Highlights

  • It’s a method to side-step the income limits of a ROTH IRA
  • It’s perfectly legal
  • It’s ideal for those who don’t already have a Traditional IRA

Estimated read time: 2 mins

It’s a new year and perhaps you’re re-thinking your retirement strategy. For most people, a ROTH IRA is an excellent investment vehicle because it allows your savings (using after-tax dollars) to grow and be withdrawn FREE of income tax. That’s a wonderful thing. But a portion of you reading this may be ineligible for a ROTH contribution. In this article, I’ll highlight the key features of a “Backdoor” ROTH and whether it’s right for you.

What is a Backdoor ROTH?

While it may sound like a devious loophole, a Backdoor ROTH is an IRS-sanctioned method of side-stepping the income limits of a ROTH IRA. Surprising fact: It’s not new. It has existed since 2010. It’s designed for those with an adjusted gross income greater than $206,000, if married filing jointly, or $139,000, if single.

How it works

The Backdoor ROTH is a 2-step process. First, you make an after-tax contribution to a Traditional IRA up to $6,000 for those under 50, and up to $7,000 for those 50+. (This is reported to the IRS using Form 8606, “Nondeductible IRAs”.) Once the Traditional IRA has been funded, it is then converted to a ROTH IRA. This can happen in a matter of days; however, we recommend to our clients that they wait a minimum of one statement cycle (anywhere from 30 to 90 days).

Disadvantages of a Backdoor ROTH

Yes, like many things, there is a catch. The big one here is that the IRS taxes conversions from Traditional to ROTH IRAs using a “pro rata” formula. The pro rata calculation assesses the total value for all of your non-ROTH IRA accounts ─ including SEP and simple IRAs ─ to determine what is taxable when before and after-tax dollars are commingled.

Example: You have a total of $100,000 in Traditional IRA funds, which includes $10,000 in after-tax dollars. Any conversion or withdrawal would be 90% taxable and 10% tax-free. Therefore, the Backdoor ROTH is not ideal for those with traditional IRAs that have large pre-tax balances.

Another shortcoming? Contributions made via the Backdoor ROTH cannot be withdrawn from for a minimum of 5 years following a conversion.

Conclusion

After reviewing the pros and cons, the Backdoor ROTH IRA is ideal for those who currently do not have a Traditional IRA and still have some years before they plan to retire.  For those that do have a Traditional IRA with pre-tax dollars, a ROTH conversion may be appropriate in certain circumstances. Be sure to speak with your financial and tax advisors before making these decisions.

About the Author

Alex Albert is a Certified Financial Planner for East Greenwich-based Lincoln Capital, a financial planning and wealth management firm. He is a graduate of the University of Rhode Island and earned CFP® certification from Bryant University. 

DISCLOSURES – This presentation is not an offer or a solicitation to buy or sell securities. The information contained in this presentation has been compiled from third party sources and is believed to be dependable; however, its accuracy is not guaranteed and should not be relied upon in any way, whatsoever. This presentation may not be construed as investment advice and does not give investment recommendations. Any opinion included in this report constitutes the judgment of Lincoln Capital Corporation as of the date of this report and are subject to change without notice. Additional information, including management fees and expenses, is provided on Lincoln Capital Corporation’s Form ADV Part 2. As with any investment strategy, there is potential for profit as well as the possibility of loss. Lincoln Capital Corporation does not guarantee any minimum level of investment performance or the success of any portfolio or investment strategy. All investments involve risk (the amount of which may vary significantly) and investment recommendations will not always be profitable. The investment return and principal value of an investment will fluctuate so that an investor’s portfolio may be worth more or less than its original cost at any given time. The underlying holdings of any presented portfolio are not federally or FDIC-insured and are not deposits or obligations of, or guaranteed by, any financial institution. Past performance is not a guarantee of future results. Lincoln Capital Corporation prepared presentation, 401.454.3040, www.lincolncapitalcorp.com Copyright © 2023, by Lincoln Capital Corporation.