes. However, some states exempt part of your distribution if you’re over a certain age.
5-Year Rule
Backdoor Roth IRAs also have two five-year rules to keep in mind. The first rule says that you must wait at least five years from your first contribution before you can make a penalty-free withdrawal from your Roth IRA—even if you’re over age 59½.
The second five-year rule states that each of your backdoor Roth conversions has its own five-year period. For example, if you do a conversion in 2023 and another in 2024, you’ll have to wait until at least 2028 to access the first conversion and 2029 to access the second.
As with anything tax-related, consult a wealth advisor to position your money in a way that minimizes tax liability and maximizes growth.
A Backdoor Roth IRA Could Be the Answer
If your income exceeds the regular Roth IRA eligibility criteria and you have the means to cover taxes on your rollover amount, you can capitalize on future growth and reduce your tax obligations during retirement. You’ve worked hard for your money, and Live Oak Wealth Management is here to help you keep more of it in your pocket. To start the process, reach out to us today at 770-552-5968 or email [email protected]. Or, if you prefer, you can simply click here to schedule an appointment online.
About Matthew
Matthew Gaude is an *investment advisor representative and the co-founder of Live Oak Wealth Management, a financial services firm in Roswell, Georgia. He serves the planning and investment needs of corporate employees, those approaching or in retirement, and 401(k) plan sponsors. Working first as a commodity broker and then as a Business Development Manager for a national broker-dealer in previous jobs, he has the insight and experience to help clients understand the complexities of the market and implement strategies to minimize risk. To learn more about Matthew, connect with him on LinkedIn or visit www.liveoakwm.com.
About Shawn
Shawn McGuire is a financial advisor and the co-founder of Live Oak Wealth Management, a financial services firm in Roswell, Georgia. He serves the planning and investment needs of corporate employees, those approaching or in retirement, and 401(k) plan sponsors. He has worked in financial services since 2002 in positions ranging from financial advisor to stock broker and portfolio manager. As a CERTIFIED FINANCIAL PLANNER™ professional, he is trained to help clients with virtually all their financial needs. To learn more about Shawn, connect with him on LinkedIn or visit www.liveoakwm.com.
Securities offered through American Portfolios Financial Services, Inc., member FINRA/SIPC. Investment advisory services offered through *American Portfolio Advisors, Inc., a SEC Registered Investment Advisor. Live Oak Wealth Management, LLC is independently owned and not affiliated with APFS or APA.
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