A Roth individual retirement account (IRA) is off-limits for people with high annual incomes.
If your earnings put Roth IRA contributions out of reach, a backdoor Roth IRA conversion is an option that lets you enjoy the tax benefits of a Roth IRA. A backdoor Roth IRA is a strategy that helps you save retirement funds in a Roth IRA even though your annual income would otherwise disqualify you from accessing this type of individual retirement account.
Backdoor Roth IRA conversions are mainly useful for high earners whose annual income (plus access to workplace retirement plans) already make them ineligible for tax deductions for traditional IRA contributions.
Who Benefits from a Backdoor Roth?
- High earners who don’t qualify to contribute under current Roth IRA rules.
- Those who can afford the taxes for a Roth conversion and want to take advantage of future tax-free growth.
- Investors who hope to avoid required minimum distributions (RMDs) when they reach age 72.
A general rule of thumb with Roth IRA conversions is that you will owe taxes on any money that has never been taxed before.
Roth IRA Conversion makes little Tax difference f
A Roth conversion will not make a significant difference to your retirement standard of living, according to an exhaustive new study.
The study findings reveal that “…only if you’re in the top 1% of retirement savers will a Roth conversion move the needle more than a little bit in your retirement.” The study, “When and for Whom Are Roth Conversions Most Beneficial?,” was conducted by Edward McQuarrie, a professor emeritus at the Leavey School of Business at Santa Clara University.
Unlike many previous analyses of Roth conversions, McQuarrie adjusted all his calculations by inflation and the time value of money, likely changes in tax rates, and a myriad other obvious and not-so-obvious factors.
McQuarrie finds that only if you have millions in your IRA or 401(k)—at least $2 million for an individual and $4 million for a couple—will your required minimum distributions in retirement be so large as to put you into even the middle tax brackets.
Only for those select few will the potential tax savings of a Roth conversion be significant. For most of the rest of us, we’ll likely be in lower tax brackets in retirement years, with an effective rate of 12% or less. That almost certainly will be lower than the tax we would pay for a Roth conversion during our peak earning years prior to retirement.
Even if tax rates themselves go up, furthermore, it’s still likely that your tax rate in retirement will be lower than preretirement. That’s because you’ll likely be at your peak earning years prior to retirement, when you might be undertaking a Roth conversion, and therefore in a relatively high tax bracket.
Once you stop working and retire, and are living on Social Security and the withdrawals from your retirement portfolio, your tax rate will most likely be lower—even if the statutory tax rates themselves have been increased in the interim.
Backdoor Roth IRA conversions lets you circumvent the prescribed AGI limits if your annual earnings put direct Roth IRA contributions out of reach.
References:
- https://www.forbes.com/advisor/retirement/backdoor-roth-ira/
- https://www.marketwatch.com/story/to-roth-or-not-to-roth-11623431970
- https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3860359