What is a Backdoor Roth IRA and How does it work?

Investment is important for our financial growth. How and w harness the best investment suitable for you? The ROTH IRA may seem far-fetched for you due to some of its requirements, however, you can still effectively make your investment realizable with an awesome investment scheme as the BACKDOOR ROTH IRA.

WHAT IS BACKDOOR ROTH IRA

A backdoor Roth IRA is a way for people with high incomes to sidestep Roth’s income limits. A backdoor Roth IRA is not an official type of retirement account.

Instead, it is an informal name for a complicated but IRS-sanctioned method for high-income taxpayers to fund a Roth, even if their incomes exceed the limits that the IRS allows for regular Roth contributions. 

Brokerages that offer both traditional IRAs and Roth IRAs provide assistance in pulling off this strategy, which basically involves converting a traditional IRA into the Roth variety.

HOW DOES A BACKDOOR ROTH IRA WORKS

Basically, a backdoor Roth IRA boils down to some fancy administrative work: You put money in a traditional IRA, convert your contributed funds into a Roth IRA, pay some taxes, and you’re done.

Even though you didn’t qualify to contribute to a Roth, you get to go in the back door anyway, no matter what your income.

That’s good news because your money grows tax-free — and that’s a pretty sweet perk when it comes time to take your money out in retirement.

Read: WHAT IS ROTH IRA AND HOW DOES IT WORK?

UNDERSTANDING BACKDOOR ROTH IRAS

A Roth IRA or Roth 401(k) allows taxpayers to set aside a few thousand dollars a year into a retirement savings account. The money deposited is post-tax.

That is, the income on those earnings is paid in the year the money is deposited.

That is different from a traditional IRA or 401(k), which gives the earner an immediate tax advantage by delaying the income taxes on the deposits until the money is withdrawn.

But when withdrawals are made, the now-retired accountholder will owe taxes on both the dollars invested and their earnings.

The problem is that people who earn above a certain amount aren’t allowed to open or fund Roth IRAs—under the regular rules, anyway.

If your modified adjusted gross income (MAGI) is well into the six figures, the IRS starts phasing out the amount you can contribute. Once your annual income exceeds a certain threshold, you cannot participate at all.

The limits, which vary depending on your taxpayer status (single, married filing jointly, etc.), are adjusted every year or so for inflation.

Traditional IRAs don’t have income limits. And, since 2010, the IRS hasn’t had income limits that restrict who can convert a traditional IRA to a Roth IRA.

As a result, the backdoor Roth has become an option for higher-income taxpayers who ordinarily couldn’t contribute to a Roth.

WHAT ARE PERKS OF A ROTH RETIREMENT ACCOUNT?

There are perks of a Roth retirement account that makes the backdoor strategy worth exploring for those who don’t qualify to contribute directly.

Aside from getting around the limits, why would taxpayers want to take the extra steps involved in doing the backdoor Roth IRA dance?

No Roth conversion limits: Currently, there are no limits on the number of Roth conversions you can make nor on the dollar amounts you can convert from your tax-deferred traditional IRA.

You can convert more of your current traditional IRAs;  however, you should work closely with your financial advisors and CPAs to understand the full potential tax liability in doing a larger conversion.

No Required Minimum Distribution rules: 

These are also known as RMDs. Certain retirement plans, such as traditional IRAs and 401(k) plans, require you to withdraw a minimum amount of funds each year once reaching age 72, based on the balance in your account.

This means account balances can create tax-deferred growth for as long as the account holder is alive.

You can take out as much or as little as you want when you want, or leave it all for your heirs.

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Defer tax for future beneficiaries:

The main advantage of a backdoor Roth IRA—as with Roths in general—is that you pay taxes upfront on your contributions, and everything after that is tax-free.

This characteristic is most beneficial if you think tax rates are going to rise in the future, or that your taxable income will be higher after you retire than it is now.

 If your heirs inherit your traditional IRA, they would be required to pay tax on any amounts that are withdrawn.

With a Roth IRA, however, they can withdraw these funds and pay no tax.

One other reason is that a backdoor Roth contribution can mean significant tax savings over the decades since Roth IRA distributions, unlike traditional IRA distributions, are not taxable.

SPECIAL CONSIDERATIONS FOR A BACKDOOR ROTH IRA

When attempting a backdoor Roth IRA conversion, you need to be aware of the quirks of IRAs and some special tax considerations.

Read: How Roth IRA Taxes Work

There Are Two Five-Year Rules for Backdoor Roth IRAs

The five-year rule states that in most cases—even if you’re over 59 ½—you generally cannot withdraw Roth IRA earnings free of taxes and penalties unless your first contribution to a Roth account was made at least five years ago.

You’re usually allowed to withdraw contributions from your Roth IRA at any time, free of penalties or taxes.

There is a second five-year rule, however, for backdoor Roth conversions. Because a backdoor Roth IRA is categorized as a conversion—not a contribution—you cannot access any of the funds held in the converted Roth IRA without penalty for the first five years after conversion.

If you do a backdoor Roth IRA conversion every year, you must wait five years to tap each portion you convert.

Otherwise, you risk paying additional penalties on money that’s already been taxed. There are exceptions to this requirement, though, if you’re 59 ½ or older or if you become disabled or die.

HOW TO MAKE A BACKDOOR ROTH IRA CONVERSION

Here’s a step-by-step guide on how to make a Backdoor ROTH IRA conversion:

Put money in a traditional IRA account. You might already have an account, or you might need to open one and fund it.

Convert your contribution to a Roth IRA. Your IRA administrator will give you the instructions and paperwork. If you don’t already have a Roth IRA, you’ll open a new account during the conversion process.

Prepare to pay taxes. Only post-tax dollars go into Roth IRAs. So if you deducted your traditional IRA contributions and then decide to convert your traditional IRA to a backdoor Roth, you’ll need to give that tax deduction back. 

When it comes time to file your tax return, be prepared to pay income tax on the money you converted to a Roth. And see below for details on the pro-rata rule, which plays a big part in determining your tax bill.

Prepare to pay taxes on the gains in your traditional IRA. If the money in that traditional IRA has been sitting there while and there are investment gains, you’ll also owe tax on those gains at tax time.

WHAT ABOUT ROTH IRA INCOME LIMITS

About those ROTH IRA income limits: For 2022, the government allows only those people with modified adjusted gross incomes below $208,000 (married filing jointly) or $140,000 (single) to contribute to a Roth IRA

Keep in mind that this is no tax dodge. When you convert money from a traditional IRA to a Roth IRA, you owe the taxes on the entire amount transferred in that tax year.

But as with any Roth IRA, you should owe no further taxes when you withdraw that money after retiring.

TAX IMPLICATIONS OF A BACKDOOR ROTH IRA

Keep in mind, this isn’t a tax dodge. You still need to pay taxes on any money in your traditional IRA that hasn’t already been taxed.

For example, if you contribute $6,000 to a traditional IRA and then convert that money to a Roth IRA, you’ll owe taxes on the $6,000.

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You’ll also owe taxes on whatever money it earns between the time you contributed to the traditional IRA and when you converted it to a Roth IRA.

In fact, most of the funds that you convert to a Roth IRA will likely count as income, which could kick you into a higher tax bracket in the year that you do the conversion. However, you don’t have to pay full taxes on the money; a pro-rata rule applies.

Also, the funds you put into the Roth are considered converted funds, not contributions. That means you have to wait five years to have penalty-free access to your funds if you’re under the age of 59½.

In this sense, they differ from regular Roth IRA contributions, which can be withdrawn at any time without taxes or penalties.

On the positive side, a backdoor Roth IRA lets you get around these limits:

Roth IRA income limits: For 2022, if your modified adjusted gross income (MAGI) is higher than $140,000 if you’re single ($139,000 for 2020) or $208,000 if you’re married filing jointly ($206,000 for 2020) or a qualifying widow or widower, you can’t contribute to a Roth IRA.3 These limits don’t apply to Roth IRA backdoor conversions.

Roth IRA contribution limits: For 2021 and 2022, you can contribute $6,000 each year ($7,000, if you are age 50 or over) to a Roth IRA. With a backdoor Roth IRA conversion, these limits don’t apply.

IS BACKDOOR ROTH IRA WORTH IT?

Backdoor ROTH IRAS is worth it for most high-earners. Once the Roth IRA conversion is complete, the account holder has effectively funded a Roth IRA.

The loophole makes it possible for anyone to invest and benefit from future tax-free growth and earnings.

Keep in mind that each Roth conversion you make is subject to the typical Roth IRA five-year rule.

For those who make multiple conversions, the IRS demands that the oldest conversions get withdrawn first when applicable. (The order of Roth IRA withdrawals goes, from first to last, contributions, conversions, then earnings.)

Those under age 59 and a half should avoid withdrawing within five years of their conversion, less they pay a 10% penalty fee (qualifying exceptions apply).

Read: What is Quantitative Value Investing? How it Works, Pros and Cons

TRADITIONAL IRAS THAT HOLD PREVIOUSLY DEDUCTED CONTRIBUTIONS

The IRS views all of your traditional IRAs as a single account when determining the taxes you owe on distributions.

Unfortunately, from the IRS’s standpoint, “distributions” include Roth IRA conversions. This fact greatly complicates backdoor Roth IRA conversions for people who already hold existing balances in traditional IRAs.

In practice, this means you may owe taxes on the money you intend for a backdoor Roth IRA conversion—even if the money has already been taxed. This happens when the IRS’s aggregation rule intersects with the pro-rata rule.

The pro-rata rule states that once money enters an IRA, you cannot separate the portion that’s already been taxed from the portion that was deducted from taxes. You may hear this described as the “cream in your coffee” rule.

Once cream hits the coffee, it’s impossible to separate the dairy from the java. The same goes for your pre-tax and post-tax IRA contributions.

Let’s say 80% of the funds in your combined IRAs earned tax deductions, and 20% did not earn any tax deduction. When you undertake a backdoor Roth IRA conversion, you can’t separate out the already taxed funds for conversion, much like the cream cannot be separated from the coffee.

In this example, 80% of the money being converted to a Roth IRA would be taxed in a Roth IRA conversion.

If you’re considering a backdoor Roth conversion, speak with a financial advisor to help you manage the process in a way that minimizes the amount of taxes you may owe.

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It could make sense to roll over some of your money into a 401(k), which is not considered in pro-rata calculations.

SOME STATES TAX BACKDOOR ROTH IRA CONVERSIONS

Most states that charge income taxes treat a backdoor Roth conversion in the same way as federal tax law. But some states will exempt some part of a pension or IRA distribution from taxes if the person is over a certain age.

Some states may exclude the entire conversion amount from tax, and states without an income tax law also don’t tax any conversion amounts.

Pennsylvania, New Jersey, and Massachusetts, for example, don’t allow a taxpayer to deduct contributions to an IRA from state taxes even if the contribution is deductible for federal income taxes.

WHAT ABOUT A ROLLOVER 401(K) TO ROTH IRA?

You can also access a backdoor Roth IRA by rolling over a traditional 401(k) into a Roth IRA.

Unlike a backdoor Roth, you will probably owe some kind of income tax on the money you convert, unless you made nondeductible contributions to your traditional 401(k).

Is a Backdoor Roth IRA Conversion Worth It?

Deciding whether a backdoor Roth IRA is the right move for you depends on your situation. Carefully consider the implications before moving forward.

WHO CAN BENEFIT FROM A BACKDOOR ROTH?

  • High earners who don’t qualify to contribute under current Roth IRA rules.
  • Those who can afford the taxes for a Roth conversion and want to take advantage of future tax-free growth.
  • Investors who hope to avoid required minimum distributions (RMDs) when they reach age 72.

Who Might Not Benefit from a Backdoor Roth?

  • Those who are already eligible to contribute to a Roth IRA.
  • Those who expect to use the converted funds within five years. The five-year rule applies to Roth conversions, so there could be a penalty for those under age 59 ½ who need to access converted funds during those first five years.
  • Those who have other traditional IRAs that create a situation under the aggregate and pro-rata rules that could complicate matters to the point the tax consequences outweigh the benefits.

If you have substantial funds in a traditional IRA or are unsure how to best manage your backdoor Roth IRA strategy, talk with a qualified financial advisor.

Read: What are Index Funds? Full Guide to Investing.

CAN ANYONE DO A BACKDOOR ROTH?

A backdoor Roth IRA is a retirement savings strategy whereby you make a contribution to a traditional IRA, which anyone is allowed to do, and then immediately convert the account to a Roth IRA.

WHEN SHOULD YOU DO A BACKDOOR ROTH?

Generally, you should only do a Roth conversion if you,

1) Have enough cash to cover your conversion taxes out of pocket (since no funds are withdrawn, only converted) and

 2) Know you will be in a higher tax bracket in retirement when your withdrawals are completely tax-free.

IS BACKDOOR ROTH STILL ALLOWED IN 2022?

Yes, backdoor Roth is still allowed in 2022, but the Roth IRA comes with income limits. You can’t earn more than $206,000 in 2022 and still directly contribute to a Roth IRA.

As a result, higher-income earners are shut out from contributing to a Roth, and thereby excluded from enjoying a fully tax-exempt retirement-savings vehicle.

DO YOU PAY TAXES TWICE ON BACKDOOR ROTH IRA?

When you go to make a distribution from the IRA in retirement, the original contribution comes out tax-free, but you’ll pay taxes on the earnings.

A backdoor Roth makes that IRA withdrawal shortly after the contribution, so you barely pay any taxes at all on the conversion to a Roth account.

IN CONCLUSION

Backdoor Roth IRAs are worth considering for your retirement savings, especially if you are a high-income earner.

A Backdoor Roth conversion can be something to consider if, you’ve already maxed out other retirement savings options.

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