A Roth IRA is an excellent choice for many investors. It’s funded with after-tax dollars and grows tax-free.
You are not required to withdraw the funds on a schedule; you can even leave it to your heirs. All other IRAs and retirement funds give you a tax advantage initially, but have some constraints later on.
But not everyone can open a Roth IRA due to income limits. For 2023, the absolute income limit for a person filing as a single taxpayer is $153,000.
The income limit for a person filing as a married person is $228,000. (The amounts include partial and entire contribution limits as well.) If your adjusted gross income exceeds this amount, the Roth IRA is not an option.
Enter the backdoor Roth IRA—a strategy to allow those with a higher income to take advantage of tax benefits associated with the Roth. It involves the conversion of their funded traditional IRA to a Roth IRA.
What is a Backdoor Roth IRA?
A backdoor Roth IRA is not a new type of retirement account, but a strategy for those who exceed the income limits to take advantage of the post-tax growth that the IRA is known for.
While it is funded with existing dollars from a traditional IRA (which is funded with pre-tax dollars), you are not avoiding taxes. Taxes are paid on the principal, earnings, and appreciation of the transferred funds upon Roth IRA conversion.
Once the funds are in the Roth IRA, the money can now grow tax-free. You can withdraw the funds (and the appreciation) tax-free when you reach 59 ½ and have held the Roth for at least five years.
So, paying taxes when the balance is low might be beneficial if you plan to hold the Roth for a significant period of time.
Roth IRA VS Traditional IRA
There are a couple of significant differences between traditional and Roth IRAs. One is when you pay taxes. Rest assured that you will pay taxes on both funds, but it’s a question of when. The other big difference is your adjusted gross income.
A traditional IRA is funded with pre-tax dollars. It lowers your income for the current year. Anyone, regardless of income, can contribute to a traditional IRA.
Once you reach retirement age and start withdrawing funds, taxes are imposed on the dollars you put in, and any earnings made on those investments. Paying taxes later is excellent for those who expect to be in a lower tax bracket in retirement.
A Roth IRA is funded with dollars that you’ve already paid taxes on. Money is placed in an investment fund and left alone to grow. Depending on market conditions, it grows into a larger nest egg by the time you reach retirement age.
At that time, you can withdraw the money tax-free, including what you put in and the amount it has grown over time. Roth IRAs do have an income limit. Your income must be below the threshold set by the IRS.
Once your modified adjusted gross income reaches a certain point, you can contribute some, but not the entire allotted amount. Once it reaches the maximum level, you are not allowed to fund an IRA—unless you use the backdoor method.
Benefits Of a Backdoor Roth IRA
One of the primary benefits of converting money into a Roth is that traditional IRAs require you to start taking distributions when you reach age 72. These required minimum distributions (RMDs) are set by the IRS and are based on the balance of your IRA and your age.
Once you start taking withdrawals, you must pay the taxes on those withdrawals. RMDs are required whether you need the money or not.
Roth IRA does not have these RMDs. In fact, you are never required to withdraw funds from your Roth and can leave the accounts to your heirs without touching any of the funds. Leaving the money in investments can allow them to grow.
Once you decide to withdraw money, you are not owed taxes on the funds, either.
Tax Implications Of a Backdoor Roth IRA
Traditional IRAs are generally funded with pre-tax dollars. When you contribute funds, you can claim a deduction on the current year’s tax return, and if the money is left in the account, you will not owe taxes until you start withdrawals after age 72.
If you convert that money to a Roth, you now owe taxes on that money. If the money has grown, you will also be required to pay taxes on the money you’ve earned. But that’s it. Once the money is in the Roth, it can grow tax-free until you need or want it.
If you happen to fund your traditional IRA with post-tax dollars and then decide to convert it to the IRA, you will not need to pay taxes on the original contribution but will be taxed on the money earned.
If you earn too much money to contribute to a Roth IRA directly, this backdoor strategy can get those funds into a Roth, where they can grow tax-free. This strategy is also a way to contribute more to the fund.
The Roth IRA contributions limit is $6,500-7,500, depending on your age. As we mentioned, there is no limit to how much you can convert to a Roth. If your IRA has $20,000, you can convert it all to a Roth (as long as you pay the required taxes).
How to Create a Backdoor Roth IRA
There are three ways to create a backdoor Roth IRA, and they all involve starting with a traditional IRA or 401(k) account and rolling over or converting the funds to a Roth.
You must be in an IRA or 401(k) that allows this type of conversion; the custodian of the account or brokerage firm should be able to let you know if this type of conversion will work.
If you are just starting to contribute to an IRA and think you might want to convert to a Roth IRA in the future, check the conversion rules ahead of time. If not, check and see if you can convert one traditional IRA to another and then to a Roth. A financial advisor is helpful in these situations.
Step 1: Contribute to a Traditional IRA
You must start with a traditional IRA account. Choose one that allows conversion and fund it with pre-tax dollars. As you’ll see in a minute, conversions will be smoothest if you find a brokerage firm that has both.
Step 2: Immediately Convert Your Traditional IRA to a Roth IRA
If you have a traditional IRA that allows conversion, the process is as simple as contributing to the IRA and then rolling over the funds to the Roth IRA.
While the annual limit to contribute to an IRA is $6,500 (or $7,500 if you are over 50), there is no limit to what you can roll over to the Roth. But remember that you are paying taxes on any principal and earnings.
To avoid paying taxes on any earnings incurred on your traditional IRA, you want to roll over the funds to the Roth IRA as soon as possible after funding the traditional IRA.
It’s essential to follow some rules, so you don’t incur penalties:
- Once you initiate a rollover from your traditional IRA, you have 60 days to transfer the funds to a Roth. Otherwise, it may be considered a distribution subject to early withdrawal penalties.
- A safer way to transfer the funds is by using a trustee-to-trustee transfer. The funds are sent electronically from the traditional IRA provider to the Roth IRA provider, leaving no question about the intentions.
- Along those same lines, if your financial institution offers both traditional and IRA accounts, you can transfer them in-house. This is called a same trustee transfer.
Step 3: Repeat the Process, If You Wish
If you convert your traditional IRA to a Roth IRA immediately, you can do this once a year. Fund your traditional IRA with the maximum allowed and convert it immediately to a Roth.
Special Considerations For a Backdoor Roth IRA
Remember these few special considerations when dealing with a backdoor Roth IRA:
There Are Two Five-Year Rules For Backdoor Roth IRAs
Once you convert funds to the Roth IRA, you must follow the Roth rules. Roth IRAs cannot be withdrawn until age 59 ½ and must exist for five years before any withdrawals or incur a penalty.
Additionally, whether you are 59 ½ or not, you must wait five years after conversion to withdraw the money or incur a penalty.
Traditional IRAs That Hold Previously Deducted Contributions
This consideration bears mentioning again. You can deduct that amount from your tax return if you contribute money to a traditional IRA. When you convert that money into a Roth, you are adding that money back into your income.
If you fund your traditional IRA with pre- and post-tax dollars, the money you’ve paid taxes on can convert over to the Roth IRA tax-free, while the money you haven’t paid taxes on will be taxed.
It would be tempting only to convert the funds you contributed after tax, but the IRS does not allow that. Instead, they will take the percentage of pre-tax funds and the percentage of after tax-funds and apply that to your end-of-year taxes.
What makes this trickier is that the IRS will look at this percentage at the end of the year rather than when you are making the conversion. The way to avoid this pro-ration is to convert your entire IRA portfolio into your 401(k), 403(b), or Roth.
Some States Tax Backdoor Roth IRA Conversions
Converting money from a traditional IRA to a Roth IRA is subject to federal and state taxes. There are several states with no state income tax—these tend to be places where people tuned into tax implications tend to retire.
There are also some states with very high state income tax rates—think California and New York. If you live in one of those latter states, you could also owe a significant amount of money to the state.
The warning here is to crunch the numbers, and if you feel that a backdoor Roth strategy is still a good idea, you will at least be well-informed.
Is a Backdoor Roth IRA Conversion Worth It?
Whether the backdoor Roth IRA is worth it depends on your specific situation. There are four factors:
- You earn more than the income limits of the Roth IRA.
- You can pay the taxes on the funds you want to transfer.
- You can wait at least five years to withdraw the money.
- The transfer does not push you into a higher tax bracket.
If you meet all of these criteria and want to grow your money tax-free until retirement, plus you do not want to be required to take minimum distributions when you turn 72, then the backdoor method to funding a Roth is a great idea. You will save taxes in the long run.
If, however, you are planning to withdraw the money in less than five years, cannot pay the taxes that you will owe in the withdrawals, or it pushes you into a higher tax bracket, the backdoor method to the Roth may not be your best bet.
So, the best way to take advantage of the backdoor Roth strategy is to contribute after-tax dollars to an IRA and immediately convert it to the Roth IRA. That way, you avoid taxes and can take advantage of that Roth.
The Bottom Line
Converting money from a traditional IRA to a Roth IRA can be a prudent financial decision for some. Adding diversity to your portfolio is a bonus.
As long as you understand the tax implications and the rules regarding funding, penalties, withdrawals, and more, funding a Roth IRA via that backdoor method can be advantageous.
Here at The Budgetnista, we have many resources and tools to help with IRA conversions or other retirement strategies.