A Backdoor Roth IRA: What's All the Hoopla?

"Backdoor" Roth conversions have been widely touted as a "rich person's Roth." That's because if your income exceeds the maximum limit to contribute to a Roth directly, you can take the indirect route of adding the annual maximum amount to a traditional IRA and then immediately transferring that contribution to a Roth account. Many wealthy Americans have reportedly socked away a pretty penny this way.

Is this a scheme to dodge taxes?

Yes and no. Yes, a backdoor Roth strategy will decrease the taxes you pay over your lifetime, but it is also perfectly legal. Investors have to pay a tax on all nontaxable money that moves from a traditional to a Roth in the transition year. While this strategy is legitimate, it has nonetheless drawn lawmakers' focus. 

What are the advantages of building your Roth IRA?

The benefits of this financial maneuver to increase your Roth assets can be numerous. For instance, all earnings in a Roth grow and are withdrawn tax-free. In addition, Roths do not require minimum distributions (RMDs). This means assets can continue to compound tax-free for the rest of your life and beyond. That's why many view this type of account as an excellent way to transfer funds to heirs.

As with everything related to estate planning, leaving your Roth IRA to heirs has its own set of rules. The basic gist is:

• Spouses who inherit a Roth IRA can treat it as their account and are not required to draw down the account during their lifetime.
• Particular specially classified beneficiaries who inherit a Roth IRA maintain the “stretch” distribution schedule over the course of their lives.¹
• Other non-spouse beneficiaries—such as children, grandchildren, other family members, and friends—must take distributions of all the assets in the account within 10 years of the original owner's death.

There are other rules, so consult a tax professional for all tax advice.

But not everyone is a good candidate for a backdoor Roth.

For example, if you already have before-tax contributions held in a traditional IRA, then converting to a Roth may not be a tax-efficient maneuver for you.

The reason is complicated, but if your IRA consists mainly of pre-tax contributions and you have significant accumulated earnings, most of the funds you convert to a Roth IRA will likely count as taxable income at the time of the conversion. You aren't allowed to "cherry-pick" and only convert the after-tax balance, which could kick you into a higher tax bracket in that year. If that's the case, it may make sense to wait until retirement, when you'll likely be in a lower tax bracket.

But start with a fresh slate. Even though your contributions will be taxed immediately, you won't have to pay taxes on earnings—which is one of the advantages of backdooring into a Roth. Contrast that with socking away the same amount in a taxable investment portfolio. Similarly, your investment dollars will be taxed immediately. But they're also taxed when you sell appreciated positions.

Let’s walk through an example:

Larry recently graduated college and is saving $6000 a year over and above his contributions to his employer’s 401(k). Larry's income is over the limit for contributing directly to a Roth IRA, so he thought the Roth just wasn't in the cards. That is, until his colleague mentioned that he might be better off doing a backdoor Roth instead. He decided to speak with a financial advisor to understand his options. Here’s the analysis the advisor reviewed with Larry.

Larry’s advisor assumed he would make an annual contribution of $6000 for the next 30 years. In addition, the advisor based the growth of the investments on the long-term average return of a 50% stock/50% bond portfolio.²

This example shows the tax advantage—$173K in this example—of the backdoor Roth over a taxable investment account. And while Larry was embarking on his career, those well into their careers also could see substantial benefits.

What’s your “why” for doing a backdoor Roth?

While converting to a Roth appears to be the financial move du jour, the decision should be highly individualized. Larry’s decision should weigh other factors—such as his wealth goals—in addition to the after-tax value. For example, does he want to spend his contributions before he is 59 ½ years old? If so, then a Roth could make sense. But if he needs to dip into the earnings, then he may get penalized and taxed.

Something else to mull over? Managing your future tax bracket.

The backdoor Roth is an effective technique for controlling future overall tax rates. In other words, by drawing spending needs from this tax-free bucket in retirement, your taxable annual income will not increase. Thus, your tax bracket should be unaffected. In contrast, spending from a taxable investment account or a Traditional IRA could raise your tax bracket.

But as with everything, there are other pros and cons. That's why it's essential to look at it from all angles. A financial planner and tax professional can help guide your decision.