Backdoor Roth contributions can be a powerful tool in retirement planning, particularly for individuals with high incomes. They offer a method for contributing to a Roth IRA even when income limitations would otherwise disallow contributions.
Financial advisors often have differing views on the benefits of backdoor Roth contributions, a variation that may stem more from their own interests than from an unbiased evaluation. In this article we explore conflicts of interests between fiduciary advisors and their clients, and why getting great advice is so important.
In This Insight
What is a backdoor Roth contribution?
A backdoor Roth contribution is an alternative method for individuals to contribute to their Roth IRAs, particularly those whose incomes are too high for a standard contribution.
Learn the basics of backdoor Roth contributions in this WealthGuideIQ article.
How much are they worth?
The value of backdoor Roth contributions is dependent on a variety of factors, including your age, tax rate, and investment portfolio. The value can range from a few hundred dollars to over a million.
Age: Backdoor Roth contributions are far more valuable for younger individuals, as they can be executed for many years. The longer you engage in backdoor Roth contributions, the greater the potential for accumulating tax savings over time.
Tax Rate: The higher your tax rate, the more valuable backdoor Roth contributions become. By sheltering future investment gains in a Roth account you save more in taxes due to your higher marginal rate.
Investment Portfolio: Portfolio's that generate more taxable income benefit more from Roth IRA accounts. This means equities with high dividend payouts or fixed income that produces ordinary income may benefit more from backdoor Roth contributions than an equity portfolio that is purely capital gains.
The worth of backdoor Roth contributions is further amplified by the fact that Roth IRAs do not require minimum distributions during the original account owner's lifetime. This differs from traditional IRA rules, which mandate that you take minimum distributions starting at the RMD age, which is currently set at 73 in 2024. Therefore, your money is allowed to grow tax-free for longer periods, potentially resulting in a larger fund at retirement. This provision further adds to the attractiveness of a backdoor Roth, particularly for high-income earners seeking to maximize their retirement funds' growth potential.
The value of backdoor Roth contributions depends on key factors such as an individual's age, tax rate, and investment portfolio.
Conflicts of interest for financial advisors
One key component of the backdoor Roth IRA contribution is the pro rata rule. The pro-rata rule dictates that when converting pre-tax IRA dollars to a Roth IRA, the conversion is prorated between pre-tax and post-tax dollars. Consequently, if your IRA accounts contain a significant amount of pre-tax dollars, you may end up owing income tax on a larger portion of the conversion than initially anticipated.
Individuals with large traditional IRA balances likely would not benefit from backdoor Roth contributions due to this rule. However, there is a workaround.
For individuals that have an active employer sponsored plan, such as 401(k), it is possible to roll existing traditional IRA monies into the employer sponsored plan and avoid penalties from the pro rate rule. This often can be very valuable for individual investors, particularly those that are younger.
This brings up a notable conflict of interest for financial advisors - even fiduciary advisors.
The majority of fiduciary financial advisors charge asset based fees, meaning the more assets under their management the higher the fees they collect. By rolling an existing traditional IRA back into an employer plan it often reduces the assets under management for an advisor, and thus, reduces their fees.
For this reason, be extremely careful when receiving advice on backdoor Roth IRA contributions and pay extra attention when an advisor says "it's not worth it". We believe that in most cases backdoor Roth IRA contributions are not only worth it, but substantially so. The best protection against conflicts of interest is consumer awareness and due diligence in selecting a financial advisor. When investigating potential advisors, investors should pay attention to the advisor's fee structure, regulatory record, and reputation for integrity.
They should also be alert to any signs that an advisor might be selling products or strategies for their own gain. In the case of backdoor Roth contributions, clients should question their advisor about the strategy's pros and cons and any potential alternatives before making a decision.
Investors must be prudent in selecting a financial advisor to avoid conflicts of interest, as these can negatively impact decisions regarding beneficial strategies like backdoor Roth contributions.
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Final Thoughts
It is vital to understand the financial significance and implications of backdoor Roth contributions. A backdoor Roth contribution allows for a strategic means of sidestepping income limitations, providing enhanced opportunities for wealth accumulation within a Roth IRA. However, the potential monetary advantage of this strategy is determined by one's specific tax situation and projected future tax environment. When choosing their contribution strategy, individuals should also be aware of potential conflicts of interest for financial advisors. Maintaining transparency and aligning interests is crucial to ensure the most beneficial outcomes.