Many people turn to a Roth Individual Retirement Account (IRA) to grow their money tax-free. With a Roth IRA, the account holder has already paid income tax on the money he contributes. From there, their funds grow tax-free and are not subject to income tax when they want to withdraw later.

Unlike a traditional IRA, however, a Roth IRA is generally closed to high income earners. Single filers with a modified adjusted gross income (MAGI) for 2021 equal to or greater than $ 140,000, or $ 208,000 for couples filing jointly, cannot contribute directly to the Roth IRAs – but they can still take advantage of this special account. going through a ‘back door.’

The Roth IRA backdoor is a strategy that high net worth investors use to bypass the usual income limits that apply to Roth IRA contributions.

“I have several clients who use this strategy,” says Faron Daugs, CFP and Wealth Advisor at Harrison Wallace Financial Group. “It’s an effective way to save more money tax-free.”

The popular backdoor maneuver is pretty straightforward: investors make contributions to their traditional IRA (a tax-deferred account), then quickly convert the account to a Roth IRA (an after-tax account). For a non-deductible contribution to a traditional IRA, only the converted income may be taxable, while income tax would be due on the entire conversion if it is a tax-deductible contribution to a traditional IRA, including earnings.

“There is no immediate tax benefit for the person implementing the strategy,” says Daugs. “It’s a way to move money into the Roth IRA position to take advantage of tax-free growth for the future.”

The retirement savings loophole could close for some

The loophole is fairly well known, so much so that the Democrats in the United States House of Representatives have proposed closing the Roth IRA backdoor strategy for people above certain incomes in a larger effort to fund a $ 3.5 trillion budget plan (this would apply to distributions, transfers and contributions made during taxable years beginning after December 31, 2031).

This decision, if approved, would create challenges for high earners as there is currently no income eligibility limit for non-deductible contributions to a traditional IRA or conversions to Roth IRAs. If this happens, investors subject to income limits should determine how much of their current traditional IRAs it makes sense to convert before those limits are imposed.

“It could result in a big income tax bill,” Daugs said. “But we have to weigh the future tax-free potential growth of the converted amounts against the tax bill due on those converted assets.”

Backdoor Roth IRAs are worth it for most high earners

After the Roth IRA conversion is complete, the account holder has effectively funded a Roth IRA. The loophole allows anyone to invest and enjoy tax-free future growth and profits.

“Even if you pay taxes now in the top tax bracket (currently 37%, plus state taxes), that money will grow tax-free until retirement, when you can withdraw. funds and pay no tax, ”says Abby Donnellan, CPA and Senior Tax Strategist at Moneta Group.

Keep in mind that every Roth conversion you make is subject to the typical Roth IRA five-year rule. For those doing multiple conversions, the IRS requires that the oldest conversions be removed first, if applicable. (The order of Roth IRA withdrawals goes, from first to last, contributions, conversions, and then earnings.) People under 59 and a half should avoid withdrawing within five years of their conversion, less than ‘they only pay a 10% penalty (allowable exceptions apply).

A Roth retirement account has additional benefits that make the backdoor strategy attractive to those who are not eligible to contribute directly:

• No Roth conversion limit: Currently, there is no limit on the number of Roth conversions you can make or the dollar amounts you can convert from your traditional tax-deferred IRA. “If a taxpayer wishes, they can convert more of their current traditional IRAs; however, they must work closely with their financial advisors and CPAs to understand the full potential tax liability of a larger conversion.” , says Daugs.
• No minimum distribution rule required: These are also known as RMD. Some retirement plans, such as traditional IRAs and 401 (k) plans, require you to withdraw a minimum amount of funds each year after you reach age 72, based on your account balance. “Some people don’t need their RMD to live and find it inconvenient to withdraw funds from their IRA each year,” says Donnellan. “[The backdoor Roth IRA strategy] gives these people the option of leaving the funds, if that is what they prefer. “
• Tax deferral for future beneficiaries: If your heirs inherit your traditional IRA, they would be required to pay tax on any amount withdrawn. With a Roth IRA, however, they can withdraw those funds and pay no tax. “Setting up a Roth IRA can also be an effective way to effectively transfer wealth tax,” Daugs said.

Are you considering a Roth conversion? Check out Select’s ranking of the best IRA accounts and the best Roth IRA accounts to get started. Charles Schwab ranks as the “best overall” on both lists for offering an abundance of ARI types like Traditional, Roth, Rollover, Inherited and Custodial IRAs, plus a personal choice retirement account^® (PCRA). Schwab also has its own robo-advisor platforms and trading accounts so you can make all of your investments in one place.

Some robo-advisers will even offer IRAs as well. Betterment has Traditional, Roth and SEP IRAs. Additionally, high net worth investors can take advantage of its premium plan (requires a minimum balance of $ 100,000) which allows users to gain unlimited access to a financial advisor.

Backdoor Roth IRAs aren’t for everyone

Donnellan cautions that great Roth IRA conversions aren’t for everyone. “Depending on your age, your tax bracket, your account balance and beneficiary information, conversions may or may not be beneficial,” she says.

As a general rule of thumb, you should only perform a Roth conversion if you 1) have enough money to cover your conversion taxes out of pocket (since no funds are withdrawn, only converted) and 2) know you will be in a higher tax bracket in retirement when your withdrawals are fully tax exempt.

If you’re worried about a large tax bill on your Roth conversion, consider moving quickly. Opening a traditional IRA, making non-deductible contributions, and then converting those funds immediately to a Roth means you don’t have to pay income taxes.

Before you take a step, talk to your financial advisor to see if a Roth conversion makes sense for you.

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