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Backdoor Roth IRAs and 401(k)s: What They are and Why You Might Consider Them

Woman thinking about whether she should consider backdoor Roth IRA conversions

What is a Backdoor Roth IRA or 401(k)?

A backdoor Roth IRA is a financial strategy where an individual converts or contributes funds from a traditional, tax-deferred individual retirement account (IRA) to a Roth IRA. A Roth 401(k) plan is sponsored by an employer that eventually needs to be converted to a Roth IRA in retirement.

A Roth IRA is a tax-advantaged account because the earnings on the account, withdrawals in retirement and the funds when the account is inherited are tax-free.

However, if you're a high earner, you aren't able to contribute to a Roth IRA. That's why converting a portion of a traditional IRA or 401(k) to a backdoor Roth IRA or contributing to a Roth 401(k) through your employer is an important tax planning strategy to consider.

How is a Roth 401(k) Different from a Roth IRA?

  • Roth 401(k)s are offered through an employer-sponsored retirement plan, while Roth IRAs are individual retirement accounts that you typically open on your own.

  • Roth 401(k)s typically have higher contribution limits than Roth IRAs.

    • In 2024, the annual contribution limit for a Roth 401(k) is $23,000 (or $30,500 for those aged 50 and older with catch-up contributions) versus $7,000 (with a $1,000 catch-up) for Roth IRAs.

  • Some employers may offer matching contributions for Roth 401(k)s, which can significantly boost your retirement savings—but most employers make the match pretax.

  • A drawback is that you'll be limited to the investments offered by your company's 401(k) plan instead of the variety available with a Roth IRA from a brokerage.

Why Might You Consider Implementing a Backdoor Roth IRA Strategy or Contributing to a Roth 401(k)?

Did the words “tax-free” catch your attention? Depending on your financial goals and circumstances, here are five key reasons you might consider a conversion to a backdoor Roth IRA or contributing to an employer-sponsored Roth 401(k).

1. Tax-Free Withdrawals in Retirement

One of the primary advantages of Roth IRAs is the potential for tax-free withdrawals in retirement. By paying taxes on the converted amount now or foregoing your pre-tax contributions to your 401(k), you can enjoy tax-free growth and withdraw funds from your Roth IRA tax-free during retirement.

This can be especially advantageous if you anticipate being in a higher tax bracket in the future because of Social Security benefits, an inheritance, and/or required minimum distributions (RMDs) from your retirement savings.

The chart below shows how this couple's income, and therefore tax rate, is lower in the first seven years of their retirement before the second spouse's Social Security benefit is taken. The means converting part of their retirement savings into backdoor Roth IRAs during these years could be advantageous.

Chart showing why to take backdoor Roth IRA conversions  early in retirement while income and tax rate is lower

2. Diversification of Tax Treatment

Having a mix of both traditional retirement accounts where withdrawals are subject to ordinary income tax and Roth accounts which are tax-free can provide tax diversification in retirement.

By converting some of your traditional retirement funds into a backdoor Roth IRA or contributing to a Roth 401(k), you create a tax-free income source that can complement your taxable withdrawals from traditional accounts. This flexibility can allow you to strategically manage how and when you’re paying your tax liabilities during retirement.

3. No Required Minimum Distributions (RMDs)

Roth IRAs do not impose required minimum distributions (RMDs) during the account owner's lifetime. This means you can maintain your Roth account and let it grow tax-free for as long as you want, allowing you more flexibility in managing your retirement funds.

This feature can be advantageous for individuals who have other sources of income like a pension, Social Security or rental income or don’t require immediate access to retirement funds.

4. Estate Planning Benefits

Roth conversions can be part of a comprehensive estate planning strategy. Roth IRAs do not require minimum distributions during the account owner's lifetime, allowing funds to potentially grow tax-free for a longer period.

Additionally, qualified distributions to your non-spouse beneficiaries are tax-free and don’t have required minimum distributions as is the case with inherited traditional IRAs and 401ks, thereby providing a tax-efficient wealth transfer vehicle.

5. Strategic Tax Planning Opportunities

Backdoor Roth IRA conversions and Roth 401(k) contributions can be timed strategically based on your current and projected future tax situation. For example, if you anticipate a lower income year, you may consider converting or contributing funds at the lower tax rate.

By working with a financial professional and tax professional, you can identify the most opportune times for conversions or contributions and minimize your overall tax burden.

Pros and cons of making backdoor Roth IRA conversions

What Are the Disadvantages to Backdoor Roth IRA Conversions?

It's important to note that Roth conversions do have tax implications and may not be suitable for everyone. Here are the top three disadvantages.

1. Upfront Tax Liability Can Affect Cash Flow

One of the main drawbacks of a backdoor Roth IRA is the immediate tax liability when doing the conversion. When you convert funds from a traditional IRA or 401(k) account to a Roth account, you must pay your ordinary income tax rate on the converted amount for that tax year.

It's important to make sure you have cash outside of your retirement accounts to cover the taxes you'll owe upon conversion. If you don't have enough cash on hand and need to withdraw funds from the retirement account to pay the taxes, it can potentially negate the long-term benefits of the conversion.

2. Potential Loss of Tax Deductions and Credits

A backdoor Roth IRA conversion may increase your taxable income, potentially reducing or eliminating certain tax deductions and credits that are income-based. Losing tax deductions and credits can have ripple effects on your overall tax planning and result in a higher-than-expected tax bill in the conversion year.

3. Uncertain Future Tax Environment

Predicting future tax rates and legislation is challenging. By converting to a backdoor Roth IRA account, you're essentially betting that tax rates will be higher in the future. However, if tax rates remain the same or decrease, the benefits of the conversion may be reduced.

4. The Conversion Might be Subject to the IRS's Pro-Rata Rule

The IRS requires rollovers from traditional IRAs to Roth IRAs to be done pro rata. Here's what that means and how it works.

  • When determining your tax bill on a conversion from a traditional IRA to a Roth IRA, the IRS is going to look at all of your traditional IRA accounts combined.

  • For example, if the total of all your traditional IRAs consist of, say, 60% pre-tax money and 40% after-tax money, that's the ratio used by the IRS to determine what percentage of the money converted to a Roth will be taxable.

  • Using the this 60/40 example, no matter how much money you convert or which traditional IRA account you pull the money from, 60% of the converted amount would be taxable because of course, the IRS doesn't allow you to convert only the after-tax money.

  • The IRS applies the pro-rata rule to your total IRA balance at year-end versus what the balance was on the day you made the conversion.

That's why it’s important to consider your personal circumstances and consult with a tax professional to assess the potential long-term tax implications.

Should I Contribute to a Roth 401(k) Now or Convert to a Roth IRA Later?

A tax break now because you're contributing to a traditional 401(k) pre-tax, thereby reducing your taxable income, can make a difference to your cash flow, but it should be balanced against your future tax picture. Under the current tax rules, every dollar you withdraw from a traditional 401(k) could be reduced by 20 to 30 percent or more, depending on your tax bracket when you're retired.

Generally speaking, if you're early in your career and fairly certain you'll earn more and be in a higher tax bracket in the future, contributing to your Roth 401(k) now may be a good choice. Even if you're mid- to late-career, it's wise to take a close look to see if the Roth option could make sense for your current and future financial situation.

When Should I Consider Implementing a Roth Conversion Strategy?

While the answer depends on your individual situation, I often recommend my clients start making annual backdoor Roth IRA conversions in the five to ten years leading up to them taking their Social Security benefits and/or the start of their required minimum distributions (RMDs). (The current age for RMDs begins at age 73 years old, but is subject to change based on future tax legislation.)

Why? Your Social Security benefits might be subject to taxation if your combined income, which is your adjusted gross income based on earned income + RMDs + interest/dividends + half of your Social Security benefits, exceeds certain income thresholds.

By converting funds from a traditional retirement account to a backdoor Roth IRA account when your income is lower prior to receiving your Social Security benefit and taking RMDs, your tax rate on the conversion might be lower. Doing so can also potentially reduce your future RMDs because the income coming from your Roth IRA is tax-free.

Download a Free Checklist for Help Deciding Whether to Contribute to a Roth 401(k)

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The Bottom Line

Making backdoor Roth IRA conversions or Roth 401(k) contributions can be a useful strategy to better manage your taxable income, reduce your tax liabilities, achieve tax diversification and enhance your estate planning strategy.

However, it’s important to consult with a financial advisor and a tax professional who can provide personalized tax guidance based on your specific financial situation to ensure the timing and amount of your Roth strategy aligns with your overall retirement plan.

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No investment strategy assures success or protects against loss. Investing involves risk, including the loss of principal. The information in this post is not intended as tax, accounting or legal advice, as an offer or solicitation of an offer to buy or sell, or as an endorsement of any company, security, fund, or other securities or non-securities offering. This information should not be relied upon as the sole factor in an investment making decision.

Please consult with a licensed tax professional before implementing any tax strategies.


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