Roth IRA conversions, also knows as backdoor Roth IRAs, allow you to convert funds you’ve saved in a pre-tax account like a traditional IRA into Roth dollars. This transaction is favored by individuals whose income limits prevent them from contributing to Roth accounts and enjoying the benefits these powerful plans offer.
As with other retirement plans, income in Roth accounts grows tax free. But distributions in retirement from Roth IRAs are tax free, as well. Additionally, distributions from the plan are not counted as income, which can greatly reduce your income tax liability in retirement. These are the main reasons why individuals who can’t contribute to Roth IRAs perform Roth IRA conversions with existing IRA or 401(k) funds. Read on to learn additional benefits and reasons you might want to convert your funds, too.
Why Can’t Everyone Use a Roth IRA?
While these are popular retirement plans, not everyone is eligible to contribute to 
one. There are Roth IRA income requirements you must meet in order to make annual contributions. In 2023, if you’re married filing jointly with a modified adjusted gross income (MAGI) of more than $228,000, or single/head of household with a MAGI of over $153,000—you’re not eligible to open an account.
However, you can open a Roth and perform a conversion with funds from another IRA or old 401(k) regardless of your MAGI, which is why Roth conversions are sometimes called backdoor Roth IRAs.
The Benefits of Roth IRA Conversions aka Backdoor Roth IRAs
The main attraction of Roth IRAs is the ability to avoid paying tax on distributions of earnings in retirement. Since distributions are not considered ordinary income, you can avoid higher income tax rates and potentially a high annual tax bill in your golden years.
Conversions are performed so people can enjoy these Roth IRA benefits:
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- Earnings on investments in the plan grow tax free and are unlimited.
- Qualified distributions are tax free in retirement.
- Withdrawals of your contributions can be made at any time without tax or penalty.
- Roth IRAs don’t require minimum distributions upon retirement, allowing your funds to continue growing in your plan.
- Once you’ve owned a Roth IRA for 5 years and are 59 ½ years or older, you can take tax-free distributions from the earnings in the account at any time, for any reason. The Roth five-year rule clock for conversions starts on January 1 in the year you converted to a Roth account.
- Your beneficiaries do not have to pay tax on distributions of unused funds they inherit.
How Roth IRA Conversions Work
Roth conversions are taxable events. This is important to understand because if you decide to convert, you’ll pay taxes on the funds or assets you convert.
Remember, your typical IRAs and 401(k)s are tax-deferred accounts. Contributions to those plans were made with pre-tax dollars, and you pay taxes on distributions in retirement. In many cases, people can take a deduction on their income taxes for contributions to IRAs.
But Roth IRA contributions are made with taxed income dollars; they are not tax-deferred contributions. That’s why qualified distributions from a Roth are tax free. So, if you convert to a Roth plan from a pre-tax plan, the government wants to tax those funds you initially deferred when you contributed to your IRA or 401(k). And they’ll get it when you make a Roth IRA conversion.
The amount you convert to a Roth IRA in a given tax year is considered ordinary income in that year. Going forward though, the benefits you gain with a Roth IRA vs a traditional IRA or 401(k) may make this move worth it, as your funds now will be growing tax free, rather than tax deferred.
Conversion Considerations
It’s important to understand the tax implications of conversions:
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- The amount of money (or assets) converted to a Roth is categorized and taxed as ordinary personal income for the year you make the conversion.
- Personal losses you may incur for that tax year can help offset the income from the conversion. (Talk to your CPA each year and don’t miss an opportunity to convert with less tax consequence.)
- Try not to pay the conversion tax with retirement funds. Otherwise, you may be subject to additional taxes and penalties the following year depending on your age.
- When converting assets (other than cash), you need a current fair market value to use for the conversion. If the value of this asset is historically low, that can be a great time to convert.
The tax on Roth IRA conversions can create a large tax liability for you in your conversion year. Depending on your situation, the tax liability may be more than it’s worth. So, make this decision carefully and discuss it with your tax professional.
Deadline to Perform a Roth IRA Conversion
If you do decide a backdoor Roth conversion is a good move, you have until December 31 to count for the current taxable year. So, if you want your conversion to count for 2023, you must perform the transaction by December 31, 2023.
Step Up Your Investing Power with a Self-Directed Roth IRA
Self-directed Roth IRAs enjoy all the benefits of a conventional Roth account. But self-directed accounts have two significant advantages that the conventional account does not.
1. Control over your investing funds and decisions.
When you self-direct your IRA, you are in charge of choosing assets for your plan. You don’t depend on the plan administrator or broker to make these decisions for you. Instead, you use your knowledge and expertise to invest in assets you know and understand.
2. Invest in alternative assets to grow wealth in your plan.
Conventional accounts are limited to investments the plan administrator or custodian sells. But self-directed retirement plans have access to a much wider pool of alternative investments to the stock market—assets other than traditional stocks, bonds, and mutual funds.
Alternative investments include real estate, private equity, gold, private lending, cryptocurrency, and much more. This is where your knowledge comes into play. You can invest in things you understand to gain critical diversity in your plan and drive higher (tax-free!) returns. And, you don’t have to worry about stock market volatility. You can rest easy knowing your alternative assets have the potential to continue generating income regardless of how the stock market performs.
Alternative assets can earn income at a faster pace than traditional assets. And when you can invest within your own level of expertise, you have the potential to increase your odds for success. This kind of control over your retirement funds and investing decisions allows you to add diversity to your portfolio to help you weather the volatility of the stock market.
Final Thoughts on Roth IRA Conversions / Backdoor Roth IRAs
Roth IRA conversions give you access to Roth IRA benefits in retirement if your income is too high for you to simply open this retirement plan with an annual contribution. Conversions are not considered contributions, which means the income requirements don’t apply in these transactions. If you think your tax liability today is less than you may face in retirement or are concerned with higher tax rates, discuss a conversion with your tax advisor. Converting your current IRA or 401(k) funds may be a great move for you.
If you have questions about Roth IRA conversions or if you want to discover how self-directed retirement plans can help you build retirement wealth, contact Advanta IRA today. We are always happy to help you learn how to maximize the benefits of your retirement plans.
Additional reading on Roth IRAs:
10 FAQs about a Self-Directed IRA (SDIRA) + Alternative Investments
How Safe Are Your Retirement Savings When Stocks Tumble?
Rehab Investments vs Rentals in an IRA during High Interest Rates and Inflation
This article was initially published in June of 2020 and has been updated with current information.
