By John Halterman

Taxes don’t go away in retirement. But there is a way to lessen their 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.

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 2021, you’re not eligible to contribute to a Roth IRA if you make at least $140,000 as an individual or $208,000 as a married couple. (1)

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. 

An IRS-Sanctioned Loophole

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. 

Here’s how it works. 

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 that you can fund a maximum of $6,000 (or $7,000 if over the age of 50) per year. (2) This may seem small, but over time you can amass a sizable retirement savings, especially when combined with other tax-advantaged retirement vehicles. 

You can use a similar process with a 401(k). In this case, you would make after-tax contributions to a 401(k) plan and then roll it over to a Roth IRA. (3) Again, the amount contributed would be subject to annual limits, but the income limits would be avoided. 

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 72. 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. 

Knowledge Is Power

Now, since you can’t have your cake and eat it too, there are some things to be aware of when considering a backdoor Roth. For one, they 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.  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. (4)

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. (5)

The second five-year rule states that each of your backdoor Roth conversions has its own five-year period. (6) For example, if you do a conversion in 2021 and another in 2022, you’ll have to wait until at least 2026 to access the first conversion and 2027 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

At Beacon Wealth Management, we understand that a simplified, yet comprehensive approach to wealth management is the key to worrying less about your finances. As such, our Wealth Strategy Portal streamlines your wealth strategy so you don’t get overwhelmed. If you’re tired of muddling through important wealth strategy issues on your own, call (304) 626-3900 or email me at [email protected] to get our help!

About John

John Halterman, best-selling author and nationally published blogger has been featured as a financial guest expert on the TV shows of self-help gurus Brian Tracy and Jack Canfield, author of Chicken Soup for the Soul. He has appeared on ABC, FOX, BRAVO, NBC, CBS, and A&E.  John is the expert host of the weekly WDTV News 5 segment, “Solutions 4 Financial Independence.”

As an authority on wealth management, he has been invited by hundreds of institutions such as universities, federal agencies, professional associations, and large energy and utility corporations to be a guest speaker and educational event host. Event topics include maximizing your retirement, managing down market investment risk, how to reduce your tax burden, and transferring your family wealth in the most tax advantageous way.

John is the founder and owner of Beacon Wealth Management, specializing in helping entrepreneurs, professional practitioners, and retirees overcome the 4 major challenges facing successful families. He is a warm communicator with a passion for helping people transform their financial futures. John understands the multifaceted set of financial worries people face as they become more successful and enter the retirement red zone. He empathizes personally with each client and delivers a collaborative client experience that empowers people to reach their life goals.

With more than two decades of experience, John’s professional credentials include:

  • Certified Wealth Strategist (CWS)
  • Accredited Investment Fiduciary® (AIF®)
  • Certified Estate Planner™ (CEP®)
  • Chartered Federal Employee Benefits Consultant℠ (ChFEBC℠)
  • Professional Plan Consultant® (PPC®)
  • Registered Financial Consultant (RFC)
  • Past member of Ed Slott’s Master Elite IRA Study Group

A native of Weston, West Virginia, John served in the United States Air Force prior to becoming a Wealth Advisor. Today, he resides with his family in Bridgeport, West Virginia. He and his wife, Lisa, have been married since 2005 and have three amazing children. A family-loving man, he enjoys giving back to his community, coaching youth sports, landscaping and architectural design, WV Athletics, and is an outdoor and racquetball-playing enthusiast.