Breaking down the backdoor Roth IRA strategy

A Roth IRA can be a solid option for growing your retirement savings. You fund the account with after-tax dollars, your earnings can grow tax-free and you won't pay income taxes on qualified withdrawals.¹

But the significant tax advantages of a Roth IRA are designed to exclude high earners. If you make more than the income limit, you can't contribute to a Roth IRA. If this applies to you, a backdoor Roth IRA conversion could be a workaround.

With tax-advantaged Roth products, the IRS places income limits on certain groups based on their filing status and modified adjusted gross income (MAGI). Depending on your situation, you only may be eligible to contribute a reduced amount to a Roth IRA—or not be allowed to contribute at all.

• If you make between the maximum MAGI listed, you can contribute but it will be a reduced amount.
• If you make equal to or more than the maximum limit listed, you can't contribute anything to a Roth IRA.

A backdoor Roth IRA lets you indirectly fund a Roth IRA even if you earn more than the income limit. You do this by funding a traditional IRA, which doesn't have income limits, and then converting the traditional IRA to a Roth IRA. While there is a cap on how much anyone, regardless of income, can contribute to their IRAs every year (there aren't any Roth conversion limits):

• In 2023, the IRA contribution limit is $6,500 for people under 50 and $7,500 for ages 50 and over.
• In 2024, the IRA contribution limit is $7,000 for people under 50 and $8,000 for ages 50 and over.

High earners may consider this strategy so they can tap into the key Roth IRA benefits of tax-free growth and qualified withdrawals. Especially if you think you'll continue to have a high income in retirement, it can help your savings go further by not paying high tax-bracket rates on your withdrawals.

Creating a backdoor Roth IRA is relatively straightforward. Here are the basic steps:

• Put money into a traditional IRA. Ideally, you'd fund this account with a nondeductible contribution using after-tax dollars, since only after-tax dollars can go into a Roth IRA. You'll have to keep annual contribution limits in mind, although your total conversion amount isn't restricted.
• Convert the traditional IRA to a Roth IRA. You may need to open a new account if you don't already have a Roth IRA.
• Potentially pay taxes. Certain conversion scenarios may cause tax implications.²

If a backdoor Roth IRA seems a lot like an everyday Roth IRA conversion, it's because they're largely the same process. One key difference is the tax implications of the move. A regular Roth conversion is usually simple, in that the money in the traditional IRA or a 401(k) that's being converted tends to be all pre-tax dollars, and the conversion triggers a tax payment on that money.

With backdoor Roth IRAs, however, working out the taxes can be much more complicated—there could be no additional taxes owed, some taxes owed or full taxes owed.

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A backdoor Roth IRA doesn't get you out of paying taxes on the contribution amount—but it may be possible that you won't need to pay additional taxes at conversion time. If you've made no other IRA contributions for the year, open a new traditional IRA, fund it entirely with a lump sum of nondeductible, after-tax dollars and then immediately convert it, you could avoid additional tax liability. That's because you, in theory, would already fully have paid the income taxes on those converted dollars.

The nuances of a backdoor Roth IRA conversion, especially if you hold multiple IRAs, can get complex and may result in a large tax bill. Here is a possibility to consider:

If you're converting some or all of your money from an existing IRA, it's also possible you've made earnings on those contributions. You'll need to pay taxes on any earnings made on the contribution between when the money was contributed to the traditional IRA and when it was converted to a Roth IRA.

When determining your tax bill for this kind of conversion, the IRS looks at the funds from all your traditional IRA accounts. If, for instance, your combined traditional IRAs contain 75% pre-tax money and 25% after-tax money, that proportion governs the taxable percentage of your conversion. In this example, 75% of the converted amount to the Roth is subject to taxes regardless of the amount you convert. The pro rata rule applies to your total IRA balance at the end of the year, not just at the time of conversion.

The best approach in all situations is to enlist the help of a tax professional in addition to consulting your financial advisor. While Thrivent does not provide specific legal or tax advice, we can partner with you and your tax professional or attorney.

Like any retirement strategy, a backdoor Roth has advantages and drawbacks that may sway your decision. Here are some common ones to help you weigh what's best for you.

• As a high-income earner, you can gain access to tax-free qualified withdrawals in retirement.
• Roth IRAs aren't subject to required minimum distributions. Your earnings can keep growing tax-free until you need to withdraw them.
• You can add more tax diversification to your investments. A mix of tax-now and tax-later retirement accounts can help you manage your tax liability more effectively.
• Your beneficiaries may have access to tax-free qualified withdrawals.

• Certain conversion situations might push you into a higher tax bracket.
• It could affect how much of your Social Security is taxed.
• It could affect your Medicare Part B premium.
• The pro rata rule can complicate your strategy if you have existing pre-tax IRA funds.
• You might lose out on deducting contributions to a traditional IRA.
• Any funds you convert into a Roth are considered converted funds rather than contributions, which will trigger the Roth IRA five-year rule for conversions. This means that, unless you meet an exception, withdrawing funds within a five-year period (starting on Jan. 1 of the year you made the conversion) would likely involve a 10% penalty on the amount you converted.

Now that you have a better understanding of how a backdoor Roth IRA works and how it may benefit your needs, consider speaking with a local financial advisor. They can review your income, your retirement savings goals and the potential benefits of a backdoor Roth to see how this strategy could fit into your overall financial plans.