Cypress Wealth Services
August 2023
Taxes will be your constant companion throughout your entire life. Even after you retire from your career, you will still have to face taxes. However, there are some surprising ways you can lessen the impact of taxes in your retirement years. One way is to use a backdoor Roth IRA. If you’re a bit unfamiliar with this strategy, let’s dig into what it is and how it can help.
A backdoor Roth IRA is an IRS-sanctioned loophole that lets high-income earners reap the benefits of a Roth without violating the income limits.
There’s a reason Americans love Roth IRAs—they come with some major tax benefits. You pay taxes on your contributions up front, but then your investments grow 100% tax-free. Additionally, when you start taking withdrawals in retirement, none of that money counts as taxable income. It’s a very attractive option for those who can qualify.
But that’s the problem—most high-income earners don’t qualify for a Roth IRA. As of 2023, you’re not eligible to contribute to a Roth IRA if you make at least $153,000 as an individual or $228,000 as a married couple.
This begs the question: How can you enjoy the sweet tax perks that come with a Roth IRA if your income is over these limits? The solution is the backdoor Roth.
Let’s say your income exceeds the legal limit for a Roth IRA, but you still want to fund an account. First, you will need to open a traditional IRA and fund it with non-deductible contributions. Then, you will immediately convert your non-deductible IRA to a Roth IRA and repeat this process each year in order to take advantage of tax-free growth.
In this scenario, you can avoid the IRA income limits, but you cannot avoid the annual contribution limits. This means you can fund a maximum of $6,500 in 2023 ($7,500 if you’re over the age of 50) per year. This may seem small, but over time you can amass a sizable retirement savings, especially when combined with other tax-advantaged retirement vehicles.
A backdoor Roth IRA is a useful wealth strategy that can save you thousands in taxes. But there’s even more to it than that.
Unlike traditional retirement accounts, backdoor Roth IRAs aren’t subject to required minimum distributions (RMDs). This means you won’t be forced to start taking withdrawals—and paying taxes on those withdrawals—when you reach age 73.
This is yet another point in favor of backdoor Roths: estate planning benefits. With no required RMDs, you’re free to let your account balance grow and build for as long as you’d like. Then, you can pass it on to your heirs if you wish to do so.
There are some things to be aware of when considering a backdoor Roth.
Backdoor Roths only work if you have zero to very low traditional IRA assets. What happens if you have both pre-tax and non-deductible after-tax contributions in your traditional IRA? Unfortunately, you cannot choose to only transfer the after-tax contributions. This is because of the pro rata rule.
Pro rata means that taxation is based on percentages or ratios. If 60% of all of your combined traditional IRA contributions were made pre-tax and 40% were made after-tax, then those are the percentages they use to determine the taxability of the conversion. No matter how much you convert or which specific IRAs it comes out of, 60% of the funds will be considered pre-tax (and therefore taxable) and 40% will be considered after-tax (and therefore tax-free).
If you have a substantial amount of pre-tax savings, you may be able to utilize a “mega” backdoor Roth strategy instead. In this strategy, you would fund after-tax contributions to a Roth 401(k) that can grow tax-free if utilized properly. Most 401(k) plans don’t allow for this provision, but if it is available to you, reach out to us at Cypress Wealth Services to learn about this implementation strategy in greater detail.
Backdoor Roths are irreversible. That means if you converted too much at once and got pushed into a higher marginal tax bracket, you can’t take it back. But this can usually be avoided by keeping your conversion amounts to the annual contribution limits.
You will also need to consider those tricky state taxes. If you live in a state that has income tax, you’ll likely owe state taxes on your backdoor Roth conversion in addition to federal taxes. However, some states exempt part of your distribution if you’re over a certain age.
Backdoor Roth IRAs also have two five-year rules to keep in mind. The first rule says that you must wait at least five years from your first contribution before you can make a penalty-free withdrawal from your Roth IRA—even if you’re over age 59½.
The second five-year rule states that each of your backdoor Roth conversions has its own five-year period. For example, if you do a conversion in 2023 and another in 2024, you’ll have to wait until at least 2028 to access the first conversion and 2029 to access the second.
As with anything tax-related, consult a wealth advisor to position your money in a way that minimizes tax liability and maximizes growth.
While taxes are a constant companion, they don’t have to dictate how you live your life, especially in your retirement years. Looking into a backdoor Roth IRA could be exactly the thing you need to decrease that tax burden and have more freedom. If you’re still unsure about if this is the right thing for you, partnering with a qualified tax advisor can radically change how you organize your financial plan. At Cypress Wealth Management, we’re dedicated to bringing clarity and confidence to your entire financial life. You’ve worked hard for your money. Let up help you ensure you get to enjoy it. If you’re ready to take that step, call us at 866.888.6563 or contact one of our offices today.
Cypress Wealth Services is an independent RIA firm providing financial planning and investment management to high-net-worth individuals, families, business owners, and institutions. Cypress Wealth Services comprises professionals with diverse backgrounds and extensive experience and qualifications. Cypress Wealth Services serves a broad range of client needs using their knowledge and expertise to act as a foundation for their client service process. The firm uses The Second Growth, which focuses on efficiently protecting, growing, and transferring the wealth and legacy a person has already built to their loved ones. With financial advisors in California, Alaska, Arizona, and Georgia, the firm serves clients across the country with Wealth Management Services, Fiduciary Services, 401(k) Design and Management, Investment Reporting Services, Financial and Retirement Planning, and more. For more information, visit www.CypressWS.com or call 760.834.7250.
