Backdoor Roth IRA: Understanding the loophole that gives high-income earners the tax benefits of a Roth IRA

• A backdoor Roth IRA is a completely legal strategy for high-income taxpayers to avoid the Roth's income limits.
• Backdoor Roth IRAs are really just a conversion, not a special type of retirement account.
• Opening a backdoor Roth IRA comes with important tax implications to consider.

Roth IRA accounts offer tax-free growth on earnings and tax-free withdrawals in retirement, making it a popular long-term savings vehicle for anyone looking to build their nest egg.

Those perks, however, come with a big asterisk: You can't contribute to a Roth directly if you exceed IRS-imposed income limits.

But people with high incomes still have a way into a Roth - a strategy that's called a "backdoor Roth IRA." Opening a backdoor Roth IRA gives high-income taxpayers a way to capitalize on the benefits of a Roth despite traditional restrictions.

According to CFP Brian Fry, a backdoor Roth IRA "is exactly what it's called, a backdoor solution, but I would say it's more mainstream than a backdoor or hidden thing."

Opening a backdoor Roth IRA will lead you to the same flexibility and investment and trading options as a traditional IRA, without having to pay taxes when you withdraw money in retirement. It's relatively easy to do, but comes with some tax implications to be aware of.

What is a backdoor Roth IRA?

Although opening a "backdoor" Roth IRA may sound shady, don't let the name mislead you. It's a totally legal loophole. At its core, a backdoor Roth IRA is a simple conversion: You put money into a traditional IRA or 401(k), then convert it to a Roth IRA.

Depending on your personal tax strategy, this could be a win-win situation, especially if you predict your tax rate will be higher in retirement.

Important: The big advantage Roth IRAs have over traditional IRAs is you pay taxes upfront. In exchange for that, the returns you accrue are tax-free, and you don't owe income taxes upon withdrawal.

Roth IRA accounts allow you to deposit money annually and pay income taxes the year the money is deposited. In contrast, a traditional IRA or 401(k) comes with an immediate tax advantage, because you are not expected to pay associated income taxes on deposits until the money is withdrawn. However, when money is withdrawn, you owe taxes on both their earnings and money that was initially invested.

To contribute directly to a Roth IRA, your income must be under a certain amount, determined by your modified adjusted gross income (MAGI). Individuals who earn above a specified income limit (based on taxpayer status) are prohibited from opening or funding Roth IRA accounts under IRS regulations.

Here is a quick look at the 2021 limits, per the IRS:

If your income is too high to contribute to a Roth, going through the backdoor can be your way in, since the IRS does not limit who can convert a traditional IRA to a Roth IRA.

These accounts can be opened at banks and brokerages that offer IRAs. If your retirement plan is part of a 401(k) offered by an employer, the associated financial services company can also help you navigate the logistics.

How to open a backdoor Roth IRA

1. Put money into a traditional IRA: After contributing to an existing traditional IRA, you can "roll over" or transfer the funds to a Roth IRA. You can also roll over money that's already in an existing IRA, and there's no maximum to how much you can roll over at once.
2. Figure out if you need to pay taxes: Money in a traditional IRA comes with earnings that are taxed upon conversion to a Roth. Taxes are also incurred on any money the account earns in the time between contribution and account conversion.
3. Convert a traditional IRA to a Roth IRA: If you go with this strategy, it's best to do so ASAP, because the sooner you convert to a Roth IRA, the fewer taxes incurred on your earned income.

It should also be noted that another option is to make an after-tax contribution to a 401(k) plan and then transfer those holdings to a Roth IRA.

Keep in mind that a backdoor Roth IRA isn't a tax dodge by any means, but it does promise the future tax savings of your typical Roth IRA account.

Tax implications to consider

A backdoor Roth IRA comes with the tax perks of a Roth IRA, meaning you will not owe further taxes when you eventually withdraw money post-retirement. However, when opening a backdoor Roth IRA, you are subject to paying taxes on the money transferred in that tax year.

Fry asks clients to consider the following questions when deciding to open a backdoor Roth IRA:

• "Where do I get the most value or the most tax-advantaged savings?"
• "Does it make sense to get the tax deduction today if I potentially qualify?"
• "Does it make sense to pay the taxes up front and have tax-free growth for potentially the rest of my life?"

"It's really just about comparing your taxes today versus down the road," Fry says, adding that "there's not any significant advantages. In the end, Uncle Sam always wins."

Disadvantages of a backdoor Roth IRA

While opening a backdoor Roth IRA is a solid option under some circumstances, it isn't for everyone.

Individuals who will need to withdraw money in five years or less, for example, will not be able do so with a Roth IRA due to its five-year rule. Withdrawing early will subject you to taxes and a 10% penalty.

If you're considering opening a Roth IRA, you should also be mindful of your tax bracket, staying alert to the fact that withdrawing too much at once may push you into a higher income tax bracket.

Finally, withdrawing money from your IRA to pay taxes limits future investment growth, and individuals who withdraw under the age 59-½ are subject to early withdrawal penalties.

The financial takeaway

A backdoor Roth IRA is not an official type of retirement account, but a way for high-income taxpayers to fund a Roth IRA despite exceeding traditional income limits. A backdoor Roth IRA is entirely legal and sanctioned by the IRS.

Although opening a backdoor Roth IRA comes along with initial taxes, it also gives investors the future tax benefits that come along with a traditional Roth account.