The Roth retirement account is an amazing retirement tool, nearly unsurpassed in its usefulness. The benefits it provides are nearly endless – no required minimum distributions, tax-free withdrawals on contributions AND earnings, tax-free gifts for beneficiaries, and the ability to exactly calculate retirement income without having to worry about taxes. To put it lightly, we love the Roth!
Unfortunately, though, high-income earners do not qualify to put directly into a Roth account. That means single filers with a MAGI (Modified Adjusted Gross Income) higher than $144,000 or joint filers with a MAGI higher than $214,000 are excluded from the Roth.
But that’s not the end of the story, because there is an IRS loophole called the Backdoor Roth Conversion. Anybody can take advantage of it – regardless of income status!
A Traditional IRA is funded with PRE-TAX (tax-deferred) funds. These funds can be deducted from your yearly income, potentially keeping you in a lower tax bracket. All contributions and earnings (compound gains even!) are taxed after retirement when you start taking withdrawals. The tax bill can be so high (up to 37% of your retirement funds) that you may find yourself struggling to outlive your money, even though it probably seemed more than enough.
A Roth IRA is funded with POST-TAX funds. You take money out for taxes, then put it into your Roth account. Contributions AND earnings grow tax-free, forever, though with some minor restrictions. Even contributions can at any time be taken out without being taxed. You can keep putting into it as long as you wish and you never have to withdraw from it. In fact, it’s great as part of an estate planning strategy. So, back to that Backdoor Roth strategy.
A person with a high income may not be able to put into a Roth, but they can, of course, open a traditional IRA – there are no income limits on who can do that.
Since 2010, there have been no income limits in place for those who qualify to do Roth conversions. To put it straight, a person who earns $150,000 a year cannot open a Roth, but they can open a Traditional IRA. Once they put into that IRA, they simply roll those funds over into a Roth. Taxes have to be paid on any funds converted, just like how taxes are already paid on any funds put straight into a Roth.
Now, the question of whether they should do that can be a difficult one. You want to do a Roth conversion if you feel you will be in a higher tax bracket in the future or retirement. Don’t forget about commonly overlooked retirement income streams which may bump you up a bracket as well.
Because the Tax Cut and Jobs Act (TCJA), which saw taxes slashed across the board, expires in 2025 and we can ALL expect a tax hike in 2026, converting now or at some point before December 2025 is likely to make sense.
Besides the TCJA expiring in 2025, another thing to keep in mind is that the Backdoor Roth Conversion was slated to be done away with by the Build Back Better Act. While that specific legislation is dead, we never know when it or a different piece of legislation prohibiting backdoor Roth conversions may be pushed through.
As you may have figured out, choosing to do a conversion or perhaps a partial conversion is a tough call. That’s where we come in – we can provide a break-even analysis while taking into account your unique tax circumstances.
Click the button for a zero-obligation consultation to determine if a Backdoor Roth Conversion is right for you!