Accessing Roth IRAs Through the Backdoor: A Workaround for High-Income Earners

Mark Bourguignon
President | Ascend Wealth Management
(415) 569-7909

Individual retirement accounts (IRAs) are powerful tax-advantaged savings accounts that many investors are either not taking advantage of at all, or not in the correct manner. Often, this is due to a misunderstanding about how IRAs work.  I sometimes hear, “I didn’t know I could contribute to an IRA, if I have a 401(k) plan at work,” or “My income level prohibits making contributions to an IRA.” Other times, investors are just unsure what type of IRA—Traditional or Roth—they should utilize.

This White Paper will explain the basic similarities, differences and benefits of traditional IRAs and Roth IRAs and discuss a unique strategy, the “Backdoor Roth IRA,” that can help you contribute to a tax-free Roth IRA, even if you are a high-income earner that is typically prohibited from accessing them.  

What’s the Difference Between a Traditional IRA and Roth IRA?

Both traditional and Roth IRAs have the same annual contribution limits ($5,500 in 2018), catch-up contribution allowance ($1,000 beginning at age 50) and qualified (non-penalty) withdrawal age, beginning at 59 ½.

The differences between the two types of IRAs are more notable. While taxes are the most often discussed reason to prefer one over the other, there are other characteristics, such as income thresholds and distribution requirements, that should be taken into consideration as well. I have highlighted these differences along with notes that may impact your planning below:

Traditional IRA: Can contribute at any income level
Roth IRA: Cannot contribute above income threshold
While there is no income threshold for making traditional IRA contributions, there is an income level at which the contributions are no longer tax deductible.

Traditional IRA: Contribute up until age 70 ½
Roth IRA: Contribute at any age
If full- or part-time work is an option that you require and/or prefer, only a Roth IRA will be available after age 70 ½.

Traditional IRA: Required Minimum Distributions (RMDs) begin at age 70 ½
Roth IRA: No RMDs
With a traditional IRA, RMDs are unavoidable and may impact your tax rate on other sources of income. Failure to take proper RMDs results in one of the most onerous penalties in our tax code: 50%!

Traditional IRA: Contributions are tax deductible
Roth IRA: Contributions are not tax deductible
Your current tax rate vs. expected future tax rate will determine the value of an up-front deduction.

Traditional IRA: Investments grow tax-deferred
Roth IRA: Investments grow tax-free
Since you will eventually owe taxes on all the investment growth (in addition to the contributions) in a Traditional IRA, the growth is only tax-deferred, not tax-free.

Traditional IRA: Distributions are taxed as ordinary income
Roth IRA: Distributions are tax-free
Again, your current tax rate vs. expected future tax rate will determine the value of an up-front deduction vs. tax-free growth and distributions.

Traditional IRA: Inherited IRAs are taxed as ordinary income
Roth IRA: Inherited Roth IRAs are tax-free
Roth IRAs are a valuable estate planning tool that can avoid “double taxation” and maximize your legacy.

So Which Type of IRA Is Right for You?

As with most things related to your wealth, the answer depends on your unique situation and outlook for the future. A good guideline, however, is that if you are planning on early retirement and/or feel that your future tax rates will be lower than they are currently, a traditional IRA makes good sense.

On the other hand, if you are seeking future tax avoidance, a Roth IRA would be a good choice. Beyond taxes, there are other reasons that a Roth IRA can be a valuable financial planning tool:

  1. No Required Minimum Distributions (RMDs). Roth IRA owners have no requirement to take distributions at a certain time, while traditional IRA owners must take RMDs according to a defined schedule beginning at age 70 ½, regardless of their need. These RMDs are taxed as ordinary income and may affect the taxation of any additional retirement income, including: social security, investment income/capital gains, part-time work, pension, rental property, etc.

  2. Investment Flexibility. Strategically allocating your investments to multiple “tax pools” (e.g., taxable, tax deferred, tax free) provides an opportunity to lower your income taxes and estate taxes, reduce trading costs, and even increase returns[i].

  3. Distribution Flexibility. Having multiple account types to withdraw from during retirement creates flexibility, enabling you to use strategies that may avoid unnecessary taxes.

  4. Estate Planning. No RMDs and the tax-free inheritance of a Roth IRA make it a better tool for leaving money to others.

IRA Contribution Rules Limit If High-Income Earners Can Contribute

If you’re now thinking that a Roth IRA is more desirable, you’re not alone. In 2010, the IRS removed the income limit on your ability to move money from a traditional IRA to a Roth IRA (known as a Roth conversion) and for the first time ever, conversions exceeded total combined contributions to both types of IRAs. In fact, the number of conversions increased over 800% in 2010 to $64.8 billion, and most of those conversions were done by high-income earners — the same cohort that IRS rules explicitly prohibit from making direct Roth IRA contributions each year.

While the income limits on conversions were removed, the income limits on contributions to a Roth IRA stood pat (>$135,000 if you’re single; >$199,000 if you’re married filing jointly). Thus, high-income earners were able to pay the associated taxes and convert unlimited amounts of money into a Roth IRA, but they still couldn’t make annual Roth IRA contributions.

As well, the ability to make tax deductible contributions to a traditional IRA is phased-out above a certain income level ($73,000 for individuals and $121,000 for married couples). This meant that many investors were denied any chance to receive the tax deduction benefits of a traditional IRA and the tax-free Roth IRA was not available at all. This left many high-income earners feeling left out.

Here’s How High-Income Earners Can Still Fund a Roth IRA

When you come home and find that the front door is closed, you normally check the back door. When it comes to Roth IRAs, a perhaps unintended, but perfectly legal, consequence of the 2010 IRS rule that removed income limits on Roth conversions, also unlocked the possibility of funding a Roth IRA every year via a Backdoor Roth IRA.

What is a Backdoor Roth IRA?

The Backdoor Roth IRA is a two-step process that provides a way for high-income earners to make annual Roth IRA contributions. This strategy is viable for two reasons: 1) anyone, regardless of income, can make a non-deductible contribution to a traditional IRA, and 2) there are no income limits on Roth conversions.

A Backdoor Roth IRA is executed by following these two steps:

  1. Make a current year non-deductible contribution to a traditional IRA.
  2. Conduct a tax-free Roth conversion of the contributed amount at a later date.

There are some important details you need to be aware of, when executing a Backdoor Roth IRA. The first is the IRS “pro-rata rule”, which is the formula used to determine how much of a distribution is taxable when you, as the account owner, hold both after-tax and pre-tax dollars in your IRA(s). The second is IRS Form 8606, a simple form that keeps track of the “basis” (i.e., non-deductible contributions) in your traditional IRA, so that you don’t pay taxes again on those dollars when they are converted into a Roth IRA.

 What’s the Value of a Backdoor Roth IRA?

“Is this really worth it?” you ask. I find that the best way to evaluate financial strategies and present options to clients is to show a year-by-year progression, using tables and charts.

It’s worth pointing out that the Backdoor Roth IRA strategy is for high-income earners who are traditionally “locked out” of making any tax-deductible contributions to a traditional IRA or any sort of direct Roth IRA contribution. The alternative is to put funds into a taxable/trust account each year. Without crunching any numbers, it’s a no-brainer to say that shifting money from a taxable account to a tax-free account is, of course, always highly advantageous.

Using conservative assumptions, we can show that utilizing the Backdoor Roth IRA strategy for 30 years increases the after-tax buying power of these investments by 49%! This assumes that all of your investments are liquidated at age 65, and only long-term capital gains taxes are paid from the taxable account. If you assume that state taxes are owed as well (they are owed in 41 states), that any of the gains during those 30 years are taxed as short-term, or if any of the money is liquidated at a later date, your buying power advantage would continue to increase.

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Some 401(k) Plans Allow a Mega Backdoor Roth IRA

If you find yourself intrigued by the benefits of a Backdoor Roth IRA, you’ll be excited to know that there’s another strategy, referred to as the “mega Backdoor Roth IRA,” that may allow you to contribute an additional $36,500 per year to your Roth IRA regardless of your income level. That’s more than 6 times the annual $5,500 contribution limit. This is a feature available in some company 401(k) Plans that, if available, offers the potential for you to drastically increase the size of your tax-free retirement nest egg.

CONCLUSION

Developing an intelligent investment strategy is only the tip of the iceberg, if you want to maximize your wealth. A comprehensive financial plan should also consider other actions, such as reducing taxes as a way of generating alpha (outperformance) from your portfolio. After all, what you don’t pay in taxes each year is available to reinvest, and compound, over many years. A Backdoor Roth IRA is just one of many viable tools for reducing taxes and increasing your risk-free alpha.

At Ascend Wealth Management, we find that utilizing all types of tax-advantaged accounts available to you (e.g., IRAs, 401(k)s, HSAs, 529s, etc.), knowing the optimal order in which to contribute to them, and taking distributions in a tax-effective manner, all serve to greatly enhance our clients’ wealth.

If you find the choices regarding your investments to be overwhelming, or don’t have the time to navigate the landscape on your own, it’s a good idea to find a reputable investment advisor to help you. At our firm, we find that many of our clients are plenty smart, but they’re also very busy and have other ways they would prefer to spend their time. They feel relieved to utilize the experience of a professional who deals with the same opportunities often.


Footnote[i] In a White Paper titled “Advanced Tax Planning: The Holy Grail of Investing”, we demonstrated how proper asset location optimization can be used to structure portfolios that lower income taxes, estate taxes and trading costs, while also increasing total returns. 

About the Author
Mark Bourguignon is the Founder and President of Ascend Wealth Management. Previously, Mark was a Director at Clearbridge Investments, a Legg Mason Company, where he was a Fund Manager for the Clearbridge Small Cap Value Fund and a Senior Portfolio Analyst for the firms all cap value, balanced income, and small cap strategies. Prior to Clearbridge, Mark served as the Director of Research for Option Advantage Partners L.P., which was the first private equity fund to provide institutional funding to entrepreneurs who wanted to tax-efficiently exercise their stock options. Mark led the fund's research effort on behalf of the General Partner and its accredited investors. Mark began his career as an equity research analyst at the investment banking firms Donaldson, Lufkin and Jenrette and Thomas Weisel Partners. Mark earned a Bachelor of Science degree in Finance from Marquette University.
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About Ascend Wealth Management
Ascend Wealth Management is an independent private wealth management firm that works with individuals and families. The firm provides the highest standard of care and ethics in the investment industry—a fiduciary standard—which means their advice always serves a single purpose: to build financial security and wealth for you and your family.

The firm works closely with its clients in order to understand their unique needs, goals and risk tolerance and then builds customized investment portfolios of institutional-class funds designed specifically for long-term investors who are seeking an alternative to what is commonly available among the investment industry. Their strategy is based on sound, time-tested principles that have been confirmed by Nobel Prize-winning research and decades of empirical evidence.

We welcome the opportunity to meet with you, conduct a thorough review of your current investment strategy, answer all of your questions, and discuss how a sensible, evidence-based investment approach can provide you with greater prosperity and peace of mind that comes from knowing that your money is being managed with expert care.

For more information, please email Mark Bourguignon at mark@ascendwealth.com or call (415) 569-7909.
 
Ascend Wealth Management Inc. is a Registered Investment Adviser. We serve as an independent, fee-only wealth management firm for individuals, families and institutions to help them achieve their investment goals. To learn more about us and our services, please visit our website or email us.
 
This newsletter is solely for informational purposes. Advisory services are only offered to clients or prospective clients where Ascend Wealth Management Inc. and its representatives are properly licensed or exempt from licensure. Past performance is no guarantee of future returns. Investing involves risk and possible loss of principal capital. No advice may be rendered by Ascend Wealth Management Inc. unless a client service agreement is in place. 

 
Mark Bourguignon