Want to contribute to a tax-free Roth IRA but exceed the income limits?
While you may not be allowed to make a Roth IRA contribution, you may be able to fund your account by way of what’s called a backdoor Roth conversion.
To help you determine whether this strategy is right for you, today we’re answering the question, “What is a backdoor Roth IRA?”
We’ll also be looking at how to do a backdoor Roth IRA conversion and important tax considerations, along with various considerations for initiating a Roth conversion. So let’s dive in.
What Is a Backdoor Roth IRA Conversion?
Once your earnings exceed the income limits set by the IRS (more on those in below), the only way to add funds to a Roth IRA account is through a backdoor Roth. Also called a Roth conversion, a backdoor Roth IRA involves transferring funds from a tax-deferred retirement account—typically a traditional 401(k) or IRA—to a tax-free Roth IRA.
Typically, this involves paying a one-time tax on the amount to be converted. Because the transfer is considered income on that year’s taxes, some investors will do a series of backdoor Roth conversions over several years to avoid the additional income pushing them into a higher tax bracket.
However, it’s also possible to contribute money to a traditional IRA and then, within the same tax year, convert that money to a Roth IRA without paying taxes on the conversion. In this case, you just wouldn’t write off the contribution to the traditional IRA on your tax return.
In any event, the backdoor Roth IRA conversion deadline under either scenario is December 31 of each tax year.
Why Do A Backdoor Roth IRA?
Unlike traditional IRAs and 401(k)s, Roth retirement accounts are funded with after-tax funds. The trade-off is that Roth distributions are completely tax-free upon reaching 59 ½ years of age (so long as you’ve had an open Roth account for at least five years). Traditional IRA and 401(k) contributions, on the other hand, are tax-deductible while distributions are subject to income taxes.
Considering taxes are historically low, it’s easy to see how a Roth IRA could pay off big. Especially if you expect to earn more at the time of withdrawal or believe taxes will be higher in the future. And with many of the provisions in the 2017 tax cuts set to expire in 2025—not to mention that the US national debt is at an all-time high—it’s not crazy to think that taxes may be higher in the future.
There’s also another reason you might want to consider a backdoor Roth conversion: Portfolio diversification. If all of your investment funds are allocated to traditional assets like stocks and bonds, you might want to consider allocating a portion of your funds to alternative investments.
Alternatives are assets that exist outside the public markets, and can include private credit, venture capital, real estate, and even fine art. Due to the fact that they exist outside traditional markets, alternatives tend to be less correlated with public equities, meaning they can help hedge against market volatility. Some, like investments in pre-IPO startups, may even offer the potential for outsized returns.
Historically, these investments have been unavailable for most retirement investors. Fortunately, investors today have more opportunities to diversify their portfolios via what’s called a self-directed IRA, making them a prime candidate for a backdoor conversion.
However, not everyone is eligible to contribute to a Roth directly.
Roth IRA Eligibility Requirements and Contribution Limits
In 2023, the maximum yearly IRA contribution is $6,500, with those over 50 allowed to contribute up to $7,500 per year. However, whether you’re eligible to contribute to a Roth IRA depends on your modified adjusted gross income (MAGI):
- People who are single, the head of a household, or married but file separate returns are eligible to contribute:
- The full amount if their MAGI is less than $138,000 a year
- A partial amount if their MAGI is less than $153,000 a year
- People who are married and file a joint return or a qualify widow(er) are eligible to contribute:
- The full amount if their MAGI is less than $218,000
- A partial amount if their MAGI is less than $228,000
Beyond these respective amounts, you cannot contribute to a Roth IRA. However, even if you can’t make regular contributions, it is still possible to add funds via a backdoor Roth.
Read more: Am I Eligible for a Roth IRA?
What Are the Advantages of a Roth IRA Conversion?
A backdoor Roth IRA gives you all the same benefits of a Roth IRA. Namely, as long as you’re eligible to take distributions, you’ll never pay taxes on gains or distributions.
There are other benefits to a Roth conversion, though.
Unlike with a traditional IRA, Roth IRA holders are not required to begin taking distributions at age 73. In fact, you don’t even have to take distributions during your lifetime, meaning you can leave your Roth IRA to your heirs. No wonder The Motley Fool calls Roth IRAs a “generational wealth secret.”
Still, just because distributions are tax-free does not mean that this strategy is right for you.
Considerations for a Backdoor Roth IRA
If you’re investing your IRA in alternative assets that you expect to yield big returns or which require a substantial investment minimum, or you anticipate that your taxable income will be higher in the future, it might make sense to take the one-time tax hit and convert your tax-deductible retirement funds into a Roth IRA. However, the same isn’t true for everyone.
Keep in mind that a backdoor Roth conversion:
- Will increase your taxable income. The amount you convert is considered taxable income for the year in which the conversion took place, which could mean owing a lot more on your taxes. This could be in the form of paying additional taxes at the end of the year or by allowing some of the converted amount to go toward taxes, which will decrease the amount transferred to your Roth.
- Could put you in a higher tax bracket. As a result, you may end up paying a higher tax rate for the year as well. For this reason, it might make sense to contribute a certain amount each year for several years instead of moving all of your funds at one time.
- May raise your Medicare premiums. Medicare premiums are based on your income two years prior. That means a conversion could result in substantially higher Medicare premiums down the road (at least for a year), making it potentially worthwhile to talk to your financial or tax advisor before making a decision.
- Might not save you money in the long run. Depending on the associated costs and how long your investment will have to grow before taking distributions, a backdoor IRA conversion might not be worth it. Again, it’s important to do your homework. When in doubt, consult an expert!
Backdoor Roth IRA Conversion Tax Example
Let’s say you want to convert your current balance of $5,000 from your traditional IRA into a backdoor Roth. Should you convert the entire amount in a single tax year, you will show $5,000 of additional income on your taxes for the year.
Assuming you are single or married but file separately with a salary of $42,000, the backdoor IRA conversion will push your total income to $47,000—just above the $44,725 maximum for your tax bracket (as of 2023). As a result, your income tax rate will increase from 12% to 22% for the year.
Because of these and other considerations, it’s always a good idea to consult with a trusted financial or tax advisor to determine the best strategy for you.
How to Use a Backdoor Roth IRA to Invest in Alternative Assets
Whether you’re looking for a way to increase your Roth IRA investment funds, have a traditional IRA that you’d like to switch to a Roth, or are looking for a savvy way to use your 401(k) from a previous job, a backdoor Roth conversion could be a worthwhile strategy for you.
If you’re looking to invest your converted funds into non-stock assets like startups, cryptocurrency, venture capital, and real estate, Alto can help you convert your traditional IRA or 401(k) to a Roth IRA or Roth CryptoIRA.
Originally published October 12, 2021
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