Backdoor Roth Taxes: What You Should Consider

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When it comes to creating a backdoor Roth, the first thing many people take into consideration is backdoor Roth taxes – and rightly so.

There are many instances in which an individual might want to open a Roth IRA. These accounts come with a host of perks, including the opportunity to withdraw funds tax-free.

However, Roth IRAs only accommodate earners up to a certain income bracket. Some earners can only contribute a reduced amount to a Roth IRA, while others can’t contribute at all. The higher your modified adjusted gross income (MAGI) is, the more likely it is that your contributions to a Roth IRA will be capped, if not prohibited altogether.

That’s where a backdoor Roth IRA comes in handy. A backdoor Roth is a legal loophole in which high-income individuals can fund a Roth IRA without contributing cash directly to it. While there are income caps limiting direct contributions to a Roth IRA, there are no income caps limiting how much can be converted to a Roth IRA from another account. This opens the “back door” to a Roth IRA that many high-income earners find very appealing.

For individuals who are anticipating higher incomes or higher taxes on their income brackets in the future, Roth conversions make a lot of sense. However, creating a backdoor Roth IRA means also triggering a taxable event. So, what taxes should you expect when creating a backdoor Roth IRA? And is it possible to avoid those taxes?

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Why Is There a Tax Bill When Creating a Backdoor Roth IRA?

For many, the beauty of a Roth IRA is that funds are able to grow tax-free and then are not taxed at the time of withdrawal. However, tax-free growth and withdrawal are possible because Roth IRAs are funded with after-tax dollars.

On the other hand, other retirement accounts are tax-deferred. This means that you are not expected to pay taxes at the time of contribution, but you will be expected to make tax payments at the time of withdrawal.

As a result, there’s a moment of reckoning when you convert a tax-deferred account to a tax-free account. In other words, using the “backdoor” option isn’t a way to get out of paying taxes.

Regardless of the retirement vehicle you choose to use, you will be taxed eventually.

A backdoor simply gives higher earners the opportunity to access a tax-advantaged account that can deliver long-term benefits.

For many, the tax bill that accompanies a backdoor Roth can be difficult to swallow. For some, the tax bill may even discourage them from a backdoor Roth altogether. However, there are opportunities to minimize backdoor Roth taxes, as well as to make manageable payments.

How Do I Calculate My Tax Bill?

Your contributions will be taxed as ordinary income, regardless of whether part of the amount contributed has been generated through means that would typically qualify as capital gains.

If you make nondeductible contributions to a traditional IRA before it’s converted, then part of your conversion will be non-taxable. However, it is not possible to simply convert the non-taxable part.

Moreover, if you have multiple IRAs and some are funded with more nondeductible contributions than others, then you won’t find a loophole by rolling over just the accounts with more nontaxable funds. Due to the pro-rata rule, all IRAs are assessed in the aggregate, meaning you won’t see a tax benefit by only converting the accounts with more nontaxable funds.

How Do I Lower My Backdoor Roth Taxes?

The good news is that there are steps you can take to lower your tax bill as much as possible.

The best thing you can do is to plan ahead. What life events are on the horizon that might pitch you into a lower income tax bracket? Because your conversion will be taxed as ordinary income, the lower your annual income is at the time of conversion, the lower your taxes will be.

Another strategy is to contribute after-tax dollars to a nondeductible IRA, which does not have the same income limits as a Roth IRA. In these accounts, only the earnings will be taxed. So, if you convert shortly after opening the account (before earnings have begun to multiply), you’ll find a far more manageable tax bill barring the backdoor to a Roth IRA.

Finally, if there are IRA accounts that you don’t plan to convert to a Roth IRA, you can roll them into an employer-sponsored retirement plan. Doing so reduces the total of taxable funds across your IRA accounts, which can proportionally increase the nontaxable part of the account you are converting.

Should I Pay Estimated Taxes?

Oftentimes, the government sets aside money for taxes as you earn it, reserving cash from your paycheck. However, there are some instances when the IRS does not do this, including during backdoor Roth IRA conversions.

Whenever this is the case, it’s a good idea to pay estimated taxes quarterly. To make these payments, calculate your anticipated tax bill for the conversion, divide that figure by the number of quarters remaining until the tax filing deadline, and then submit that amount of money as estimated tax payments to the IRS each quarter.

Doing so has the dual benefits of breaking a large bill down into smaller, more manageable payments, while also avoiding penalties and fees that the IRS can levy against those who do not make estimated payments.

The Bottom Line

Backdoor Roth taxes can be challenging to understand and, sometimes, challenging to afford. However, the long-term benefits of a Roth IRA can significantly improve your quality of life during retirement, stretching your savings to their full potential.

The team of retirement planners at Advanced Retirement Strategies has the expertise and qualifications to design and implement maneuvers like the backdoor Roth – maneuvers that can create opportunities for a long and comfortable retirement.

Advanced Retirement Strategies financial planners specialize in helping diligent savers in Bountiful, Utah and the surrounding areas with $250,000 or more of investment and retirement assets (not counting your primary residence) prepare for and then transition into retirement.

We would love the opportunity to assist you. Just head to the get started page and set up a free 15-minute quick consult.

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