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If you’re making $275,000 a year, you can’t contribute to a Roth IRA due to income limits. However, a backdoor conversion can allow a high earner to sock away unlimited sums in a Roth account, enabling tax-free requirement withdrawals and a way past pesky required minimum distribution rules (RMDs) that many pretax retirement account require. But this will likely require sufficient after-tax funds – such as from a non-retirement bank account or brokerage account – to pay the upfront tax bill that a backdoor conversion strategy generates.
Conversions are most advisable for savers who will be in a higher tax bracket after retirement. Assuming these conditions are met, a backdoor conversion can be a useful method of avoiding Required Minimum Distributions (RMDs) and enjoying tax-free withdrawals in retirement. Consider discussing a Roth backdoor conversion with a financial advisor to make sure you understand the ins and outs of this strategy.
Backdoor Basics
Roth retirement accounts allow savers to use after-tax money to fund accounts where investments accumulate earnings tax-free and, in most circumstances, withdrawals are also tax-free. Another appealing feature of Roth accounts is that they are exempt from RMD rules requiring savers to begin withdrawing from pre-tax savings accounts such as IRAs and 401(k)s after age 73, which can expose retirees to unwelcome tax bills.
Roth IRAs also have income limits that make them inaccessible to some high earners. For 2024, individuals earning $161,000, married couples filing jointly earning $240,000 and married couples filing separately earning $10,000 are all prohibited from contributing to Roth retirement accounts at all.
However, since 2010 it’s been possible for a saver to convert unlimited funds from a pre-tax retirement account to a Roth account. This backdoor conversion, as it’s known, has become a popular way for people who earn and lot and have saved a lot to get the advantages of Roth accounts.
To perform a backdoor conversion, a saver can transfer funds from a pre-tax retirement account such as a 401(k). 401(k)s and other qualified accounts may not limit an investor based on his or her income, and its annual contribution limits are also much higher than Roth IRA contribution caps. Next, they transfer funds from their other retirement account to a new Roth IRA account. Because the funds from the 401(k) are pre-tax, the saver will have to pay income taxes on the converted amounts in that tax year, as if they were withdrawals treated as ordinary income. A large transfer can generate a large tax bill if the entire amount is converted at once. Sometimes conversions of large IRAs are done gradually over several years to manage the tax bill and keep the person in lower tax brackets.
After conversion, the funds in the Roth account can grow tax-free and later be withdrawn tax-free, in most cases, in addition to being free from RMDs. There are no restrictions on how much money can be converted at once or on how often conversions are done, so it’s possible to move very large sums through the backdoor process.
Consider using this free tool to match with fiduciary financial advisors and discuss your tax strategy.
Backdoor Limitations
Backdoor conversions solve some problems but may not suit every saver. The major issue is the tax bill that comes due when the conversion is completed. It’s preferable to have sufficient funds to pay this bill in after-tax brokerage or bank accounts, so funds in the retirement account can continue to grow tax-free. Using retirement funds to pay the taxes due can dampen long-term accumulation in the accounts.
Another consideration is that backdoor conversions may be less fruitful if a saver if very close to retirement. Specifically, the five-year rule may prevent someone from accessing that money within five years of it being converted.
Finally, a backdoor conversion may not be a good idea at all if a saver expects to be in a lower tax bracket after retirement. In this case, it would save money to leave funds in a pre-tax account where they can grow tax-free and withdraw them later when the tax bill will be lower. Remember, a financial advisor can help you determine the right strategy for your goals.
Bottom Line
For someone earning $275,000 a year, a backdoor conversion is the only way to save for retirement using a Roth IRA. The strategy involves paying taxes now, but allows for tax-free future growth as well as tax-free withdrawals and immunity from RMD rules. There are no income limits for backdoor conversions, and the strategy can be employed as many times as desired. Conversions aren’t always best for savers who will be in lower tax brackets after retirement, and other restrictions may apply. But the strategy is popular for higher-income earners who want the benefits of having funds in a Roth IRA.
Tips
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A financial advisor can help you determine whether a backdoor conversion makes sense for you. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors in your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
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Wondering how much your 401(k) will be worth in the future? SmartAsset’s 401(k) Calculator can give you an answer.
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Keep an emergency fund on hand in case you run into unexpected expenses. An emergency fund should be liquid — in an account that isn’t at risk of significant fluctuation like the stock market. The tradeoff is that the value of liquid cash can be eroded by inflation. But a high-interest account allows you to earn compound interest. Compare savings accounts from these banks.
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Are you a financial advisor looking to grow your business? SmartAsset AMP helps advisors connect with leads and offers marketing automation solutions so you can spend more time making conversions. Learn more about SmartAsset AMP.
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