Last week’s blog was an introduction to the Roth IRA and the intricacies of the tool. We highlighted the perks the Roth can provide and who can use it. We also discussed the barriers the IRS has put in place to make a direct contribution. What we didn’t dive into, however, is the backdoor that the IRS has left open for everyone else. Plenty of people are aware of the Roth IRA and how to contribute regularly. Fewer are aware of what is referred to as the backdoor strategy.
Typically, those participating in this strategy have income levels that exceed the Roth IRA contribution thresholds set by IRS. Essentially, this is a means to overcome the barriers. You can think of the strategy as an enabling tool. The IRS is fully aware of the strategy and recognizes that people utilize it to fund their Roth IRAs. Part of the reason they do so is because of the complexity. It’s crucial that you are working with your financial advisors and trusted tax professional to make sure everything is conducted properly.
How does the strategy work?
The first step in the backdoor Roth strategy is not what you might expect. First, you contribute to a traditional IRA. For this reason, you obviously must be eligible to do so. This means you or your spouse must have earned income. Commonly, this contribution will be a non-deductible contribution to the traditional IRA – meaning funds that have already been taxed will be utilized. However, if a deduction is made from the funds contributed, a tax liability is created in the process. In addition, if any gains are made on the contribution before the funds are converted to Roth, taxes will be owed. Finally, after the funds have been contributed to the traditional IRA, the next step is to convert them to Roth funds. This opens the imaginary backdoor to the Roth IRA and the Roth will be funded.
Let’s take a look at an example together: Joe is single, 45 years old and makes an income of $250,000 per year. Because his income has launched him over the thresholds set by the IRS to contribute to a Roth IRA in 2020, he must find an alternative. Therefore, he contributes $6,000 of post-tax funds to a traditional IRA (the maximum allowed by the IRS for 2020). Then, Falcon Wealth Advisors helps him convert the funds into his Roth IRA. He has successfully made a contribution to his Roth – it just took a little bit more work.
Why do this?
What would compel one to go through this process? The Roth IRA is a powerful investing tool. It allows for tax-free growth AND tax-free distributions once the funds have been in the account for 5 years and the owner is above the age of 59.5. Not only that, it does not come with required minimum distributions a traditional IRA entails. Therefore, the Roth IRA serves as an excellent addition to your retirement planning as well as estate planning if you wish to pass on funds in a tax-efficient manner.
While the strategy may seem rather straightforward – making a contribution to a traditional IRA and then converting the funds to Roth – plenty of complexities are sprinkled into the strategy. As I mentioned, it’s essential that you are working with your financial advisor and trusted tax professional to make sure everything is handled correctly. The last thing you want is to create a tax liability you weren’t expecting. This blog has highlighted the general overview of the strategy, but there are plenty of details that cannot be missed when completing the strategy. This is where we come in at Falcon Wealth Advisors. If a backdoor Roth contribution is something you are interested in, a great place to start is by emailing me at email@example.com. We are looking forward to helping you meet your goals!
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