What Is a Backdoor Roth IRA?
A backdoor Roth IRA is a way to contribute to a retirement account even if you’ve already reached the contribution limit for the year. It involves setting up a traditional IRA and converting it into a Roth IRA. This allows high-income earners to benefit from the tax savings of a Roth IRA. Otherwise, they would not qualify for those savings due to income limits set by the IRS.
- Typically, high-income earners cannot contribute to a Roth IRA due to income limits. The Backdoor Roth IRA strategy makes it possible to get around this restriction.
- A backdoor Roth IRA is a strategy that involves converting a traditional IRA into a Roth IRA.
- The pro-rata rule states that during a Roth IRA conversion, you must pay taxes on the untaxed percentage of funds from your traditional IRA.
Benefits of a Backdoor Roth IRA
The Roth IRA differs from a traditional IRA in two important ways that make these accounts very appealing to investors:
- No Required Minimum Distributions (RMDs): Owners of traditional IRAs must begin withdrawing money at age 73 (the age will rise to 75 in 2033). There is no RMD for Roth IRAs. This allows the investments inside the account to continue growing. Because of the ability to keep your money in your Roth IRA indefinitely, some people use these accounts to pass on wealth to their heirs.
- Tax-Free Growth: Withdrawals from a traditional IRA during retirement are subject to income taxes. But Roth IRA withdrawals are not subject to taxes because the IRS taxes that money upfront. This allows your money to grow over time through the investments inside your IRA account. However, when you withdraw that money, you won’t pay any taxes on the growth.
Because the tax savings of a Roth IRA are so advantageous, individuals must have an income below $153,000 (below $228,000 for married couples) to qualify for this benefit.
High-income earners would be stuck with traditional retirement savings accounts if it weren’t for the backdoor IRA strategy. This strategy allows you to convert your traditional IRA into a Roth IRA, regardless of your income.
How to Set Up a Backdoor Roth IRA
Setting up a backdoor Roth IRA involves three main steps. Here’s what you need to do:
Open a Traditional IRA
- Choose your IRA provider: You can open an IRA through most banks, credit unions, brokers, and investment companies. Consider which providers charge annual fees or fees for each trade. Here are a few popular IRA options with $0 trade fees and plentiful educational resources for investors:
- Open your account: Usually, this step includes providing personal information and identification. You’ll also need to select your preferred contribution method and who the account will pass to when you die.
- Fund your account: You can contribute up to $6,500 to your IRA in 2023 or $7,500 if you’re over age 50. It’s best to contribute once per year to simplify how you report your taxes. So, if you can, add that $6,500 or $7,500 all at once.
Once you’ve funded your traditional IRA, leave the money in cash until you can transfer it to a Roth IRA. It’s best to avoid any growth through investments while it’s still in your traditional IRA. Investment growth can complicate the Roth conversion process, as well.
Convert Your Traditional IRA to a Roth IRA
- Open a Roth IRA: You can set up your Roth IRA with any provider, but the process will be most simple and quick if you choose the same provider you used for your traditional IRA. In fact, many financial institutions will have you first open a traditional IRA with them, if you don’t have one already, before allowing you to convert funds into a Roth IRA.
- Fill out the necessary forms to convert your traditional IRA into a Roth IRA: Most IRA providers will have an online form for you to fill out to move your funds into a Roth IRA.
- Begin investing: Once you have converted your traditional IRA into a Roth IRA, be sure to invest your contributions so they can begin growing.
How Do Taxes on Backdoor IRAs Work?
The backdoor IRA doesn’t allow you to avoid taxes altogether. Often, the money inside a traditional IRA is pre-tax money. But because Roth IRA withdrawals are tax-free, you cannot put untaxed money into a Roth IRA. If the money inside your traditional IRA has never been taxed, you’ll need to pay taxes during the Roth IRA conversion.
However, you won’t need to pay taxes while converting your IRA if the money inside your IRA has already been taxed. The backdoor IRA is for high-income earners who did not qualify for a tax deduction when contributing to a traditional IRA, so their IRA funds have been taxed already. You’ll only need to pay taxes for a backdoor IRA if you contributed money to a traditional IRA when your income was lower.
Imagine you have been making over $153,000 in annual salary for the last five years. Five years ago, you opened a traditional IRA and have been contributing to it regularly. You now have learned about the backdoor Roth IRA, so you’d like to convert your traditional IRA.
Because you have only been contributing to your traditional IRA as a high-income earner, you never qualified for a tax deduction. So you don’t have to pay taxes when doing a Roth IRA conversion because the money has already been taxed.
The pro-rata rule states that if you have 30% tax-deductible money and 70% non-deductible money inside your traditional IRA, you cannot avoid taxes by moving only the post-tax money into a Roth IRA. No matter which funds you choose to move into a Roth IRA, you’ll need to pay taxes on 30% of it because that’s the amount you have not yet paid taxes on.
If you have $10,000 in your IRA and $3,000 came from tax-deductible contributions, and $7,000 came from nondeductible contributions, 30% of your money is un-taxed, while the other $7,000 has already been taxed.
Some people think they can convert $7,000 to a Roth IRA and avoid paying taxes. But because 30% of your traditional IRA has not yet been taxed, no matter how much you convert into a Roth IRA, you’ll have to pay taxes on 30% of it. So if you choose to convert $7,000 to a Roth IRA, you’ll pay taxes on $2,100. The IRS taxes that $2,100 at the same rate as regular income.
A Reverse Rollover Can Help You Avoid the Pro-Rata Rule
In a reverse rollover, you move money from an IRA to a 401(k). This is in contrast to a traditional rollover. The traditional rollover involves moving money from a 401(k) to an IRA. Individuals who have a percentage of untaxed money in their IRA can use this strategy to avoid a tax bill during a backdoor Roth IRA conversion.
To do this, move all your untaxed money into your 401(k) before doing the conversion. Then, convert the remaining money in the IRA to a Roth IRA. Since all the remaining money is already taxed, you won’t have to pay taxes during your IRA conversion.
Not all 401(k) plans allow reverse rollovers, so before you plan on using this strategy, check to see if it is possible with your current plan.
Who Is a Backdoor Roth IRA Best For?
The Backdoor Roth IRA has many advantages, but it’s not right for everyone. If you’re considering this strategy, make sure you meet these two characteristics:
- You are a high-income earner: Remember, if you earn less than $153,000 annually (or $228,000 annually if you’re married and filing jointly), you don’t have to use the Backdoor IRA strategy. You can fund a Roth IRA without going through all the extra steps.
- You don’t need access to these funds in the near future: There are strict rules about when you can begin withdrawing money from a Roth IRA. You will not be able to withdraw your IRA contributions or earnings during the first five years of holding your account. If you need to withdraw money from your account before the five years are up, you’ll have to pay a 10% penalty.
After the five years are up, you can withdraw your contributions. However, your earnings will not be accessible until you’ve reached age 59 and a half. Accessing your earnings early also results in a 10% penalty.
Consult With a Financial Expert to Maximize Retirement Savings
The Backdoor Roth IRA method is an advanced tax strategy to maximize your income in retirement. But just like many tax strategies, it comes with certain laws and regulations. Before pursuing this strategy, consult with a tax professional to ensure it’s the best way to save money.
And while IRAs are excellent savings accounts that prepare you for retirement, they shouldn’t be your retirement plan. Look into each of these investment options to ensure you’ll be prepared when you’re ready to quit working:
- 401(k): Many people have access to a 401(k) but choose not to max it out. As of 2023, you can contribute up to $22,500 to your 401(k) each year. Before moving on to other investments, be sure you’re contributing as much as possible to this account.
- Real Estate: Real estate is an excellent option for securing income in retirement. Many retirees live comfortably off rental income because they planned ahead and purchased an investment property while they were young.
- Annuities: An annuity is a contract with an insurance company. In exchange for an upfront payment, owners of fixed annuities are guaranteed a certain amount of income. The income is for a specified period of time, usually during retirement or until death.
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