Maximizing Savings With a Backdoor Roth IRA
By Daniel Baumgartner & Petra Peters
Roth IRAs have become a staple for those saving for retirement. The tax benefits alone are enough to make them worth it. But depending on your level of income, a Roth IRA can seem a little “out of reach.” This isn’t the case.
Enter the backdoor Roth IRA. This type of account can help high-income earners utilize all that a typical Roth has in common. Let’s look into how this IRA works and if it’s right for you.
An IRS-Sanctioned Loophole
A backdoor Roth IRA is an IRS-sanctioned loophole that lets high-income earners reap the benefits of contributing to a Roth even though they exceed the income limits for traditional Roth IRA contributions. Here is how it works.
Let’s say your income exceeds the legal limit for a traditional Roth IRA contribution, but you still want to fund an account. First, you will need to open a traditional IRA and fund it with non-deductible contributions. Then you convert your non-deductible IRA balance to a Roth IRA and repeat this process each year in order to take advantage of tax-free growth. In this scenario, you can avoid the income limits for Roth IRA contributions, but you cannot avoid the annual contribution amount limits. This means that you can fund a maximum of $6,500 in 2023 (with $1,000 catch-up contributions if over the age of 50) per year. This may seem small, but over time you can amass a sizable retirement savings, especially when combined with other tax-advantaged retirement vehicles.
A backdoor Roth IRA is a useful wealth strategy that can dramatically increase your after-tax wealth; that is, the wealth you have after all taxes have been (or will be) paid. Unlike traditional retirement accounts, Roth IRAs aren’t subject to required minimum distributions (RMDs). This means you won’t be forced to start taking withdrawals—and paying income taxes on those withdrawals—when you reach age 73. This is yet another point in favor of backdoor Roths: estate planning benefits. With no required RMDs, you’re free to let your account balance grow and build for as long as you’d like. Then, you can pass it on to your heirs free of taxes if you wish to do so.
Knowledge Is Power
There are some things to be aware of when considering a backdoor Roth. For one, they are irreversible. That means if you converted too much at once and got pushed into a higher marginal tax bracket, you can’t take it back. But this can usually be avoided by keeping your conversion amounts to the annual contribution limits. You will also need to consider state taxes. If you live in a state that has an income tax, you’ll likely owe state taxes on your backdoor Roth conversion in addition to federal taxes. However, some states exempt part of your distribution if you’re over a certain age. Finally, this strategy is less effective if you have existing IRA balances that were made with pre-tax contributions.
Backdoor Roth IRAs also have two five-year rules to keep in mind. The first rule says that you must wait at least five years from your first contribution before you can make a penalty-free withdrawal from your Roth IRA—even if you’re over age 59½.
The second five-year rule is more nuanced and relates to whether or not taxes and penalties will be assessed if converted funds in a Roth IRA are distributed (or withdrawn) within five years of when they were each converted (each Roth IRA conversion has its own five-year clock in this context).
As with all tax-related matters, please consult a tax professional for tax advice that is specific to your situation. This article is not meant to be tax advice.
Is a Backdoor Roth IRA the Answer?
Whether you live abroad or are settled in the United States, you are probably working hard to keep your money working for you while avoiding the risks. Minimizing (or eliminating) taxes on future growth is one way to accomplish this. If you make too much money to qualify for a regular Roth IRA and can afford to pay taxes now on your contributions, consider a backdoor Roth to increase your flexibility in retirement income planning, as well as optimize your future estate transfers.
At Terra Nova Asset Management, we want to create a long-term relationship that is centered around your goals. Whether living in Europe or the United States, our goal is to bridge geographical and language distances to help you realize the future you envision. Reach out to us directly at 212-355-1234 or ppeters@terranovausa.com for the New York office (Petra) or 855-248-6630 or baumgartner@terranovausa.com for the New Jersey office (Daniel). You may also contact us here to schedule a meeting and we’ll get in touch with you soon!
About Daniel
Daniel Baumgartner is a founding partner of Terra Nova Asset Management LLC, a partner-owned investment advisory firm that manages individual portfolios for clients. Daniel has extensive experience in marketing, development of special U.S.-investment products, as well as customer acquisition and relationship management. His ultimate goal is to make a difference in his clients’ financial lives through honest investment advice. He strives to provide high-touch, personalized service and enjoys getting to know a client’s personality as it relates to their financial circumstances before crafting the right solutions. As money is a very personal subject, Daniel takes his responsibility as an advisor very seriously, forming long-term relationships with clients based on trust.
Daniel received his degree in finance and international business from New York University. Outside of the office, he is a hobby landscape, street photographer, and has a great interest in U.S. and European history (16th-19th centuries), believing it helps him answer the question “Why is something the way it is?”
About Petra
Petra Peters is a founding partner and the Chief Executive Officer of Terra Nova Asset Management LLC, a partner-owned investment advisory firm that manages individual portfolios for clients. Petra has decades of experience in the banking industry, asset management, overseeing the administration of individual accounts, and designing and advising specialized funds tailored to the requirements of international private and institutional clients. With extensive knowledge of both Europe and the U.S., she’s able to provide advice and services beyond the typical investment advisor. Petra desires for her clients to live a financially care-free life so they can pursue their passions, and she values their trust and gratitude. Creating invaluable friendships formed over years of partnership, some clients even consider her part of their family.
Petra’s interests outside of work include classical music, history, travel, charities, motorcycling, and golf. She is also on the board of a German charity.