What is a Backdoor Roth Conversion?

January 20, 2023

Estimated Reading Time: 7 Minutes 

A backdoor Roth conversion is a strategy an individual can use to contribute to a Roth IRA even if their income exceeds the limits for traditional contributions. The strategy involves first making a non-deductible contribution to a traditional IRA, and then converting that contribution to a Roth IRA. It's called a "backdoor" conversion because it's a way for high-earning investors to still contribute to a Roth IRA, even if the income restrictions bar them from doing so directly.

What are the Benefits of a Backdoor Roth Conversion?

There are several benefits to performing a backdoor Roth conversion:

  1. Tax-free growth: One of the main benefits of a Roth IRA is that the contributions, and any subsequent growth, can be withdrawn tax-free in retirement.
  2. No required minimum distributions: Unlike traditional IRAs, Roth IRAs do not require investors to take required minimum distributions (RMDs) when they reach a certain age. This means they can leave their money invested for as long as they want, which can be particularly beneficial for individuals who plan to pass their investments down to heirs.
  3. No income limits: Even though there are income limits to making direct Roth IRA contributions, individuals whose income exceeds that limit can still contribute to a Roth IRA by performing a backdoor Roth conversion.
  4. Flexibility: With a backdoor Roth conversion, investors have the ability to convert their traditional IRA into a Roth IRA whenever they choose. This allows them to take advantage of market conditions, or to convert their traditional IRA when their tax rate is lower.
  5. Diversification: After performing a backdoor Roth conversion, an individual can have both a traditional and Roth IRA, which can help them diversify their portfolio and take advantage of the different tax situations associated with each account.

If you are interested in learning more about the different scenarios in which a Roth conversion could be particularly advantageous, check out our previous article on The Benefits of Roth Conversions.

What are the Risks Associated with Backdoor Roth Conversions?

One risk associated with backdoor Roth conversions is that it can be difficult to accurately report the non-deductible contribution (the initial contribution to a traditional IRA). The IRS requires individuals to file Form 8606 to report non-deductible contributions to traditional IRAs. If the form is filled out incorrectly or not filed at all, it may result in paying taxes on the contributions that should have been tax-free.

Additionally, the withdrawal from the traditional IRA could push an individual into an even higher income tax bracket, so investors should be wary and convert just enough that they are not forced into a higher tax rate than they would have been otherwise.

It's also important to consider that if the individual changes their mind after converting and wants to recharacterize the Roth IRA back to a traditional IRA, there are restrictions and limitations on when that can be done, and it may have potential tax implications.

How to Perform a Backdoor Roth Conversion

The backdoor Roth strategy does not prevent an individual from paying taxes, but rather creates an opportunity for them to optimize their IRA contributions and take advantage of market conditions, tax rate changes, or other unique situations.

Step 1: Make a Non-Deductible Contribution to a Traditional IRA

First, you must open a traditional IRA and make after-tax contributions. This means that you will not be able to claim a tax deduction for the contribution on your tax return. Any individual with earned income, no matter how high the income, can open a traditional IRA.

Step 2: Convert the Traditional IRA to a Roth IRA

After making the non-deductible contribution to the traditional IRA, you will then need to convert that contribution to a Roth IRA. This can be done by simply transferring the funds from the traditional IRA to a Roth IRA.

Step 3: Report the Conversion on Your Tax Return

When you convert a traditional IRA to a Roth IRA, you will need to report the conversion on your tax return. This can be done by completing Form 8606 and including it with your tax return. On Form 8606, you will need to report the amount of the conversion and the amount of your initial non-deductible contribution to the traditional IRA.

Step 4: Track Your Basis

It is important to track your basis (non-deductible contributions) in all of your traditional IRAs, since you will be taxed on a pro-rata basis on conversions from all traditional IRAs. Tracking your basis will help you determine the portion of the conversion that is taxable.

Step 5: Avoid Prohibited Transactions

It is important to avoid prohibited transactions when performing a backdoor Roth conversion. Prohibited transactions include things like using IRA funds for personal benefit, lending money to the IRA, or using the IRA as collateral for a loan. These transactions can result in the IRA losing its tax-favored status and subject the account owner to other penalties.

Speak to a Financial Advisor

A backdoor Roth conversion can be a great way for individuals whose income exceeds the limits to still contribute to a Roth IRA. However, it is crucial to understand the process and rules involved in order to avoid any potential penalties or taxes.

If you are interested in performing a Roth conversion, or if you have any additional questions, please contact an advisor to schedule a meeting. It is always a good idea to talk with a financial professional before making any decisions to ensure that the strategy is the best fit for your specific financial situation and overall goals and objectives.

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