A Roth IRA is an excellent way for people to save for their retirement and not have to worry about paying additional taxes in the future. However, it is directly accessible to only a handful of savers. Those who earn above the income limit must execute a backdoor Roth IRA in order to enjoy the myriad benefits of a Roth account.
A Roth IRA gives savers an opportunity to pay taxes on the funds they deposit to the account, rather than paying taxes at the time of withdrawal. The account can grow tax free and then offer a reprieve from additional income taxes once the saver reaches retirement age.
Here are three steps to execute a backdoor Roth IRA while simultaneously minimizing tax liabilities and remaining within the law.
Keep in mind that there are important regulations and taxes attached to backdoor Roth IRAs. It can be a good idea to work with a trusted financial advisor when executing this process.
Step One: Contribute to a Non-Roth IRA or Related Account
The first step to executing a Backdoor Roth IRA is to get your money into a retirement account. If you already have one or more retirement accounts, work with a financial advisor to determine whether it makes sense to rollover any of your existing accounts. Also discuss whether it’s better given your unique financial situation to convert your account partially or in full.
If none of your existing accounts are good candidates, you may elect to create an account. Accounts that are commonly rolled over to a Roth IRA are traditional IRAs and non-deductible IRAs. You can open traditional IRAs independently (without an employer) and make contributions tax-free. Similarly to a 401(k), these contributions are taxed at the time of withdrawal (or, for our purposes in this article, at the time of conversion to another account).
Nondeductible IRAs are similar to Roth IRAs, in that contributions are made with after-tax dollars. However, whereas the funds in a Roth IRA can grow tax free, any growth in a nondeductible IRA will be taxed as income.
Consequently, if you convert a nondeductible IRA to a Roth IRA, it can be best to do so earlier in the account’s lifespan. That’s because, typically, the longer a nondeductible IRA sits, the more it will grow, and more growth in a nondeductible IRA means more taxes.
Step Two: Determine the Best Time for Rolling Over
One of the most important things to think about when creating a backdoor Roth IRA is timing.
Most of the funds you convert to a Roth IRA will be taxed as income. So, ideally, you will execute a rollover when your income is relatively low. The lower the income you claim in a given year, the lower your income tax bracket will be. This effectively alters the “true” cost of converting an IRA into a backdoor IRA.
It is also important to think about the time of year you want to make the conversion. If you convert at the beginning of the year, you will have a wider window to make tax payments. Many people find it much easier (both financially and emotionally) to make smaller, quarterly tax payments rather than making all of their payments at once.
Step Three: Convert Your Selected Account to a Roth IRA
Once you know which account to convert and when you want to make the conversion, the next step is to actually convert. Two important things to keep in mind are the IRA Aggregation Rule and the Step Doctrine.
The IRA Aggregation Rule states that when someone is in possession of multiple IRAs, the accounts will be treated as if they were a single account. In other words, shuffling funds between these accounts will not help you avoid any broader tax consequences, because you can’t isolate nondeductible contributions from deductible contributions.
The Step Doctrine indicates that if contributions and conversions are done “in rapid succession,” and if the IRS believes the sole purpose of these contributions was to make an “impermissible Roth contribution,” the individual could be subject to a penalty.
Simply put, backdoor Roth IRAs need to have an “organic” component that could be defended to the IRS. Ask yourself, “does it look like my contributions are being made in pursuit of growth? Or to avoid taxes?” Doing a brief self-audit (and speaking with a financial advisor) can help you stay within the law
Finally, it’s important to make sure that the funds in the account you are converting to a Roth IRA do not at any point end up in your possession. If, for example, you transfer the funds to your bank account, then you’ll be taxed twice – once when the funds are withdrawn from the original account and once when the funds are contributed to the Roth.
Roth IRA Rollovers with the Help of Advanced Retirement Strategies
The long-term benefits of a Roth IRA can significantly improve your quality of life during retirement, stretching your savings to their full potential. By carefully organizing your accounts, timing your rollover, and acknowledging relevant laws, you can successfully access a backdoor Roth IRA and continue building towards your financial future.
The team of CERTIFIED FINANCIAL PLANNERS™ at Advanced Retirement Strategies in Davis County, Utah has the expertise and qualifications to execute Roth IRA rollovers and design backdoor Roth IRAs – maneuvers that can create opportunities for a long and comfortable retirement.
Advanced Retirement Strategies financial planners specialize in helping diligent savers with $250,000 or more of investable 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.