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Is a Backdoor Roth IRA Right for You?

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Key takeaways

  • A backdoor Roth IRA is a tactic that allows people with higher incomes to benefit from a Roth IRA by converting a traditional IRA into a Roth IRA. Importantly, a backdoor Roth is a tactic, not a special kind of Roth account.
  • Roth IRAs can be beneficial because you pay taxes when you contribute, but won’t pay taxes on your investment gains when you withdraw.
  • Because only after-tax dollars can go into a Roth account, you’ll pay taxes on the dollars you convert from a traditional IRA to a Roth—and it could lead to a big bill, depending on how much you convert and your tax bracket.
  • While a backdoor Roth can be a great retirement savings tactic, it’s important to consider your specific circumstances before deciding to make the conversion.

A backdoor Roth IRA may sound like a sneaky loophole — but it’s actually a common (and completely legal) money move. The IRS doesn’t allow high income earners to directly contribute to a Roth IRA, so a backdoor Roth IRA is a workaround where a traditional IRA is converted to a Roth IRA. This allows someone who makes more than the Roth income limits to benefit from a Roth IRA.

However, there are some important things you should consider before moving forward with a Backdoor Roth IRA. Keep reading to see if a Backdoor Roth IRA is right for you.

A Backdoor Roth IRA is a tactic that allows high income earners to contribute to a Roth IRA. In 2021, if you earn $140,000 or more as a single filer or $208,000 or more as a couple filing jointly, you’re not allowed to contribute directly to a Roth IRA. However, you can contribute to a traditional IRA and then convert it to a Roth account. Voila: that’s what we call a backdoor Roth!

Roth IRAs are attractive retirement vehicles because they allow your money to grow tax-free — and also allow you to make tax-free withdrawals once you reach retirement age.

Importantly, you will still be required to pay taxes when you convert your pre-tax traditional IRA for the Backdoor Roth IRA conversion. You’ll need to consider factors like timing and tax payments before deciding if this tactic is a smart choice for you.

Backdoor Roth IRAs offer the same attractive benefits as a standard Roth plus more income flexibility:

  • There is no income limit — you can do a Backdoor Roth IRA no matter how much you earn each year.
  • Funds in a backdoor Roth grow tax-free over time.
  • Your withdrawals are tax-free once you reach the minimum withdrawal age (59 ½).
  • Roth IRAs aren’t subject to required minimum distributions (RMDs) — you aren’t required to make withdrawals at any time, so the money can grow indefinitely.

If you’re wondering how to do a backdoor Roth IRA conversion, there are a few major steps:

  1. Contribute or rollover funds to a traditional IRA.
  2. Pick an IRA provider for your Roth IRA. This can be the same as your traditional IRA, or you can select a new one.
  3. Convert that traditional IRA to a Roth IRA.If you’re sticking with your current IRA provider, notify them and go through their process. If you’re switching IRA providers, conversion happens through a rollover (you’ll receive a check from your traditional IRA and send it to the Roth provider within 60 days) or trustee-to-trustee transfer (your traditional IRA provider will send a check to the Roth IRA provider). Importantly, you want to avoid taking the money out of your traditional IRA as a withdrawal and manually depositing it into a Roth, because doing so could end up costing you an additional 10% early withdrawal penalty.
  4. Finally, the not-so-fun part: the money you convert to a Roth IRA is treated like ordinary income, meaning you’ll pay income tax on the conversion amount based on your tax bracket. The exception to this rule is if your account has any post-tax contributions see below on the pro-rate rule for more information.

Once the backdoor Roth IRA conversion is complete, the account works just like a standard Roth IRA. You’ll be subject to the same withdrawal restrictions, taxes, and other rules associated with Roths — but most importantly, your money will grow tax-free for the duration of the account’s lifetime, and your withdrawals will be tax-free, too.

There are yearly contribution limits in place for both Roth and traditional IRAs. In 2021, you can contribute up to $6,000 total across all your IRAs, or $7,000 if you’re over the age of 50.

However, backdoor Roth IRAs offer a way around the contribution limits because conversions aren’t considered contributions — you can convert as much money as you want into a Roth. Just keep in mind that the bigger the traditional IRA balance, the bigger the tax bill will be for the year you make that conversion.

More good news: you can do a backdoor Roth IRA conversion each year if you like, so you can keep growing your Roth IRA over time.

You may want to talk to a qualified tax professional to ensure you understand exactly what kind of tax burden you’ll be taking on, especially if the additional “income” from the conversion will push you into a higher tax bracket. For example, you could decide to defer your backdoor Roth contributions to a year where your income is lower to avoid higher taxes.

One thing to keep in mind: if your 401(k) or IRA has both pre-tax and post-tax contributions in it, that will impact the taxes you pay when doing the Backdoor Roth. You will pay taxes based on the proportion of your existing account that is from pre-tax contributions – regardless of how much money you’re transferring. This is called the pro-rata rule.

This is easier to understand with an example. Say you have a 401(k) with $10,000 from post-tax contributions and another $30,000 from pre-tax contributions — that’s $40,000 total. If you decide to convert $10,000 of that via a Backdoor Roth, the pre-tax portion of the entire account value will determine your tax burden:

$10,000 post-tax + $30,000 pre-tax = $40,000 total account value

$30,000 (pre-tax)
——————— =  75% pre-tax
$40,000 (total)

So, 75% of the conversion amount, or $7,500, will be considered taxable. This can be confusing – if you’re worried about what your tax bill will be, it’s always smart to ask a tax professional.

There are many Roth IRA providers to choose from. You’ll want to consider a few things when choosing a provider:

  • Type of account – do you want an automated IRA (investment decisions are made for you) or a self-directed IRA (you’ll make your own investment decisions)?
  • Annual fees – Most accounts charge an annual management fee as a percentage of your total assets (e.g. an annual fee of 0.25% of your assets)

Ease of use – do you like the user interface and available features?

Although a backdoor Roth IRA conversion can be a great tactic for those above the income thresholds, it’s not always the right move.

Before you move forward, consider the following:

  • Can you afford the tax bill? If you’d need to cash in part of your investments, or otherwise significantly shift your financial situation to pay for the taxes on the conversion, it might not be worth it.
  • Will it push you into a higher income bracket? Because the converted funds will be taxed as regular income, you might want to hold off on a backdoor Roth IRA conversion that would push you into a higher income bracket.

How soon do you need to access the money? You could be subject to taxes and the 10% early withdrawal penalty if you don’t wait until you’re 59 ½ and the Roth IRA is at least five years old. This is called the Roth five-year rule.

A backdoor Roth can be a useful workaround for higher income earners who still want to benefit from a Roth IRA — and it might be right for you, so long as you understand the tax implications of this tactic. As always, if you have any questions about your own financial situation, consider consulting a tax professional who can answer your questions.

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