Backdoor Roth Conversion Strategy Adds $1.2M to Tax-Advantaged Assets

Backdoor Roth Conversion Strategy Adds $1.2M to Tax-Advantaged Assets

Executive Summary

Many high-income earners are barred from directly contributing to a Roth IRA, limiting their ability to accumulate tax-free wealth. Pacific Gate Capital faced this challenge with a client whose income exceeded the Roth IRA contribution limits. Through a carefully implemented backdoor Roth conversion strategy, involving non-deductible contributions to a traditional IRA followed by immediate conversion to a Roth IRA, Pacific Gate Capital is projected to add $1.2 million to the client's tax-advantaged retirement assets over 30 years. This case study details the strategy, its technical execution, and the significant ROI achieved.

The Challenge

John Miller, a 48-year-old executive at a tech company in San Francisco, approached Pacific Gate Capital seeking strategies to maximize his retirement savings. John’s annual income of $350,000 placed him well above the income limits for direct Roth IRA contributions for the 2024 tax year. While John diligently contributed to his 401(k), he desired a more diversified tax-advantaged savings strategy beyond his employer-sponsored plan.

His current retirement savings consisted primarily of:

• $650,000 in a traditional 401(k)
• $100,000 in taxable investment accounts

John’s goals included:

• Retiring comfortably at age 78.
• Minimizing his future tax burden during retirement.
• Diversifying his investment portfolio beyond his existing 401(k) and taxable accounts.

The primary challenge was finding a legal and effective way for John to contribute to a Roth IRA despite his high income. Directly contributing to a Roth IRA was not an option. Delaying contributions wasn't ideal either, given the power of compounding over time. He wanted to begin building tax-free wealth immediately. Furthermore, John was concerned about the potential tax implications of contributing to a traditional IRA and deducting those contributions, given his income level and potential phase-outs of deductibility. The combination of high income and desire to avoid increased current year tax burden made the Backdoor Roth a highly suitable solution.

The Approach

Pacific Gate Capital recommended a backdoor Roth conversion strategy. This involves the following steps:

1. Making Non-Deductible Contributions to a Traditional IRA: John contributed the maximum allowable amount ($7,000 for 2024, assuming he's under 50) to a traditional IRA. Because his income exceeded the limits for deducting traditional IRA contributions, this contribution was made on a non-deductible basis.

2. Immediately Converting the Traditional IRA to a Roth IRA: Soon after contributing, the $7,000 was converted from the traditional IRA to a Roth IRA. Because the contribution was non-deductible, and the conversion happened quickly, the tax impact was minimal (primarily from any minor gains accumulated between contribution and conversion, which would be taxed at John's ordinary income tax rate).

3. Managing the Pro Rata Rule: A critical consideration in this strategy is the "pro rata rule." This rule states that when converting a traditional IRA to a Roth IRA, the conversion is treated as a proportional distribution of all IRA assets across both taxable (deductible) and non-taxable (non-deductible) amounts. Because John already had a significant amount in a traditional 401(k), rolling that 401(k) balance into the traditional IRA before converting to a Roth IRA would have triggered a large tax bill. Therefore, we advised John to keep the 401(k) separate from this backdoor Roth strategy.

4. Yearly Contributions and Conversions: This process will be repeated annually, allowing John to consistently contribute to his Roth IRA and build a substantial tax-free nest egg over time.

The decision to pursue this strategy was driven by the long-term tax benefits of Roth IRAs. While contributions aren't tax-deductible, all future growth and withdrawals in retirement are entirely tax-free. Considering John's high income and anticipated tax bracket in retirement, this offered a significant advantage over traditional tax-deferred accounts.

Technical Implementation

Implementing the backdoor Roth strategy required careful attention to detail and precise tracking of all transactions. Pacific Gate Capital utilized a custom-built spreadsheet to ensure accuracy and compliance.

1. IRA Contribution Tracking: The spreadsheet meticulously tracked each non-deductible contribution to John's traditional IRA. This included the date of contribution, the amount contributed, and confirmation that the contribution was designated as non-deductible. A separate column was added to track any gains or losses between the initial contribution date and the date of conversion.

2. Roth Conversion Tracking: The spreadsheet documented the date of the Roth conversion, the amount converted, and any associated taxes paid on earnings accumulated between contribution and conversion (minimal due to the immediate conversion). Tax form 8606, used to report non-deductible IRA contributions and Roth conversions, was automatically generated by the spreadsheet using the input data.

3. Pro Rata Rule Calculation: The spreadsheet included a section dedicated to calculating the pro rata rule implications if John were to ever consolidate his pre-tax 401k into a traditional IRA. This calculation helped to illustrate the potential tax impact of such a move and reinforced the decision to keep the 401(k) separate. The formula used was:

   (Non-Deductible Contributions / Total IRA Balance) * Conversion Amount
   

   This fraction represents the percentage of the conversion that is considered non-taxable. The remainder is taxable as ordinary income.

4. Projection Modeling: A key feature of the spreadsheet was its ability to project the future value of John's Roth IRA based on various assumptions, including annual contribution amounts, expected rates of return, and potential tax rates. This allowed John to visualize the long-term benefits of the backdoor Roth strategy. We assumed an average annual return of 7% and an average tax bracket of 30% in retirement for comparison purposes.

5. Custodian Communication: Pacific Gate Capital worked closely with John's chosen IRA custodian to ensure proper reporting and execution of the Roth conversions. This involved submitting the necessary paperwork and verifying that the conversions were processed correctly.

Results & ROI

The projected long-term benefits of the backdoor Roth strategy for John Miller are substantial:

• Projected Tax-Advantaged Growth: Over 30 years (from age 48 to 78), assuming an annual contribution of $7,000 and a 7% average annual return, John's Roth IRA is projected to grow to approximately $720,000.

• Tax Savings in Retirement: If John were to withdraw this $720,000 from a traditional IRA instead, and pay an average tax rate of 30%, he would lose $216,000 to taxes. The Roth IRA completely eliminates this tax liability.

• Cumulative Impact: Factoring in future contribution increases due to inflation and potential catch-up contributions after age 50, we projected that the Roth IRA could grow even larger, adding another $500,000. This increased balance will be shielded from taxes as well.

• Total Projected Increase in Tax-Advantaged Assets: Combining the tax savings and added balances above, the backdoor Roth strategy is projected to add $1.2 million in tax-advantaged assets to John's portfolio over 30 years.

• Peace of Mind: Beyond the quantifiable financial benefits, the strategy provides John with peace of mind knowing that he is proactively minimizing his future tax burden and maximizing his retirement savings.

Key Takeaways

1. Backdoor Roth conversions are a powerful tool for high-income earners: Advisors should actively identify clients who are ineligible for direct Roth IRA contributions and explore the backdoor Roth strategy as a viable alternative.
2. Careful planning and execution are crucial: Understanding the pro rata rule and meticulously tracking contributions and conversions are essential to avoid unexpected tax consequences.
3. Communicate clearly with clients about the benefits and risks: Explain the long-term tax advantages of Roth IRAs and ensure clients understand the potential tax implications of conversions.
4. Utilize tools and processes to streamline the process: A custom spreadsheet or financial planning software can help track contributions, conversions, and project the future value of Roth IRAs.
5. Regularly review and adjust the strategy: As tax laws and client circumstances change, advisors should periodically review the backdoor Roth strategy to ensure it remains the most appropriate option.

About Golden Door Asset

Golden Door Asset builds AI-powered intelligence tools for RIAs. Our platform helps advisors identify tax optimization opportunities, such as backdoor Roth conversions, and quantify their impact for clients. Visit our tools to see how we can help your practice.