A Guide to Roth Conversions & Backdoor Roth IRAs

Estate Planning Guidance for Those Without Heirs

The Build Back Better Act of 2021 had many families scrambling to understand Roth conversions and backdoor Roth IRAs before proposed restrictions limiting their use were passed. As of April 2022, however, it seems unlikely that those proposals will make it through Congress.

While the urgency to understand these wealth management strategies is gone, their tax advantages are still important and worth exploring. In this guide, we’ll provide an in-depth look at the difference between Roth conversions and backdoor Roth IRAs and how they can be utilized to minimize taxes in retirement.

What Is a Roth Conversion?

A Roth conversion takes place when you convert funds from a traditional IRA to a Roth IRA. In doing this, you are changing the tax characteristics of the account since traditional IRAs are funded with pre-tax dollars and Roth IRAs are funded with after-tax dollars.

Benefits

  • No Income Phaseouts: Roth conversions are used for many reasons, but one of the biggest benefits is the ability to avoid the Roth IRA income restrictions. In general, taxpayers with modified adjusted gross incomes (MAGI) greater than $144,000 (single) or $214,000 (married filing jointly) are not eligible to contribute to Roth IRAs,[1] but this phaseout does not exist for Roth conversions.
  • Tax-Free Withdrawals: After converting the account, contributions, conversions, and earnings can be withdrawn tax-free in retirement. This is especially useful if you expect to be in a higher tax bracket in the future.
  • No RMDs: Roth IRAs are not subject to the required minimum distribution rule, meaning you will not have to make mandatory withdrawals starting at age 72. If you don’t actively need the funds for living expenses, your account can be left grow for as long as you want. It can also be passed to your heirs as a tax-free inheritance.
  • No Limit on Conversion Amount: Unlike backdoor Roth strategies, Roth conversions do not have a limit on the amount you can convert.

Drawbacks

  • Out-of-Pocket Tax Liability: Roth conversions are great because you can avoid taxes on withdrawals in retirement, but the downside to this is an upfront tax liability at the time of the conversion. When you transfer your pre-tax dollars to a Roth IRA, you owe income tax on both the amount contributed as well as any earnings. This tax bill can be substantial if you are in a high tax bracket or have a large account balance to convert.
  • Additional Contributions Are Taxable: Another downside to Roth conversions is that any additional contributions made to the account will be taxable in the current year. Only traditional IRAs, SEPs, and SIMPLEs allow you to deduct contributions from your taxable income. This may not be the biggest disadvantage, though, because what you lose in current year tax deductions, you make up for in tax-free withdrawals in the future.
  • Pro Rata Rule: If you have more than one traditional IRA when you enter a Roth conversion, you will be required to compute a pro rata ratio to determine how much of your conversion is taxable. This can make Roth conversions complicated and confusing for those who have multiple accounts. If this is the case for you, it is highly recommended that you work with a professional before utilizing a Roth conversion strategy.

What Is a Backdoor Roth IRA?

A backdoor Roth strategy is a proactive way to obtain the benefits of a Roth IRA if you are above the income phaseout threshold and not allowed to contribute directly to a Roth account.

In this case, you would make a non-deductible contribution to a traditional IRA. Then, you would immediately convert the non-deductible contribution to a Roth IRA. These steps are done back-to-back, before the account has time to produce any investment earnings. This will allow you to minimize the amount of taxes paid on the conversion. Since you can only contribute and convert $6,000 per year ($7,000 if over the age of 50),[2] a backdoor Roth is a multi-year strategy that requires proactive planning and foresight.

Benefits

  • Easy Process: All-in-all, backdoor Roth IRAs are relatively easy to navigate once the accounts are set up. This is a great benefit since the strategy requires that you will contribute and convert funds each year.
  • Tax Free Withdrawals: Like Roth conversions, withdrawals from a backdoor Roth will be fully tax-free in retirement.
  • No RMDs: Backdoor Roth IRAs are also not subject to the RMD requirements.
  • Lower Upfront Tax Liability: Because annual IRA contributions are limited to $6,000, or $7,000 depending on your age, your upfront tax liability is reduced. The most you will pay tax on is your annual contribution. This is great if you are in a high tax bracket and want to spread your tax liability over several years.

Drawbacks

  • Low Contribution Limits: The flip side of the lower upfront tax liability is that contribution limits for backdoor Roth IRAs are quite low, especially if you are a high-income earner saving for retirement. This means that contributing to a backdoor Roth for a single year, or even 5 years, may not make much a difference for your long-term financial picture. To be useful, backdoor Roth IRAs must be diligently funded over many years, so starting early is key.
  • Pro Rata Rule: Like Roth conversions, the pro rata rule will apply to backdoor Roth IRAs if you have more than one traditional IRA. Essentially, this rule prevents you from picking and choosing which amounts should be withdrawn (pre-tax vs. after-tax), meaning each conversion will consist of a partially taxable amount based on the pro-rata ratio. This can severely limit the efficacy of the backdoor Roth strategy.

Making the Right Choice

We believe choosing between a Roth conversion and a backdoor Roth IRA requires careful planning and proactive tax management. There are many factors to consider when deciding which strategy is best for you, including time frame until retirement, tax bracket, other sources of retirement funding, income needs, and desire to leave an inheritance.

To make the most of your decision, we find it critical to carefully weigh the pros and cons against your unique financial situation. At Aviance Capital Partners, we provide multi-dimensional wealth management services, and we can help you reach that decision based on your individual circumstances. To learn more about your tax-deferred retirement options, reach out to us at wealthrelations@aviancepartners.com or 239-598-4747 to get started today.

Aviance Capital Partners, LLC (“ACP”) is an SEC registered investment adviser located in Naples, Florida. Registration as an investment adviser is not an endorsement by securities regulators and does not imply that ACP has attained a certain level of skill, training, or ability. While information presented is believed to be factual and up-to-date, ACP does not guarantee its accuracy and it should not be regarded as a complete analysis of the subjects discussed. All expressions of opinion reflect the judgment of the authors as of the date of publication and are subject to change. Not all services will be appropriate or necessary for all clients, and the potential value and benefit of the ACP’s services will vary based upon the client’s individual investment, financial, and tax circumstances. The effectiveness and potential success of a tax strategy and financial plan depends on a variety of factors, including but not limited to the manner and timing of implementation, coordination with the client and the client’s other engaged professionals, and market conditions. The tax and estate planning information provided is general in nature, which should not be construed as specific financial planning or tax advice tailored to an individual reader. ACP suggests that readers consult a financial professional, attorney or tax advisory professional about their specific financial, legal or tax situation. All investment strategies have the potential for profit or loss, and different investments and types of investments involve varying degrees of risk. There can be no assurance that the future performance of any specific investment or investment strategy, including those undertaken or recommended by ACP, will be profitable or equal any historical performance level. Additional information about ACP, including its Form ADV Part 2A describing its services, fees, and applicable conflicts of interest and its Form CRS is available upon request and at https://adviserinfo.sec.gov/firm/summary/146597.

[1] Roth IRA Contribution Limits | Charles Schwab

[2] IRA Contribution Limits for 2022 | IRAs | US News

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