What is a backdoor Roth IRA, and who should consider it? Let's break it down.
Q: I'm thinking about a Roth IRA conversion to benefit from a lower tax payment. Should I proceed with a backdoor Roth IRA? My partner and I fall into a high tax bracket, and we believe the funds we invest now will grow significantly by retirement. Is it wiser to pay taxes now at a higher rate instead of later at a lower rate? I have multiple traditional IRAs across various brokers. Should I convert them all at once or take my time? Thanks. – Rose
A: We often get queries regarding whether a Roth IRA is preferable to a traditional IRA. I'm glad to address your question on Roth conversions, or backdoor Roth IRAs. For those unfamiliar, a backdoor Roth IRA serves as a workaround for high-income individuals who exceed the income limits for regular Roth contributions by first funding traditional IRAs and then converting those to Roth IRAs.
When you transfer assets from a traditional IRA to a Roth IRA, taxes are due on the converted amount at that time. Generally, it's advisable not to convert unless you have external funds available to cover those taxes. You want to avoid withdrawing from a tax-advantaged account to pay taxes, as this could lead to losing over 30% of each dollar, depending on your tax bracket. Fortunately, it seems that's not the scenario you're facing.
Another factor to consider is your anticipated tax rate. People typically choose a traditional IRA when they expect their tax rate to decrease in the future. Conversely, a Roth is chosen when individuals believe their current tax rate is lower and will rise later. The goal is to pay taxes at the lowest possible rate. Your inquiry suggests you expect a reduction in your tax rate, which makes me hesitant to recommend converting all your assets to Roth via a backdoor method.
If you believe that taxes will rise overall in the future — and I personally share that belief — then having some assets in a Roth can be advantageous. Additionally, a Roth allows high earners to leave funds to their heirs without tax implications. If this is part of your plan, a backdoor Roth conversion could be a smart move.
I recommend reviewing your traditional IRAs, as you have several, and converting them strategically based on your financial circumstances and ability to pay taxes from non-retirement funds at that time.
