Is a “Backdoor” Roth IRA Right for You?
Is your income higher than the maximum the IRS allows for regular IRA contributions? You may be in luck! A “Backdoor” Roth IRA is an IRS-sanctioned way for high-income taxpayers to fund a Roth IRA for retirement.
What is the difference between a Roth IRA and a “Backdoor” Roth IRA?
A traditional Roth IRA is a retirement savings account where taxpayers can deposit up to $6,000 each year or up to $7,000 if you are over 50 years old. The assets grow and can be withdrawn tax-free after age 59. However, if your income is over a certain amount, you are not eligible for a traditional Roth IRA.
High-income taxpayers are legally allowed to fund a “Backdoor” Roth IRA by converting a traditional IRA to a Roth IRA.
Taxes on “Backdoor” Roth IRAs
It is important to know that you may still be taxed on a “Backdoor” Roth IRA. Taxes will need to be paid on any money from the traditional IRA that has not already been taxed.
You will also be taxed on any earnings after the money was put in a traditional IRA and before it was converted to a Roth IRA. Many taxpayers make a contribution to a nondeductible-traditional IRA and then as soon as possible convert it to a Roth IRA. This works exceptionally well for taxpayers who do not already have any IRA accounts. Tax avoidance is much easier to accomplish under this scenario.
If money from a prior year’s deductible IRA or money from an IRA from a prior employer’s retirement plan is converted to a Roth IRA, the amount that is converted to the Roth IRA will be considered taxable income. This could move you to a higher tax bracket for the year.
There is good news! Traditional Roth IRAs have income and contribution limits, but these limits do not apply to “Backdoor” Roth IRAs.
Four Benefits of “Backdoor” Roth IRAs
1. You pay taxes upfront on your contributions but everything after is tax-free.
2. Roth IRAs are not taxable, so there can be significant tax savings.
3. Roth IRAs do not have required minimum distributions (RMDs) so funds in the account will grow tax-free as long as the account holder is alive.
4. After the time limitation is met, you can withdraw as much as you want whenever you want.
Three Ways to Create a “Backdoor” Roth IRA
1. Deposit money into an existing traditional IRA. Then, move the funds to a Roth IRA. There is no limit to the amount of money that can be rolled over.
2. Convert your traditional IRA to a Roth IRA. The IRA custodial bank or brokerage can assist with this process.
3. Make an after-tax contribution to a 401K. Then, move the funds to a Roth IRA.
Your CPA Can Help!
“Backdoor” Roth IRAs are complicated and they may not be the most advantageous choice for all high-income taxpayers.
We are happy to help you determine if it is beneficial to convert all or part of your existing IRA to a Roth IRA. Please contact us with questions or to start the process!