Backdoor Roth Strategy

Written by Dan Westin. Dan is a Certified Financial Planner and Senior Managing Director of QA’s Wealth Management Team.  He is also a partner in the firm.

Most Americans, while not excited about paying taxes, accept that they need to pay everything they owe.  However, they understandably have no desire to pay any more than is required. As wealth management advisors, we seek to help our clients optimize their financial resources through planning, including ways to effectively manage or reduce taxes over time.

One approach that can be advantageous to many, especially those in higher income tax brackets, is called a “backdoor Roth IRA”, a two-step strategy for funding a Roth IRA.  It is an acceptable approach for persons not otherwise eligible to contribute to a Roth IRA.

Why might this be valuable?  Well, most Americans, including the majority of our clients, have most of their nest egg in pre-tax retirement accounts, including 401(k)s and 403(b)s.  These pre-tax funded accounts allow individuals the benefit of making tax-deductible contributions; however, they will be responsible to pay ordinary income taxes on all withdrawals when these funds are used in retirement.  (And while some employer retirement plans now allow for Roth 401k contributions, most of our clients are in high tax brackets and generally inclined to contribute to their retirement plans on a pre-tax basis to get the deduction.)

Thus, the backdoor Roth IRA strategy provides a way to fund a retirement account which is not only free from taxation on the investment gains year over year, but allows (at least) this portion of one’s nest egg in retirement to be free from any future tax obligations when withdrawn. This can prove to be a valuable tool in managing retirement plan taxes.

The first step is to direct investment dollars into a non-deductible Traditional IRA (keeping the contribution uninvested to avoid any interest or gains from accruing). The second is to then do a tax-free conversion of these funds into a Roth IRA).  After that, these after-tax monies in the Roth IRA benefit from tax deferred growth and, assuming a few stipulations are met, can be distributed tax free in retirement.  However, it’s critical this multi-step strategy is implemented correctly (and assumes you DO NOT have an existing pre-tax IRA in order to be most effective).

For a deeper look, take a look at this Pathfinder flowchart at QA Wealth View and feel free to contact us if you would like to discuss further.

 

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The ChFC® and CASL® marks are the property of The American College, which reserves sole rights to their use, and are used by permission.

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