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The Best Interest » Backdoor Roth IRAs: The 6-Figure Power of Simple Advice

Backdoor Roth IRAs: The 6-Figure Power of Simple Advice

Highlights

  • Financial planning is about understanding the interplay of income, investments, taxes, etc., and optimizing long-term outcomes.
  • Even simple planning tools – like a backdoor Roth IRA – can lead to $100,000+ in savings over the long run.

What’s a Backdoor Roth IRA?

You can set up a backdoor Roth IRA in less than 30 minutes per year. Over a 30-year timespan, that choice could easily save you over $100,000.

First, let’s make sure we know what a Roth IRA is.

  • It’s an Individual Retirement Account
  • You contribute after-tax dollars to it. e.g. you’ll pay income tax now in 2023.
  • But you won’t pay taxes on dividends or interest inside the account, nor will you pay capital gains upon withdrawal. No taxes ever again!
  • You can contribute up to $6500 in 2023, or $7500 if you’re over 50 years old.

Roth accounts are powerful. In short, Roth = taxes now, then never again. But you can only contribute to Roth IRA if your income is below the thresholds shown below:

Some people simply earn too much to utilize the Roth advantage.

Enter the backdoor Roth IRA!

What’s a Backdoor Roth IRA?

A backdoor Roth IRA allows high income earners to garner the power of a Roth every year, despite earning more than the stated limits. Despite the name (“backdoor?!”), there’s nothing wrong or sneaky about it. It’s perfectly legitimate within the tax code.

Though Congress might change this loophole in coming years…

Here’s how the backdoor Roth IRA works:

  • Step 1: you contribute up to $6500 (or $7500 if over age 50) of after-tax money into a Traditional IRA
  • Step 2: inform your custodian (Vanguard, Fidelity, etc.) that you wish to convert those Traditional IRA dollars into Roth IRA dollars [you should typically do this ASAP after Step 1]
  • Step 2B: we’ll discuss something called the “pro rata rule” later…you’ll want to be aware of it.
  • Step 3: make sure you or your tax preparer files Form 8606 to inform the IRS you did this.
  • Step 4: …that’s it. Because you already paid taxes in Step 1, you owe nothing more. You’re done. You’ve contributed your annual limit of IRA dollars into a Roth, and you’ll never owe taxes on them again.

You now have no-red-tape Roth dollars to invest. Fantastic!

The Amazing Savings of a Backdoor Roth

If someone doesn’t use a backdoor Roth, what other option would they use?

They’d deposit the money into a normal taxable brokerage account and invest it. While taxable accounts are very flexible, they have two big drawbacks compared to a Roth:

  1. Every year, the taxable investor pays taxes on dividends and interest.
  2. Upon eventual withdrawal, the taxable investor will pay capital gains taxes (unless, ironically, careful financial planning work is done).

When you compound this inefficient tax drag over 30 years, we can conservatively** estimate the backdoor Roth IRA would save someone over $100,000. Here’s a supporting spreadsheet.

**A more realistic, less conservative estimate would put the savings closer to $200,000 over 30 years.

The backdoor Roth process takes 30 minutes to execute every year. It’s not hard.

But its benefits are massive.

That’s the power of financial planning. It’s understanding the interplay of earning, saving, investing, paying taxes, protecting your assets…all the financial puzzle pieces.

Some of the high-hanging fruit of financial planning requires in-depth knowledge, and it can certainly save you 6-figures over a lifetime.

But there are also low-hanging fruit – like a backdoor Roth IRA – which can save you massive amounts. And it’s worth asking yourself: what fruit are you missing out on?

Side Bar: The Pro Rata Rule

I mentioned the pro rata rule above. Let’s review it here. It’s important!

First and foremost: the pro rata rule matters when you already have Traditional IRA assets in place before trying to execute the backdoor Roth IRA.

Imagine the following situation:

  • Kevin has $26000 in a Traditional IRA. This money was all contributed pre-tax, per usual for Traditional IRAs. That’s important!
  • Now, Kevin wants to execute a backdoor Roth IRA in 2023, for the full $6500.

When Kevin tries to convert $6500 into his Roth IRA, the IRS would observe Kevin’s accounts and see the following:

  • $32500 in Traditional IRA assets ($26000 old and $6500 new)
  • The old $26000 (or 80% of the total) is pre-tax. The new $6500 (or 20% of the total) is post-tax.

The IRS would NOT allow Kevin to convert only his post-tax dollars. Instead, they would enforce the pro rata rule. Kevin would only be allowed to convert post-tax dollars in proportion to his overall IRA tax status. Meaning:

  • 20% of his conversion must come from post-tax dollars
  • 80% of his conversion must come from pre-tax dollars…and Kevin will owe income tax on these dollars!

If Kevin’s not careful, he’ll cause a painful tax bill for himself this year, and he won’t get the full benefit of the backdoor Roth IRA. This is why careful planning is needed before conducting a backdoor Roth IRA conversion!

In general, it’s best to first convert all of your Traditional IRA dollars into Roth dollars…which might take several years to do efficiently…and then begin backdoor Roth contributions. Your current and future income is important here too, because IRA benefits (pay tax now? or pay tax later?) are all about tax rates! Do your due diligence first.

Time to File…

At the end of the day, financial planning saves you big money. The backdoor Roth IRA is just one of many tools in your financial planning belt.

Thank you for reading! If you enjoyed this article, join 7500+ subscribers who read my 2-minute weekly email, where I send you links to the smartest financial content I find online every week.

-Jesse

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