So many terms in the financial industry seem mysterious and confusing, and some even sound completely made up.  The Backdoor Roth IRA doesn’t need to remain a mystery.  If you haven’t heard of a Backdoor Roth, financial advisor Kelly Kranstuber wrote a short article explaining the basics.  The team at Ramsey Solutions suggests saving 15% of your income for retirement (also known as Baby Step 4). 

One frustration many of our clients share is that reaching that 15% can be difficult because of the income limits imposed on those making Roth IRA contributions. Before 2010, there was an income limitation for those who could do Roth IRA conversions. 

Advantages of Roth IRA

In 2010, the IRS changed the rules to make a way for high-income earners to make Roth conversions.  One advantage of making contributions to a Roth IRA is that many high-income earners will actually be in a higher tax bracket later in life, and thus, paying the tax now allows them to take the hit when they are in a lower tax bracket, saving money. 

A second advantage is that funds inside a Roth IRA can grow tax-free.  If an individual contributes to a traditional IRA, the investment is tax deductible in the current year, but the growth of the investment is tax deferred.  For younger investors with a longer timeline for investment growth, the difference in taxing contributions now versus taxing the growth later could be tens of thousands of dollars in tax liability—even if they remain in the same tax bracket their entire working career. 

A third advantage is that because contributions are taxed going into a Roth IRA, there are no Required Minimum Distributions (commonly referred to as RMDs) when the account owner reaches the age of 70 ½, as is the case with investments in a traditional IRA.

Misconception #1: Process NOT Product

A Backdoor Roth IRA is not actually a type of account… instead, it is a PROCESS whereby high-income earners can avoid the IRA income limitations for making contributions to a Roth IRA.  This process has become a popular tax-advantaged strategy for making retirement contributions in a way that avoids the income limitations associated with making Roth IRA contributions (in 2023, the limit for couples married filing jointly is $218,000-$228,000 and the limitation for those filing single is $138,000-$153,000). 

If you are unfamiliar with the difference between a Roth IRA and a traditional IRA, take a few minutes to read this description of the differences posted by Fidelity—one of our custodial partners at Whitaker-Myers Wealth Managers.  

Misconception #2: I can do this on my own

Yes and no.  The process of making backdoor contributions is relatively simple if the investor(s) do not already have IRA accounts (traditional IRAs, SIMPLE IRAs, SEP IRAs).  If an interested investor does have preexisting IRAs, making a backdoor Roth contribution is still possible, but there are complex tax issues involved in calculating the Pro-Rata tax treatment of funds being converted.  We advise seeking direction from a CPA in these cases. 

For those looking to increase or begin making retirement contributions, the primary move is to open two accounts: an IRA and a Roth IRA.  The contributions are made to the IRA and held in cash for no more than the time it takes for the transaction to settle. Then, the transaction is moved into the Roth IRA and invested within that account. 

However, an important step involves notifying your CPA to ensure you file the appropriate forms.  Most CPAs will assume that contributions to an IRA will not be withdrawn because doing so triggers the taxation and, in some cases, a penalty.  In the case of a Roth conversion, this withdrawal will trigger the issuance of a 1099 unless the CPA files IRS Form 8606 to note the funds that have been converted into the Roth account.  If you have questions about your particular tax situation, consult your CPA or contact Whitaker-Myers Tax Advisor Kage Rush for more information.

Misconception #3: Money inside a Roth IRA will take care of itself

Remember, the Roth IRA is simply an umbrella under which an investor can save for retirement and enjoy tax-free investment growth.  The funds inside the Roth should be invested with careful consideration of the objectives and goals of the individual investor, including the appropriate risk profile and time horizon based on the expected retirement income projections.  Since one of the reasons for converting into a Roth is to avoid taking RMDs, investors using a target date fund may miss out on potential growth opportunities by having an asset allocation mix that doesn’t fit their specific situation.

Summary

If your household income falls within the high-income limitations described above—or your income is approaching those limits, it may make sense for you to talk to a financial advisor about whether making Backdoor Roth IRA contributions is right for you.  When done correctly, the Backdoor Process involves three basic steps:

• Open two accounts, an IRA and a Roth IRA

• Move funds into the IRA for the minimum holding period (usually a few days) before converting into the Roth

• Work with your CPA or tax professional to file form 8606

At Whitaker-Myers Wealth Managers, our team can assist clients through various aspects of financial management, retirement income planning, and tax advice.  If you are interested in speaking with a financial advisor, schedule a conversation today.