If you are wondering what in the world a “backdoor Roth IRA” is, you're not alone! In short, if you've been frustrated by the contribution limits associated with Roth IRAs, then read on - this article describes a strategy that designed to help.
We all know that the IRS imposes annual contribution limits for both traditional and Roth IRAs. For most people, that limit is currently set at $6,000 ($7,000 if you're age 50 or older) 1, but if your income is high (as in 'healthily into six figures' high) your permitted Roth contribution may be reduced or eliminated altogether. The calculations for determining those limits are a bit complicated and involve your modified adjusted gross income (MAGI), tax filing status, and more. This page on the IRS site provides all the details.
The backdoor Roth IRA is an IRS-sanctioned strategy that involves converting a traditional IRA or 401(k) account (which are not subject to income-determined contribution limits) to a Roth IRA as a legal workaround for high earners whose income would normally prohibit Roth contributions.
Some key points to keep in mind about the backdoor Roth IRA strategy:
- Only one Roth IRA conversion is permitted per year.
- You'll still pay taxes on the funds in the year they convert, but the end result will be a Roth IRA account.
- Funds deposited to a Roth in this manner count as converted funds rather than contributions, meaning that for five years you'll be subject to penalties if you make withdrawals prior to age 59½.
- Roth IRA conversions are not subject to the current $6,000/year ($7,000 if you're age 50 or older) contribution limits.
- It's often advisable to convert a traditional IRA established for the conversion immediately. If you accumulate gains in your traditional IRA before conversion, you'll likely have to pay taxes on those gains as well.
- The backdoor Roth IRA pro-rata rule is a little-known, but highly important regulation that can have significant implications for anyone executing a backdoor Roth IRA conversion. It stipulates how the IRS will treat pre-tax and after-tax contributions when the taxpayer executes a Roth conversion. Talk with your tax advisor before converting non-deductible IRA to Roth.
Creating a backdoor Roth IRA
There are several common ways to implement this strategy, including:
- Contribute money to a new traditional IRA account and then roll the funds over to a Roth IRA.
- Roll over a portion of an existing traditional IRA account into a Roth. As mentioned above, this can be any amount, even if that amount exceeds the annual contribution limit.
- Similarly, you can convert an entire traditional IRA account to a Roth IRA account.
- Make an after-tax contribution to a 401(k) plan and roll it over to a Roth IRA.
In each of these instances keep in mind that you'll generally have to pay taxes on any contributions or earnings rolled into a Roth IRA account if they haven't been taxed before.
Backdoor Roth IRAs can be a valuable strategy for high earners who generally can't make Roth contributions, for those who value future tax-free growth, or for avoiding required minimum distributions down the road. But… they can be complicated to implement. We'd love to help you explore the possibilities and map out a plan if you feel that a backdoor Roth IRA could play a valuable role in your retirement portfolio.
Investing involves risks including possible loss of principal. No investment strategy or risk management technique can guarantee return or eliminate risk in all market environments.
This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.
The Roth IRA offers tax deferral on any earnings in the account. Withdrawals from the account may be tax free, as long as they are considered qualified. Limitations and restrictions may apply. Withdrawals prior to age 59 ½ or prior to the account being opened for 5 years, whichever is later, may result in a 10% IRS penalty tax. Future tax laws can change at any time and may impact the benefits of Roth IRAs. Their tax treatment may change.
Traditional IRA account owners should consider the tax ramifications, age and income restrictions in regards to executing a conversion from a Traditional IRA to a Roth IRA. The converted amount is generally subject to income taxation.
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