Pros and Cons of a Backdoor Roth IRA Conversion
A strategy many advisors implement with their clients when appropriate is what’s known as a "Backdoor Roth IRA" conversion. To understand this strategy and whether it is best for you, let’s take a step back and get a better understanding of IRAs in general.
A Roth IRA is a retirement account that you can contribute to with after-tax money. This is different from a Traditional IRA or a 401k, which you can contribute to with pre-tax money. Upon initial glance, it might seem Traditional IRAs or 401(k)s are “better” simply because of the tax treatment on the front end. However, the benefit to a Roth IRA is that you can withdraw the money in retirement tax-free, including all the growth that happened within the account from the years you were invested. Traditional IRAs and 401(k)s will be taxed at normal income tax rates when you withdraw from the account in your retirement years.
In other words, the Roth provides a tax benefit down the road, and the Traditional IRA and 401k provide a tax benefit now.
Benefits of a Roth IRA:
- No taxes in the future
The biggest advantage for Roth IRAs is that since you are contributing to the Roth with after-tax dollars, the IRS isn’t coming for your distributions later when you need them. We don’t know what our income will be in the future, so by diversifying the tax treatment of distributions among your retirement accounts, we can lessen the potential impact of your tax burden in retirement.
- Diversified income streams = greater flexibility.
Roth IRAs provide a significant advantage to retirees by diversifying their income streams and the tax treatment of their income streams in retirement. This means retirees have more planning options and strategies they can implement with a financial advisor to minimize taxes in retirement.
- No RMDs
With Roth IRAs, retirees are not required to take a required minimum distribution like they are with qualified plans such as a Traditional IRA. This means if the funds do not need to be accessed in retirement, there’s more to leave with your loved ones when you pass.
- No early-withdrawal penalty on contribution withdrawals
If you need access to the money you’ve contributed to a Roth, you should be able to access that money without there being any tax consequences, or early-withdraw penalty like you would have with a qualified plan. Be careful with this, though. First, you need to be sure you are not withdrawing the earnings, just the contributions. Secondly, we don’t recommend withdrawing from a retirement account unless necessary since it could significantly impact the compounding effect of your investments.
What sort of people benefit most from a Backdoor Roth strategy?
The people who this strategy might benefit are the ones who understand the benefits of a Roth IRA and decide it makes financial sense for them. This could be individuals who otherwise might not be able to contribute to a Roth. Not everyone is eligible to contribute to a Roth. For example, if you’re married, filing jointly, and earning more than $214,000 a year in 2022, the IRS doesn’t allow you to invest in a Roth IRA. However, you can invest in a Traditional IRA and convert your Traditional IRA to a Roth since there are no income requirements on a Roth conversion. Sound shady? It’s perfectly legal and has been since 2010.
It also might be for people who have never thought about starting a Roth. Maybe they’ve accumulated quite a bit in qualified plans over the years and want to use some of those funds to diversify into a different type of retirement account.
Drawbacks to a Backdoor Roth IRA conversion:
If you are reading this and getting excited about this strategy and its benefits, we need to bring you down just a couple of notches. As with anything, with upsides come a few downsides.
The first drawback is the tax consequence right now. When you convert a Traditional IRA to a Roth, it means that, come tax time, you will have to pay income taxes on that conversion since you are converting pre-tax dollars – and it could be significant!
Working with a qualified financial advisor is essential to make sure you know the tax implication and have a game plan for how to pay it, so there are no surprises.
The second drawback is – this might not lower your tax bill. We don’t know your income in retirement, but it might be much lower than what you are earning now. If that’s the case, paying income taxes in retirement might result in lower taxes overall than paying them now.
Finally, the last drawback is the opportunity cost. Remember, the value of a dollar right now is worth more than a dollar tomorrow. Implementing this strategy would require significant dollars (sometimes thousands) to be paid to Uncle Sam. That’s money that could have been invested elsewhere.
A Backdoor Roth IRA conversion can be a complicated strategy and one you can’t afford to do wrong. There are rules and penalties that can occur if you do not follow them, and unfortunately, ignorance is not bliss when it comes to the IRS. For example, as we mentioned earlier, a withdrawal can typically be made from a Roth without any withdrawal penalties. However, if you are withdrawing the funds from a conversion, you must wait five years before doing so or else face penalties.
You also can pay the tax bill out of the IRA you are converting – but we do not recommend that. Doing so could hurt your ROI significantly.
The bottom line is that this strategy could be very beneficial. Yet, it is extremely important that you understand what you’re doing or hire a professional to help you. This is your future, your retirement, and you can’t afford to get it wrong.