Date: March 21, 2022

Reduce Your Retirement Tax Bill With a Backdoor Roth Conversion

Capital gains and other taxes spike for higher income brackets, so reducing tax liability is crucial in high net worth investing strategies. 

Roth IRAs present a rare opportunity to accumulate gains and withdraw them tax-free in retirement. However, direct contributions are not allowed for higher-income individuals.

If your individual Modified Adjusted Gross Income (MAGI) is $144,000 in 2022 or your joint MAGI is $214,000 in 2022, you cannot contribute to a Roth IRA. 

However, there is another long-term investing strategy that allows you to capitalize on the retirement tax benefits of the Roth. It’s called a backdoor Roth conversion.


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Advantages and Limitations of a Roth IRA

Aside from rigid income restrictions on regular contributions, the downside of Roth IRAs is they are funded with after-tax dollars, and there is no upfront tax deduction. Money contributed or converted will be taxed the year it is added to the account.

On the bright side, as long as you’ve had the Roth for five years, after age 59½, you can withdraw your principal and earnings tax-free. In addition, there are no minimum distribution requirements. 

Traditional IRAs and 401(k)s have required minimum distributions starting at age 72 (or the year you retire if it’s later than that).

Since it doesn’t have distribution requirements, you can pass on a Roth IRA to your beneficiaries. In many cases, they will continue to benefit from its tax-free status for up to ten years after receiving it. 

You can see why many people interested in financial planning for high net worth individuals consider a Roth IRA to be an outstanding retirement planning tool. 


High Net Worth Investing Strategies: The Roth 401(k)

Before diving into the backdoor Roth IRA conversion details, there is another noteworthy high net worth investing strategy to consider. A growing number of employers are adding Roth options to their 401(k) plans. 

Like a Roth IRA, Roth 401(k) contributions have no tax advantage in the year funds are added to the account. However, there are no income limits to qualify for post-tax payroll deduction contributions. 

Once you are eligible for retirement withdrawals, your Roth 401(k) money is all tax-free.


Minimize Taxes on Your Backdoor Roth Conversion

scissors cutting stacks of coins implying minimizing taxes

A Roth conversion transfers assets from a traditional 401(k) or IRA into a Roth IRA. Unlike a regular contribution, there are no income limits on a Roth conversion. However, a Roth conversion is a taxable event in the year you do it.

There are three retirement planning strategies to limit or eliminate the tax consequences of a backdoor Roth conversion. They include:

  • Converting the account in a lower-income year
  • Making a non-deductible contribution to a traditional IRA or 410(k) and converting it to a Roth IRA in the same year
  • Leaving no pre-tax funds in any traditional IRA the year you make the conversion

What is a Non-Deductible Contribution?

If you’re planning to hold money in a traditional IRA or 401(k), you get to deduct your contributions from your gross taxable income and save money on your annual tax bill. 

However, if you’re using the backdoor Roth conversion as a high net worth investing strategy, you are sacrificing current-year tax benefits for tax-free growth and withdrawals in retirement. 

The first step is contributing to a traditional Roth or 401(k). Instead of using pre-tax dollars, you make a nondeductible contribution. There is an IRS Form 8606 your accountant or tax advisor will need to file as part of this strategy.

It’s critical to avoid holding nondeductible contributions in a traditional IRA indefinitely. This is because once you mingle the funds with pre-tax dollars, you may end up paying more taxes than necessary once you’re ready to withdraw retirement funds.

Nondeductible contributions also pave the way for the mega Backdoor Roth conversion. A few larger employers allow you to exceed 401(k) contribution limits with additional nondeductible contributions. 

In that case, you may be in a position to convert up to $45,000 a year into a Roth IRA – well above the normal limits.

Earnings Are Taxable on Conversion

Suppose you make your nondeductible contribution in January and wait until December to do the conversion while the stock market has a fantastic year. In that case, you will owe taxes on the earnings. 

On the one hand, it’s a good problem to have. However, it would be even better to earn those returns inside the Roth IRA.

To avoid paying taxes on earnings, either keep the contribution in cash or convert it into a Roth IRA immediately.

Holding Any Pre-Tax IRA Money Will Increase Your Roth IRA Conversion Taxes

Here is the caveat. This rule gets somewhat complicated: Your backdoor Roth conversion will be a taxable event if you’re holding pre-tax funds in traditional IRA accounts.

IRA distributions, including Roth conversions, are subject to “pro-rata” rules that look at all of your pre-tax IRA holdings on December 31st of each year. 

Your annual distributions are compared to your total holdings to determine the taxable percentage. If you’re in this situation, your accountant or registered investment advisor in CT can help you calculate how much of the conversion would be taxable.

There is a way to eliminate pre-tax IRA accounts subject to the “pro-rata” rules. Converting a sizable and long-held IRA to a Roth IRA could be expensive, especially if you’re in a higher tax bracket. 

However, if you rolled over your traditional IRA from a qualified retirement plan, you may be able to roll that money into the 401(k) account with your current employer. 

This strategy maintains your account’s pre-tax status but eliminates the “pro-rata” rules. Just make sure you don’t have any funds in an old 401(k) with a previous employer before proceeding.

The Five-Year Rule

wooden blocks arranged as stairs

Any funds converted into a Roth IRA must be held for five years to avoid paying a 10% withdrawal penalty. Even if you are already retired when you make the conversion, you must wait five years to realize the account’s tax benefits.

This rule applies to each conversion event. So, if you convert $20,000 from a 401(k) in 2022 and $21,000 in 2023, the first amount will qualify for tax-free withdrawal in 2027. The second amount will be available in 2028.


Quantify your retirement goals and determine the necessary steps to achieve them. Heritage Capital, LLC can help! 

High Net Worth Tax Strategies Are About Planning

The backdoor Roth conversion isn’t for everyone. However, with strategic planning, it allows high-net-worth investors to grow tax-free retirement income with no required minimum distributions. 

If you’re curious how a backdoor Roth IRA strategy may fit into your retirement planning, start a conversation with our registered investment advisors at Heritage Capital in Connecticut. Read our promise to you, and reach out today!


Paul Schatz, President, Heritage Capital