What is a Backdoor Roth IRA Conversion?

The first time I ever wondered, “What is a Backdoor Roth IRA?” was reading about strategies to pay zero (or lower) taxes in retirement.

A Roth IRA has a backdoor? I had no clue! I just assumed the income level requirements barred anyone making above Roth IRA contribution levels from participating. Not so!

For people that make too much money to contribute to a Roth IRA the standard way, there is a “backdoor” method of contributing. This requires making qualified contributions to a traditional IRA and then rolling these contributions over to a Roth. Of course, you must pay taxes on the contributions when you roll them over.

To Start, What is a Roth IRA?

A Roth IRA is an investment vehicle that allows you to invest after-tax money now and withdraw it later in retirement tax free.

In other words, you cannot deduct the money you put into a Roth IRA from your tax base the year you put it in. However, if you follow all the rules, you can take all the money (principal and interest) out of a Roth tax-free.

Roth Rules

Roth IRA’s have contribution limits and rules you must follow. To read more about income rules, contributions and withdrawals, please read our article, “Roth IRA Contribution Limits.” In summary, inBOTH 2019 and 2020, your Roth IRA contribution limits are:

$6,000 for the year.
$7,000 per year if you are older than 50.

In addition, you can find the official IRS webpage for Roth IRA’s here.

Second, What are the Strategic Uses of a Roth IRA as an Investment Tool?

The purpose of a Roth IRA as an investment tool is to provide a place where your invested funds can grow tax-free. In addition, since you already paid your taxes on your initial investments, you can take out both the money you put in and the interest it accrued tax-free.

These tax free withdrawals are a big deal in retirement. Especially if most of your retirement income is coming from your investments. Every extra dime makes a difference in retirement. Therefore, having access to funds that are not taxed means 10 – 30%+ more cash for you to live off of.

The financial community is always preparing for a rise in income tax levels. Our tax levels have been very low, for a long time. At some point, they are expected to rise. Consequently, it may be better to pay known tax levels on your investments now versus when you withdraw them later at unknown tax levels. A Roth protects you from paying much larger, unknown future amounts of tax by paying taxes now.

Here are Taxable Retirement Accounts:

Your regular IRA accounts you funded with pre-tax dollars.
Your social security (Taxed if you have income above a certain amount each year.)
Any pensions.
Your real estate income.
All other mutual funds, stocks and other investments.

These are Your Non-Taxable Retirement Accounts:

Your Roth IRA withdrawals.
Any cash loans from qualified life insurance vehicles do not count towards your tax basis. (For example, Whole Life Policies and IUL’s. (Indexed Universal Life).
A reverse mortgage payment. (Just like cash from a life insurance policy, this is considered a loan and not a distribution.)

Finally, What is a Backdoor Roth IRA Conversion?

Now that you understand how valuable tax-free withdrawals are in retirement, you probably want access to this financial tool.

However, not everyone can use a Roth IRA. If you make more than $124,000 single, or $196,000 married in 2020, you cannot contribute fully to a Roth IRA. Moreover, if you make over $139,000 single, or $206,000 married, in 2020, you cannot contribute at all. Click here to read more on contribution limits.

So, what do you do to get these tax-advantaged withdrawals in retirement? In comes the backdoor Roth IRA conversion. If you make too much money to contribute to a Roth, or if you want to put more money than limits allow, into your Roth IRA, you can use the backdoor.

How Does it Work?

To start a Backdoor conversion, you first make qualified contributions to a traditional IRA.
Then, you roll these contributions over to a Roth IRA.
Of course, you must pay taxes on the contributions when you roll them over.

What Rules Apply to a Backdoor Roth IRA Conversion?

What is a Backdoor Roth IRA Conversion? - Medicare Life Health (3)

Now, you must pay close attention to the rules set by the IRS when you do a Roth conversion. If you do your conversion incorrectly, you may end up paying more taxes and fees than you bargained for.

First, make sure that you follow Traditional IRA rules for contributions including investing only earned income. Also, make sure you are within the age limits of investing in a regular IRA (70 1/2 as of 2020). Finally, make sure you pay taxes on investments where necessary. Remember, taxes now – at known levels – are better than taxes later – at unknown levels!

Conculsions

Back-door Roth IRA conversions are on the rise as a popular method to lower an investor’s tax basis in retirement. As of now, the government is okay with this as a strategy. We do not know, if this will change at some point, so take advantage of the “backdoor” while you can.

If you are looking for other ways to access tax-free cash in retirement, please read these articles:

Life Insurance in Retirement
What is Indexed Universal Life (IUL)?
Best Retirement Books
And, of course, Roth IRA Contribution Limits

FAQs

What is a Backdoor Roth IRA Conversion? - Medicare Life Health? ›

A backdoor Roth IRA is a conversion that allows high earners to open a Roth IRA despite IRS-imposed income limits. Basically, you put money you've already paid taxes on in a traditional IRA, then convert your contributed money into a Roth IRA, and you're done.

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Does a Roth conversion count as income for Medicare? ›

Roth conversions require you to understand the potential effect it has on your Medicare premiums. When funds are converted, the IRS sees this as income that has come out of the traditional IRA, which can raise your MAGI past a certain level, thereby increasing the premiums you pay for Medicare B and D.

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What are the downsides of backdoor Roth IRAs? ›

Cons: All or part of a backdoor Roth IRA conversion could be a taxable event. You may have to pay federal, state, and local taxes on converted earnings and deductible contributions. Conversions could kick you into a higher tax bracket for the year.

Does a Roth conversion count as income for healthcare? ›

Because Roth Conversions increase taxable income in the year of the conversion, if you rely on, or plan to rely on, an Affordable Care Act health plan and receive premium tax credits, you may want to determine whether Roth Conversions will reduce or eliminate your premium tax credits and weigh the trade offs of ...

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What are Roth IRA conversions? ›

A Roth conversion occurs when you move assets from a Traditional, SEP or SIMPLE IRA (collectively referred to as a Traditional IRA in this article) or an eligible distribution from your qualified employer sponsored retirement plan (QRP) — such as a 401(k), 403(b), or governmental 457(b) — and reposition them to a Roth ...

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Do Roth IRA withdrawals count as income for Medicare? ›

It does not include withdrawals from Roth 401(k)s and/or Roth IRAs. The IRMAA surcharge is determined by your earnings for two years prior to signing up for Medicare. Your income at 63 years old will affect what you pay for Medicare when you turn 65.

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What are the risks of a Roth conversion? ›

What Is the Downside of Converting From a Traditional IRA to a Roth IRA? The most obvious downsides are the hit to your current tax bill—your IRA withdrawal amount will count as taxable income for that year—and that you can't touch any of the money you convert for at least five years unless you pay a penalty.

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Is a Roth conversion reported as income? ›

The amount you convert from a traditional account to a Roth account is treated as income—just like all taxable distributions from pretax qualified accounts. Therefore the conversion amount is part of your MAGI, and it may move you above the tax's thresholds.

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Can I use my Roth IRA to pay for health insurance? ›

Health Insurance Premiums

As long as you are eligible, you can use your Roth IRA withdrawals to cover medical insurance premiums for you, your spouse, or your dependents. You will not be subject to the 10% penalty and earnings taxation as long as your withdrawals don't exceed your payment amounts.

What type of income does not need to be reported on the healthcare.gov application? ›

Income type	Include as income?
Veterans' disability payments	No
Worker's Compensation	No
Proceeds from loans (like student loans, home equity loans, or bank loans)	No
Child Tax Credit checks or deposits (from the IRS)	No

15 more rows

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When should you not do a Roth conversion? ›

Money that you'll need soon isn't a good candidate for conversion because your assets may not have time to recoup the taxes you would have to pay. You're currently receiving Social Security or Medicare benefits.

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At what age can you no longer do a Roth conversion? ›

However, there are no limits on conversions. A taxpayer with a pre-tax IRA can convert any amount of funds in a year to a Roth IRA. Roth IRAs also are exempt from required minimum distributions (RMDs). These mandatory withdrawals from retirement accounts begin at age 72 and can create a tax burden on affluent retirees.

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At what age does a Roth IRA not make sense? ›

Even when you're close to retirement or already in retirement, opening this special retirement savings vehicle can still make sense under some circ*mstances. There is no age limit to open a Roth IRA, but there are income and contribution limits that investors should be aware of before funding one.

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Do Roth conversions count as income? ›

Does Roth conversion count as earned income for Social Security? ›

Social Security Is Based on Covered Earnings

This includes salary, hourly wages, bonuses, commissions and self-employment earnings. Sources of retirement and investment income are specifically excluded from the Social Security benefit calculus. That includes Roth conversions.

Does a Roth conversion count as an RMD? ›

Sometimes you don't need your RMDs, but you are still forced to take them. You might be wondering, "does a Roth conversion count as an RMD?" The answer is simple: no. A Roth conversion does not count as an RMD.

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Is a Roth conversion included in adjusted gross income? ›

Before you decide to make a conversion your AGI and your modified AGI are both equal to $80,000. If you convert this IRA to a Roth IRA your AGI will increase to $200,000. But the conversion doesn't count as part of your modified AGI, so you can still make contributions to your Roth IRA.