If you want the take advantage of current low-income tax rates and set yourself up for tax-free income in retirement, Roth IRA is the best option. However, Roth IRA is unfortunately not an option for people with high incomes. But there is a way high-income earners can contribute to and take advantage of a Roth IRA – it’s called the backdoor Roth IRA.
What is a backdoor Roth IRA?
A backdoor Roth IRA is a strategy for retirement savings where you contribute to a traditional IRA and then immediately convert your IRA account to a Roth IRA.
Understanding backdoor Roth IRAs
Individuals who earn above a certain amount aren’t allowed to contribute or open Roth IRAs. But, traditional IRAs don’t have income limits. Moreover, since 2010, the IRS hasn’t set revenue limits to convert a standard IRA to a Roth IRA. This opens the backdoor for higher-income taxpayers to establish and contribute to a Roth IRA.
How to do a backdoor Roth IRA conversion?
Here are the key steps for backdoor Roth IRA conversion:
- Funding your IRA account: Fund it if you already have a traditional IRA account. If you don’t have one, you might need to open one and then put money into it.
- Converting to a Roth IRA: Your IRA administrator will provide you a short form to fill to go ahead with the process of converting IRA to a Roth IRA.
- Paying applicable taxes: You’ll have to pay income tax on the money you convert to a Roth IRA. You have until the tax deadline for the year in which the conversion was made to pay the applicable taxes on the converted amount.
Backdoor Roth IRA Rules
Follow these rules set by the Internal Revenue Service (IRS):
The Pro-rata Rule
The rollovers from traditional IRAs to Roth IRAs have to be done on a pro-rata basis. This is what it means:
To determine the tax bill on the conversion from a traditional IRA to a Roth IRA, the IRS looks at all of your traditional IRA accounts combined. For example, if all of your traditional IRAs combined has 80% pre-tax money and 20% after-tax money, this ratio helps to determine what percentage of the money you convert to a Roth IRA is taxable.
In this example, 80% of the amount you convert is taxable. The IRS applies this pro-rata rule to your total IRA balance at the end of the year and not at the time of conversion.
Types of Transfers
Only one of the following conversions is possible:
- Rollover: You withdraw money from your IRA and deposit it into a Roth IRA within 60 days.
- Same trustee transfer: This type of transfer involves transferring the money from the IRA to the Roth IRA at the same financial institution.
- trustee-to-trustee transfer: In this type, the IRA provider directly sends the money to your Roth IRA provider.
Tax Implications of a Backdoor Roth IRA
You cannot contribute to a Roth IRA directly if your annual MAGI is higher than a certain limit. If your income is above the phase-out limit, you cannot contribute to a Roth IRA at all.
Backdoor Roth IRAs allow high-income earners to bypass these limits as they don’t apply to backdoor conversions.
Roth IRA Contributions Limits for 2022
Tax filing status
Phase-Out Income Limit
|Married, filing jointly||
|Married filing separately||
Benefits of a Backdoor Roth IRA
Backdoor Roth IRAs offer tax benefits in the long run. In a backdoor Roth IRA, your contributions are made after-tax dollars, and everything after that is tax-free. This is the best advantage when you expect your income to be in a higher tax bracket later in life.
Another advantage of a backdoor Roth IRA is that you are not required to make Required Minimum Distributions (RMDs). This means your money in a Roth IRA grows tax-free. You can take as much or as little you want from your account or leave it all for your heirs to inherit.
When to avoid a backdoor Roth IRA?
A backdoor Roth IRA might not be the right strategy for everyone. For example, if you’re in a relatively high tax bracket right now but qualify for the traditional IRA tax deduction, a traditional IRA and not a backdoor Roth IRA will make more sense for tax optimization.
Is a backdoor Roth IRA worth it?
The backdoor Roth IRA strategy allows you can get your money into a tax-free account, doesn’t require you to take RMDs, and allows you to withdraw contributions whenever you want. That said, it isn’t the right strategy for everyone. Before you decide to go for the backdoor Roth IRA, ask yourself or your financial advisor whether it’s a sensible choice.
Is a backdoor Roth IRA legal?
A backdoor Roth IRA is legally permissible as long as the tax law requirements are met.
How do I set up a backdoor Roth IRA?
There are 3 ways:
- Put cash into a traditional IRA and then roll it into a Roth IRA
- Convert your entire IRA right into a Roth IRA.
- Make an after-tax contribution to a 401(k) and then roll it into a Roth IRA.
Why create a backdoor Roth IRA?
If you cannot open a Roth IRA because of your excess income, you may want to do it for the tax benefit of withdrawing tax-free funds in retirement. With a backdoor Roth IRA, it’s possible to open and fund a Roth IRA. This is a significant benefit if you expect to be in a higher tax bracket during retirement. Additionally, with a Roth IRA, you are not required to take RMDs. You have the choice to withdraw money when you want it or leave it all for your heirs.
Rick Pendykoski is the owner of Self Directed Retirement Plans LLC, a retirement planning company based in Goodyear, AZ. He has over three decades of experience working with investments and retirement planning, and over the last ten years has turned his focus to self-directed ira accounts and alternative investments. If you need help and guidance with traditional or alternative investments, call him today (866) 639-0066.