The unique tax treatment of Roth IRAs presents a compelling opportunity for investors. Though income limits may prevent higher-earning individuals from making direct contributions to a Roth IRA, there is a two-step process to accomplish the contribution that has become known as a “backdoor” contribution. But first, some background on Roth IRAs.
Roth IRAs: A Refresher Course
Created by the Taxpayer Relief Act of 1997, Roth IRAs offer investors long-term, tax-free growth. Accountholders can make tax-free withdrawals once they are 59.5 years old and if their accounts are at least five years old. In contrast, withdrawals from traditional IRAs are taxed as ordinary income. There are certain qualifications regarding direct contributions to a Roth IRA:
- For single filers in 2020, modified adjusted gross income must be less than $124,000 for a full contribution ($6,000 for people younger than 50 and $7,000 for those 50 and older), and less than $139,000 for any contribution.
- For married joint filers, the limits are $196,000 for a full contribution and $206,000 for any contribution.
Another feature that has made Roth IRAs popular: no required minimum distributions (RMDs), which means a longer time horizon to grow your wealth. Roth IRAs also offer advantages in terms of passing wealth to heirs. Because Roth IRA withdrawals are tax free, beneficiaries won’t have to pay income taxes on any Roth funds left to them. Thus, we often recommend that clients use other accounts for retirement income before they use Roth IRAs.
Roth IRAs also play a significant part in an efficient asset location strategy. Diversifying your investment assets among different types of accounts provides flexibility and preparedness for an uncertain tax environment. For instance, aggressive, growth-oriented investments (e.g., emerging market funds) are usually best suited for a tax-free account (like a Roth IRA). Conversely, tax-inefficient investments (e.g., bonds and real estate investment trusts) are best suited to tax-deferred accounts (like traditional IRAs), while tax-efficient assets (e.g., stock market index funds) fit well within taxable accounts.
A Closer Look at Backdoor Contributions
Since the income limits on contributions to traditional IRAs were lifted, some higher-earning individuals have made contributions to Roth IRAs through so-called “backdoor” conversions. The well-known, but often misunderstood, backdoor contribution strategy is an attractive option for taking advantage of the unique benefits of Roth IRAs and minimizing your tax burden in retirement. However, there are some other factors to consider.
The basic “backdoor” process, which can be executed annually, involves contributing to a traditional IRA and, later, converting some or all of the value of the traditional IRA to a Roth IRA, where it can grow tax free. This strategy works best when:
- you have little to no other traditional IRA assets, and
- your contribution to the traditional IRA is non-deductible.
In fact, if both these criteria are met, you can make a non-deductible contribution and convert with zero up-front tax cost, but all the growth in the account will occur completely tax free until withdrawn from the Roth IRA. If you do this throughout your working career, you could have over 30 years of compounding tax-free growth in your Roth IRA!
Roth IRAs: Not Necessarily a No-Brainer
If you have questions about converting a traditional IRA to a Roth IRA or are considering making a backdoor contribution, it’s best to talk with your advisor. Again, these steps make sense for many people, but others may be better off sticking with a traditional IRA. In the end, the right decision will depend upon your priorities, financial goals, and personal income tax situation.