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When it comes to retirement savings accounts, there are several options available. But your choices for individual retirement accounts can seem limited if you’re a high-income earner. This is especially true when you look at the Roth IRA.
A Roth IRA (Individual Retirement Account) is an excellent way to save for retirement. Though you pay tax on the contributions, the growth and withdrawals in a Roth IRA are tax-free.
As with most retirement accounts, Roth IRAs come with a set of “rules.”
Two main rules limit the use of Roth IRA’s:
- You can contribute earned income, up to the $6000 limit annually ($7000 for those 50 and up), to a Roth or traditional IRA (2021)
- Your income must fall below the maximum income limits to contribute to a Roth IRA (single: $140,000, married: $208,000 in 2021)
If the tax advantages of a Roth IRA are appealing to you, but your income is too high to make contributions, there is still a way you can invest in a Roth IRA.
The “backdoor” Roth is a legal method you can use to take advantage of the benefits of Roth IRAs.
What is a Backdoor Roth IRA?
A “backdoor” Roth IRA means you’re converting money from a traditional IRA to a Roth IRA.
A backdoor Roth IRA is a strategy, not a retirement product. This strategy is a way to get around the income limits of the Roth IRA.
In 2010, the government removed the income limits for Roth IRA conversions. Currently, there are still no income limits on conversions from a traditional to a Roth IRA.
That said, there are potential tax consequences of making conversions. If you’ve made any tax-deductible contributions to your traditional IRA accounts, you will have to pay taxes at the time of the conversion.
How does a Backdoor Roth IRA Work?
At face value, a backdoor Roth IRA strategy is not difficult to carry out. But you should understand how it works before jumping right in, as mistakes happen. Most errors made with this strategy have tax implications.
How to do a Backdoor Roth IRA:
- Contribute $6000 to a non-deductible traditional IRA. (The traditional IRA can be either a new or old account.)
- Convert the $6000 contribution from your traditional IRA to a Roth IRA.
Note: Do the conversion in the same calendar year to make taxes easier. If you are using a tax-deductible IRA, or if part of your traditional IRA includes tax-deductible contributions, you will have to pay taxes on the contributions that were tax-deductible (see tax implications below). Talk to a CPA and/or do the tax calculations before making a conversion to see what effect a backdoor Roth IRA has on your taxes.
What are the Benefits and Drawbacks of a Backdoor Roth IRA?
- You pay taxes upfront, but growth and withdrawals are tax-free.
- If your income exceeds the income limits for contributing to a Roth IRA, the backdoor Roth is the only way for you to invest in a Roth. You can then take advantage of tax-free growth and withdrawals.
- If you expect your earnings and tax rate to be higher in the future, you could benefit from the backdoor Roth IRA strategy.
- There are no required minimum distributions (RMDs) for a Roth IRA during the account owner’s lifetime so the entire balance could be passed on to heirs.
- If you don’t understand the tax implications, you could end up paying more than you need or want to.
(If all or part of the contributions you’ve ever made to your traditional IRA were tax-deductible, you would pay taxes on some of the money converted to a Roth IRA. In this case, a conversion could mean you pay more in income taxes for the current year. See tax implications section below.)
- If you’re under the age of 59½, you have to wait five years to access the converted money – unless you want to pay the 10% penalty. Funds in a backdoor Roth IRA are considered converted funds, not contributions. (With a regular Roth IRA, you can withdraw contributions tax and penalty-free, but this is not the case with conversions.)
- It is impossible to predict how long the backdoor Roth IRA strategy will be available.
- If you wait too long to make the conversion, it could complicate your taxes.
The Tax Implications of a Backdoor Roth IRA
Taxes can get complicated when you’re converting money from a traditional IRA to a Roth IRA. That is if any of your original contributions to your traditional IRA were tax-deductible.
The taxes you pay on the conversion depend on how much of your combined traditional IRA contributions used pre-tax and after-tax money.
If your traditional IRA contributions used a mix of pre-tax money (tax-deductible) and after-tax money, you would pay taxes on the percentage of tax-deductible contributions you originally made to all your IRA accounts combined.
It’s essential to file IRS Form 8606 when you file taxes for the year to avoid excess taxation. Form 8606 tracks your non-deductible contributions to your traditional IRA. That way, when you convert this money to a Roth IRA, it is not taxable since you’ve already paid taxes on it.
- If you contribute $6000 to a non-deductible traditional IRA and convert that $6000 to a Roth IRA, you will not pay taxes on the conversion. (That is as long as you don’t have any past tax-deductible IRA contributions still sitting in an IRA account).
- If you’ve contributed $6000 to a tax-deductible traditional IRA and convert it to a Roth IRA, you will pay taxes on the entire conversion and any growth between the time of the contribution to the time it's converted to the Roth IRA.
- If you have a mix of tax-deductible and non-deductible traditional IRA contributions, you will pay taxes on the percentage of all your tax-deductible contributions. This is called pro-rata.
To figure pro-rata, calculate the percentage of tax-deductible contributions in all your traditional IRA accounts combined.*
For example, let's say you’ve contributed a total of $100,000 to all your traditional IRA accounts. $25,000 of these contributions used after-tax money and $75,000 of these contributions were tax-deductible.
You will owe taxes on 75% of the money converted to a Roth IRA. So if you want to convert $6000 from a traditional to a Roth IRA this year, you’ll pay taxes on 75% of that $6000, or $4500.
Backdoor Roth IRA tax implications can be confusing and complicated. It’s always a good idea to talk to your CPA or another tax professional, especially if you’ve made tax-deductible IRA contributions.
Is a Backdoor Roth Right for You?
You may want to consider a Backdoor Roth IRA if:
- You expect your income to be higher in the future when you make withdrawals
- Your income exceeds the limits to make contributions to a Roth IRA
- You won’t need the money for five years (if you’re under 59½), and/or
- You want to avoid the required minimum distribution (RMD).
If you decide a backdoor Roth is right for you, understand the process. Though it’s a simple process, mistakes are common.
Consider all the tax implications and how they will affect you and consult a professional if you have concerns or questions.
*If you have a 401k plan allowing you to roll in funds from other accounts, you may be able to avoid pro-rata. For more on that, this article is helpful.