What is a Backdoor Roth IRA?
A backdoor Roth IRA is not a traditional retirement account. It is an informal term used for complicated, IRS-sanctioned method of funding a Roth for high-income taxpayers. It works even if their incomes exceed the limits allowed by the IRS for regular Roth contributions. Experienced financial advisors can assist you in this strategy.
Backdoor Roth IRA
Roth IRA or Roth 401(k) both allow taxpayers to contribute 6 to 7 thousand (depending on your age) and $19,500 dollars respectively, annually to a retirement savings account. These contributions are post-tax, meaning the income on those earnings is paid in the year the money is deposited.
However, traditional IRAs or 401(k)s give the earner an immediate tax advantage by deferring the income taxes on deposits until the money is withdrawn. The downside to this is that when withdrawals are made, the accountholder will owe taxes on both the money invested and their earnings.
Modified Adjusted Gross Income
The problem with these types of accounts is that once people reach a modified adjusted gross income in the six figures, the IRS starts phasing out the amount you can contribute. Then, when your annual income exceeds a certain amount, you cannot participate at all. These limits will depend on your taxpayer status and are adjusted every year or so to account for inflation.
Enter the backdoor Roth, which is essentially a strategy to convert a traditional IRA into one of the Roth variety. Since traditional IRAs don’t have income limits, the backdoor Roth has become an option for higher-income taxpayers who wouldn’t normally be able to contribute to a Roth.
Creating a Backdoor Roth IRA
There are a few ways to create a backdoor Roth IRA. First, you can contribute money to an existing traditional IRA and then roll those funds over to a Roth IRA account. Or you can rollover funds from an existing traditional IRA into a Roth, as much as you want at one time, even if it’s more than the annual contribution.
Another option is to convert your entire traditional IRA account to a Roth IRA account. Another strategy for making a backdoor Roth is by making an after-tax contribution to a 401(k) plan and then roll it over into a Roth IRA. Your financial advisor will help you choose the best strategy for your financial needs.
It’s important to remember that this is NOT a tax dodge. You will need to pay taxes on any money in your traditional IRA that hasn’t already been taxed. For instance, if you contribute $8,000 to a traditional IRA and then convert that money to a Roth, you will owe taxes on the $8,000 as well as whatever money it has earned.
Furthermore, most of the funds that you convert to a Roth IRA will count as income, which could push you up into a higher tax bracket. If this occurs though, you won’t have to pay full taxes on the money. Also, the funds you put into a Roth are considered converted funds, not contributions so you have to wait five years from the first conversion to have penalty-free access with some special exceptions.
Another positive of backdoor Roth IRAs is that they allow you to get around certain limits. Such as:
- Roth IRA contribution limits. For 2021 you can contribute $6,000 each year to a Roth URA. With a backdoor Roth IRA conversion, these limits don’t apply.
- Roth IRA income limits. For 2021, if your MAGI is higher than $140,000 if you’re single, or $208,000 if you’re married, (or a qualifying widow/widower) you can’t contribute to a Roth IRA. However, these limits do not apply to Roth IRA backdoor conversions.
More Advantages of Backdoor Roth IRAs
Aside from avoiding the limitations on Roth IRAs, why would a taxpayer want to take the extra steps for a backdoor IRA? First, Roth IRAs don’t have required minimum distributions. This means the account balances can create tax-deferred growth for as long as the account holder is alive. You can withdraw as little or as much as you want, when you want. Or you can leave it all to your heirs.
Another advantage is that a backdoor Roth contribution can offer significant tax savings over the decades since Roth IRA distributions are not taxable. Finally, the main advantage of a backdoor Roth IRA is that you pay taxes upfront for your contributions and everything after that is tax-free. This is very beneficial if you think tax rates will rise in the future or your taxable income will be higher after you retire than it is now.
Ask a Financial Planner in Northern Virginia About a Backdoor Roth IRA
If you are considering a backdoor Roth, it is important to speak to a financial advisor and consider the pros and cons of this strategy. To learn more about backdoor Roth IRAs and decide if this option is right for you, contact Argent Bridge Advisors today.