Unlock the Potential of a Backdoor Roth IRA: A Guide to Tax-Free Growth

This isn’t the first time we’ve covered Roth IRAs! Roth IRA is one of our favorite investment vehicles at Mana, because of its tax free status and flexibility with which you can withdraw funds in the future. A Roth IRA is traditionally thought of as a retirement account, but we’ve seen individuals use them to fund college for their kids, to launch a business, or to help parents with long term care needs. In today’s blog, we’ll describe how high earners can take advantage of the Roth IRA to meet longer term goals. Although traditionally, high earners were restricted from contributing directly to a Roth IRA due to income limitations, the backdoor Roth IRA strategy allows these individuals to bypass those restrictions and enjoy the long-term tax advantages offered by a Roth IRA.

In this guide, we will explain the step-by-step process of setting up a backdoor Roth IRA, highlight the tax implications, and provide strategies for maximizing growth within this tax-advantaged account. Let's dive in and discover how to achieve tax-free growth on your investments.

What is a Backdoor Roth IRA?

To begin, let’s define Roth IRA. The Roth IRA is an individual retirement account that enables you to save after-tax dollars and grow those dollars without tax consequence. Investors contribute after-tax dollars, meaning that contributions are not tax-deductible. However, the growth and withdrawals from a Roth IRA are completely tax-free, making it an attractive option for long-term wealth accumulation. It was established in the 1997 Taxpayer Relief Act, named after Senator William Roth. (Fun Fact: This was the same Act that introduced the exemption of $250k per spouse of capital gains on the sale of a primary residence, dropped the capital gains rates, and established the child tax credit. What a guy!) 

There’s a misconception that individuals over a certain income level have no way to contribute into a Roth IRA. While there is some truth to that statement, changes in the 2017 Tax Cuts and Jobs Act expanded the flexibility of taking advantage of the Roth account structure. In this strategy, funds are contributed to a Traditional IRA (an account with no income limitations) and then converted to a Roth IRA. This strategy is referred to as the backdoor Roth.

Benefits of a Backdoor Roth IRA

The main benefit of a backdoor Roth IRA is the ability to grow your wealth in a tax-free environment. By contributing after-tax dollars to a Roth IRA, you can take advantage of the potential for tax-free growth over the long term. This can be especially beneficial for high earners, or those wanting to build material wealth, who may be subject to higher tax rates in retirement.

Another advantage of a backdoor Roth IRA is the flexibility it offers. Unlike a traditional IRA, which requires individuals to start taking required minimum distributions (RMDs) at age 72, a Roth IRA has no RMDs. This means that you can continue to let your investments grow tax-free for as long as you want, without being forced to withdraw funds. Furthermore, if you need funds ahead of retirement, you are able to withdraw any contributions made to the account so long as the account has been opened for 5 years without any penalty or tax. While we love to see money growing tax free for a longer time horizon, having a Roth IRA can provide an additional safety net if needed. 

Lastly, a backdoor Roth IRA can provide a source of tax-free income in retirement. Since qualified withdrawals from a Roth IRA are not subject to income tax, you can potentially reduce your tax liability in retirement by having a portion of your income come from a tax-free source.

Eligibility and contribution limits for a Backdoor Roth IRA

To be eligible for a backdoor Roth IRA, there are a few requirements that must be met. First, there are no income limitations for converting a traditional IRA to a Roth IRA. However, there are income limitations for making a direct contribution to a Roth IRA. As of 2024, individuals with a modified adjusted gross income (MAGI) of $146,000 or more (or $230,000 or more for married couples filing jointly) are not eligible to contribute directly to a Roth IRA. When it comes to contribution limits, the overall limit for both traditional and Roth IRAs is $7,000 in 2024 (or $8,000 for individuals age 50 or older). 

Setting up a backdoor Roth IRA may seem complex, but with the right guidance, it can be a straightforward process. Here's how it works:

• Step 1: Determine your eligibility - Before proceeding with the backdoor Roth IRA strategy, make sure you meet the eligibility criteria, including the income limitations for direct contributions to a Roth IRA.

• Step 2: Open a traditional IRA - If you don't already have a traditional IRA, you'll need to open one with a reputable financial institution. Make sure to choose an institution that offers low fees and a wide range of investment options. If you already have a traditional IRA with money in it, halt right there! You absolutely want to consult with a tax advisor to determine if this makes sense for you. 

• Step 3: Make a non-deductible contribution - Once your traditional IRA is open, you can make a non-deductible contribution. The contribution limit for both traditional and Roth IRAs is $7,000 in 2024 (or $8,000 for individuals age 50 or older).

• Step 4: Convert the traditional IRA to a Roth IRA - After making the non-deductible contribution, you can initiate the conversion process. Contact your financial institution and inform them of your intention to convert the traditional IRA to a Roth IRA. They will guide you through the necessary steps and provide the required forms.

• Step 5: Pay any applicable taxes - Since the conversion from a traditional IRA to a Roth IRA is a taxable event, you may owe taxes on any pre-tax earnings in the traditional IRA. Consult with a tax professional to ensure you properly calculate and pay any taxes owed. Report your contribution to the IRS using Form 8606. This lets the IRS know that any Roth conversion is done with after-tax dollars, to avoid paying double taxes. 

• Step 6: Keep records of your contributions in the case that you need to withdraw funds in the future.  Keeping a record of your tax documents in a secure (ideally electronic!) place where you keep all of your financial documents is highly recommended. We personally create a spreadsheet every year that is titled “Year - Tax Related Items”. When we start our next year’s tax planning, we’ve already got last year’s to work with. 

• Step 7: Invest wisely - Once your backdoor Roth IRA is set up, it's time to invest your contributions. Consider your risk tolerance, investment goals, and time horizon when choosing your investments. Diversification is key to managing risk and maximizing potential returns. We recommend working with an advisor to execute this strategy to ensure investments are monitored on at least an annual basis, including rebalancing, diversification, management of risk vs. return. 

By following these steps, you can successfully set up and contribute to a backdoor Roth IRA, unlocking the potential for tax-free growth and long-term wealth accumulation.

Tax implications of a Backdoor Roth IRA

While a backdoor Roth IRA can provide significant tax advantages, it's important to understand the potential tax implications associated with the strategy. Here are a few key points to consider:

1. Taxable conversion - When converting a traditional IRA to a Roth IRA, any pre-tax earnings in the traditional IRA are subject to income tax. It's important to calculate and pay any taxes owed to avoid penalties and interest.

2. Pro-rata rule - The pro-rata rule applies to individuals who have both pre-tax and after-tax funds in their traditional IRAs. This rule determines the tax treatment of the conversion and can have implications on the overall tax liability.

3. Future tax-free growth - Once the funds are in a Roth IRA, they can grow tax-free, meaning you won't owe taxes on any investment gains or qualified withdrawals in the future. This can be a significant advantage, especially for high earners who may be subject to higher tax rates in retirement.

To ensure you navigate the tax implications of a backdoor Roth IRA correctly, it's advisable to work with a knowledgeable tax professional or financial advisor who can guide you through the process and help you make informed decisions.

Common mistakes to avoid when utilizing a Backdoor Roth IRA

While the backdoor Roth IRA strategy can be highly beneficial, there are some common mistakes that individuals should avoid. These include:

1. Neglecting to pay taxes on the conversion - When converting a traditional IRA to a Roth IRA, any pre-tax earnings are subject to income tax. Failing to calculate and pay the taxes owed can result in penalties and interest.

2. Not understanding the pro-rata rule - Individuals with both pre-tax and after-tax funds in their traditional IRAs need to be aware of the pro-rata rule. This rule determines the tax treatment of the conversion and can have implications on the overall tax liability.

3. Overlooking contribution limits - While the backdoor Roth IRA strategy allows individuals to contribute to a Roth IRA regardless of income, it's important to be mindful of the contribution limits. Exceeding these limits can result in penalties and tax consequences.

4. Ignoring the impact on other retirement savings accounts - Before executing the backdoor Roth IRA strategy, consider how it may impact other retirement savings accounts, such as a 401(k) or SEP IRA. Consult with a financial advisor to ensure you have a comprehensive retirement savings plan in place.

By avoiding these common mistakes, you can ensure that your backdoor Roth IRA strategy is executed correctly and maximize the benefits of tax-free growth.

Is a Backdoor Roth IRA right for you?

A backdoor Roth IRA can be a powerful tool for high earners seeking tax-free growth and flexibility in long term savings. By utilizing this strategy, you can unlock the potential for long-term wealth accumulation in a tax-advantaged account. We like the Roth IRA specifically to support long term goals, because the real benefit comes from tax free growth over a long period of time. 

It's important to evaluate your specific financial situation and goals when choosing the right retirement savings option. A financial advisor can help you determine the best strategy to maximize your long-term wealth accumulation and tax advantages, including comparing this strategy to investing in a 401k, SEP IRA, Traditional IRA, or taxable brokerage account. Depending on your workplace plan, you may even be able to do a mega backdoor Roth, which we describe in further detail in this blog. 

It's important to carefully consider your financial situation and consult with a financial advisor or tax professional before executing a backdoor Roth IRA. They can guide you through the process, ensure all tax implications are properly managed, and help you determine if this strategy aligns with your overall financial goals.

Don't miss out on the opportunity to secure your financial future and unlock the potentials of a backdoor Roth IRA. With the right knowledge and guidance, you can achieve tax-free growth that will propel you to achieve your greatest dreams.

Follow our Instagram for personal finance tips and inspiration.

Stephanie Bucko and Cristina Livadary are fee-only financial planners based in Los Angeles, California. Stephanie is the Chief Investment Officer and Cristina is the Chief Executive Officer at Mana Financial Life Design (FLD). Mana FLD provides comprehensive financial planning and investment management services to help clients grow and protect their wealth throughout life’s journey. Mana FLD specializes in advising ambitious professionals who seek financial knowledge and want to implement creative budgeting, savings, proactive planning and powerful investment strategies. As fee-only fiduciaries and independent financial advisors, Stephanie and Cristina never receive commission of any kind. Stephanie and Cristina are legally bound by their certifications to provide unbiased and trustworthy financial advice.