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Investing 202 - Roth IRAs and Backdoor Roth IRAs

Updated: Aug 31, 2023

Welcome to the podcast! On this third episode of investing, we are digging into Roth IRA’s and Backdoor Roth IRAs. We’ll discuss what they are, how they work, and the potential pros and cons of utilizing this retirement account strategy.


Roth IRA

Roth IRA

A Roth IRA is a type of individual retirement account (IRA) where you contribute money after-tax. This means that you pay taxes on the money now, but your earnings and withdrawals in retirement are tax-free.


There are income limits for making direct contributions to an individual Roth IRA. If your modified adjusted gross income (MAGI) is above a certain level, you will not be able to make direct contributions to a Roth IRA.


2023 IRA Contribution Limits are $6,500 or $7,500 over age 50 with catch up contribution provisions. However, keep in mind eligibility is based on income levels.

2023 Modified Adjusted Gross income under $138,000 as single and phasing out at $153,000. For Married Filing Jointly the MAGI must be under $218,000 combined for full contribution phasing out up to $228,000.


However, just because you make more than the income limitations, doesn’t preclude you from contributing to a Roth IRA. Stay tuned and we’ll go over this in a moment…..

Roth IRAs offer a number of advantages over traditional IRAs, including:

  • Tax-free withdrawals in retirement: Withdrawals from a Roth IRA are tax-free in retirement, regardless of your income. This can be a significant advantage for high net worth clients, who may be in a higher tax bracket in retirement.

  • Potential for tax-free growth: Earnings in a Roth IRA grow tax-free. This can lead to significant tax savings over time, especially if your investments grow at a high rate.

  • Flexibility: Roth IRAs offer a lot of flexibility. You can withdraw your contributions at any time, without penalty, just not your earnings until it’s been at least 5 years since first contributing to a Roth IRA and you are over the age of 59.5, to avoid paying taxes and penalties on the earnings.


  • Other Roth Withdrawals Options to Avoid Penalties (but not taxes) include:

    • *You use the withdrawal (up to a $10,000 lifetime maximum) to pay for a first-time home purchase.

    • You use the withdrawal to pay for qualified education expenses.

    • You use the withdrawal for qualified expenses related to a birth or adoption.

    • *You become disabled or pass away.

    • You use the withdrawal to pay for unreimbursed medical expenses or health insurance if you're unemployed.

    • The distribution is made in substantially equal periodic payments.1


However, Roth IRAs also have some disadvantages, including:

  • Contributions are not tax-deductible: Contributions to a Roth IRA are not tax-deductible. This means that you cannot deduct your contributions on your tax return.

  • Early withdrawal penalties: If you withdraw money from a Roth IRA before age 59½, you may have to pay an early withdrawal penalty. The penalty is 10% of the amount you withdraw.

Overall, Roth IRAs can be a good option for retirement savings, especially for high net worth clients. However, it's important to weigh the pros and cons before deciding if a Roth IRA is right for you.


For High Net Worth Clients the annual limitation can be problematic to direct Roth IRA contributions, however, there is a solution, called the Backdoor Roth IRA.


What is a Backdoor Roth IRA?


A Backdoor Roth IRA is a way for high-income earners to contribute to a Roth IRA, even if they exceed the income limits for direct contributions. To do this, you would first make a non-deductible contribution to a traditional IRA, and then convert the traditional IRA to a Roth IRA, usually the next business day. The conversion is taxable, but you won't have to pay taxes on any earnings that have accrued in the traditional IRA if it’s done right away. Otherwise, a delay could require taxes due on earnings too.


How Does a Backdoor Roth IRA Work?

Here are the steps involved in a backdoor Roth IRA:

  1. Open a traditional IRA.

  2. Make a contribution to the traditional IRA.

  3. Convert the traditional IRA to a Roth IRA.

  4. Pay taxes on any earnings that have accrued in the traditional IRA.

Pros of Backdoor Roth IRAs

There are several potential pros to using a backdoor Roth IRA, including:

● The ability to contribute to a Roth IRA, even if you exceed the income limits for direct contributions.

● Tax-free withdrawals in retirement.

● Potential for tax-free growth.

● Flexibility.


Cons of Backdoor Roth IRAs


There are also a few potential cons to using a backdoor Roth IRA, including:

● The conversion is taxable, so you may have to pay taxes on your contributions and earnings.

● You may have to pay income taxes on earnings if you withdraw them before age 59½.

● The process can be complex and confusing.


Why Are Backdoor Roth IRAs Useful for High Net Worth Clients?


Backdoor Roth IRAs are useful for high net worth clients because they allow them to contribute to a Roth IRA, even if they exceed the income limits for direct contributions. This can be a valuable tax planning strategy, as Roth IRA withdrawals are tax-free in retirement.


For example, let's say you're a single filer with an income of $420,000. The income limit for full direct contributions to a Roth IRA in 2023 is $138,000 for single filers or $218,000 for married filing jointly. This means that you cannot contribute directly to a Roth IRA. However, you can still use a backdoor Roth IRA to contribute to a Roth IRA.


Backdoor Roth IRA Growth Example


Let's say you contribute $6,000 to a backdoor Roth IRA every year for 10 years. Assuming an average annual return of 7%, your account would grow to $92,361 after 10 years. If you withdrew all of the money in the account at age 60, you would not have to pay any taxes on the withdrawals, contributions or growth.


Conclusion

Backdoor Roth IRAs can be a valuable tax planning strategy for high net worth clients. If you're considering a backdoor Roth IRA, it's important to speak with a financial advisor to determine if it's right for you and to help you with the process.

If you have any questions about backdoor Roth IRAs, please feel free to leave a comment below.

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