Saving for retirement is important for everyone, including those with high incomes — just because you make a lot now doesn’t mean you don’t need to plan for a future when you are no longer working. While generally the adage “more money, more problems” doesn’t exactly turn out to be true — apologies to Christopher Wallace — there is one specific issue people with high income have to deal with — they can’t use a Roth IRA. That said, there is a loophole still open allowing wealthy people to use a Roth IRA, known as a backdoor Roth conversion. If you’re thinking of employing this strategy, though, there are some pitfalls you’ll want to avoid.
For help implementing a backdoor Roth conversion or with any other retirement considerations, consider working with a financial advisor.
Backdoor Roth Conversion Basics
Here’s how a backdoor Roth conversion works. If you earn too much money to use a Roth IRA — the limits are currently set at $140,000 for individuals, $208,000 for married couples filing jointly, $10,000 for married couples filing separately, and $140,000 for head of household filers — you instead fund a traditional IRA. After you’ve put all the money into it you want to, you implement a rollover to a Roth account. You’ll have to pay taxes on any money in the account which has not been taxed and on any gains you’ve made through your investments.
A Roth conversion may cost you a bit of money up front in all those taxes, but it allows you to let your investments grow tax free until you retire — and you won’t have to pay taxes on the withdrawals in retirement.
Backdoor Roth IRA Mistake 1: Forgetting the Pro Rata Rule
The pro rata rule relates to investors with other traditional IRA accounts they are not rolling over. If you have a lot of money in a traditional IRA that has never been taxed — money that was rolled over from a 401(k), for instance — you’ll owe more taxes on the rollover. The actual calculation can be a bit confusing, so working with a financial advisor may be advisable if you think this might apply to your situation.
Backdoor Roth IRA Mistake 2: Ignoring the Escape Hatch
If the above pro rata rule has you worried, there is a possible fix: the escape hatch. If the company you currently work at offers a 401(k) plan, you might be able to roll your IRA assets into that plan. Once they are in the 401(k), they no longer apply to the pro rata rule. If you are self-employed, consider rolling traditional IRA assets into a Solo 401(k) for the same result.
Backdoor Roth IRA Mistake 3: Accumulating Capital Gains
When you fund your traditional IRA in preparation for a backdoor Roth conversion, you’ll have options in terms of investments. If you choose equity investments like stocks, they’ll potentially start earning money if the value of the investments go up. If you leave the traditional IRA for too long before completing your conversion, those gains could be substantial, and upon the conversion, you’ll be taxed on them.
You can avoid these taxes by investing in cash-equivalents and making sure you complete the conversion as quickly as possible.
Backdoor Roth IRA Mistake 4: Only Converting Once
The maximum contribution to an IRA each year is $6,000. For wealthy people likely to take advantage of a backdoor Roth IRA conversion, this is a drop in the bucket to their overall retirement plan. To really take advantage of a backdoor Roth, you’ll need to contribute $6,000 year after year and complete the conversion each time.
Backdoor Roth IRA Mistake 5: Being Scared of Congress
Many in congress want to close this lucrative loophole. Some legislators even want to start taxing Roth withdrawals. While all of this can be scary, anyone who pays attention to government knows that until something is actually signed by the president, you shouldn’t count on it happening. If legislation surrounding Roth accounts happens you’ll have to deal with it, but don’t let that possibility scare you off.
The Bottom Line
A backdoor Roth conversion allows wealthy people to take advantage of Roth IRA accounts via a loophole. There are several mistakes you should avoid, such as allowing too much growth before you convert and forgetting about the pro rata rule’s impact on taxes.
- For a Roth conversion or any other retirement considerations, consider working with a professional. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- If you’re saving with a 401(k), make sure you take advantage of any employer match available. This is free money, don’t leave it on the table.
Photo credit: ©iStock.com/designer491, ©iStock.com/shapecharge, ©iStock.com/Luke Chan