What is a backdoor Roth IRA? What does it offer and how can you create one? Is it worth opening anyway? Hello and welcome to this post in which I will help you find the answers to the above questions, as you determine whether you will open a backdoor Roth IRA, or will simply look at the other available options. All you have to do is to read on till the end to find out.
What is a Backdoor Roth IRA?
The term “backdoor Roth IRA” refers to a type of conversion that makes it possible for people who have a high income to tactfully avoid paying Roth’s income limits.
Essentially, you usually put your money in a traditional IRA, after which you convert the funds you have contributed into a Roth IRA so that you can pay the due taxes and you are good to go. This means that even though you did not qualify to open a Roth IRA, you can get to enjoy the benefits of one anyway, regardless of your income status.
This should come as good news since you get the opportunity to see your money grow tax-free, which is quite beneficial to anyone who intends to maximize the size of their retirement fund.
What are the Roth IRA income limits?
In 2021, the US government only allowed those earning a modified adjusted gross income of less than $208,000 (for married contributors filing jointly) or $140,000 (for the single contributors), to open and contribute to a Roth IRA.
Those whose income is above this limit can take advantage of a backdoor Roth IRA so that they can see their money grow tax-free.
How to create a backdoor Roth IRA?
Here is how you can sail through with a backdoor Roth IRA conversion:
Put your funds in a traditional IRA account
You may already have your traditional IRA, but if you do not have one, you will have to open one and fund it.
Convert the contributions to a Roth IRA
It will be necessary to coordinate with your IRA administrator so that they can give you the right instructions on how to fill out the required paperwork to complete the conversion. If you do not have a Roth IRA at this juncture, you will be required to open a new one.
Paying the taxes
As per the rules set by the IRS, only post-tax dollars make their way into Roth IRAs. If you, as such, deducted your traditional IRA contributions and go with the backdoor Roth IRA creation process, then you will have to give back the tax deductions.
When the time to file your tax returns comes, you should be ready to pay income tax on the funds you moved to your Roth IRA.
Pay taxes on the gains in your traditional IRA
If you have had the funds in your traditional IRA for a while and there have been some investment gains, then you will have to pay the tax gains owed to the taxman.
The rules you should mind during the creation of a Roth IRA
You should mind the rules below to avoid getting penalized by the IRS:
Rules based on the type of transfer
You can only make your conversion in one of the following ways:
- A rollover, in which you receive the funds from your IRA and proceed to deposit them in your newly created IRA within 60 days.
- A trustee-to-trustee transfer, in which the traditional IRA service provider gets to send the money directly to a Roth IRA provider, or
- A “same trustee transfer”, in which the funds are transferred from your traditional IRA to your IRA, at the same IRA service provider.
The pro-rata rule for backdoor Roth IRAs
The IRS necessitates all the traditional IRA to Roth IRA rollovers to be done pro-rata. Basically, during the determination of your tax bill as you convert from a traditional IRA to a Roth IRA, the IRS examines all your traditional IRAs combined.,
If your traditional IRA comprises 80% pre-tax money and 20% after-tax money, this ratio will determine what percentage of the funds you convert to your Roth IRA is taxable. In this case, no matter the amount of money you convert, or the type of IRA you pull your money from, 80% of the funds you convert to the Roth IRA are viewed as taxable. The IRS will not allow you to only convert your after-tax money.
Note that the pro-rata rule is applied to one’s total IRA balance at the year, and not on the balance at the time of conversion.
Is creating a backdoor Roth IRA worth it?
You should refrain from opening a Roth IRA if:
- The only tax payment option for you is the funds you can access as your IRA withdrawals. If you decide to open a backdoor Roth IRA in such a financial state, you will end up sacrificing the expected investment growth on those funds. Also, if you are aged below 59.5 years, you will have to pay a 10% early withdrawal penalty to the IRS.
- You will need to use your money is 5 years (or less). The funds converted from any type of IRA to a Roth IRA automatically fall under the Roth 5-year rule, for which those who do not wait for a minimum of 5 years to take their withdrawals, end up owing the IRS taxes as well as a 10% penalty.
- Taking the withdrawal from your IRA will end up pushing you into a higher income tax bracket. The general recommendation is usually to convert just enough funds to ensure that you do not move a higher income tax bracket.
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That will be all for this post in which we have discussed what a backdoor Roth IRA is all about. I hope that you found it beneficial and that you now know whether you will be opening one. If you have any more questions about how you can convert your traditional IRA to a Roth IRA, drop them in the comments section, and I will respond to them ASAP. Also, let me know if you have considered opening a self-directed IRA.
I wish you well,
Eric, Investor and Team Member at Gold Retired!