Retirement planning is an important part of securing one’s financial future. There are multiple options available to investors when it comes to retirement accounts each with its own particular benefits, limitations, and rules. The Internal Revenue Service (IRS) limits individuals from investing in certain retirement plans based on their income. For instance, high-earning investors cannot invest in a Roth IRA (Individual Retirement Account). Herein, you contribute after-tax dollars and earn tax-free returns on your funds. Apart from tax-free growth, you can also make tax-free withdrawals provided you meet certain conditions. To make penalty-free withdrawals, you must have held the account for at least 5 years and reached 59.5 years of age. Doing so marks the withdrawals as qualified and tax-exempt. In addition, if you invest in a Roth IRA account, you are not mandated to take out Required Minimum Distributions (RMDs) unlike in a traditional IRA and traditional 401(k) where you must take our RMDs by April 1 of the year you turn 72 as mandated by the IRS.
However, due to income limitations stipulated by the IRS, high-income taxpayers adopt the backdoor Roth IRA approach to invest in a Roth IRA. Herein, a traditional IRA or 401(k) is converted into a Roth IRA. The funds held in the aforesaid accounts are rolled over to the Roth IRA account. A backdoor Roth IRA is not a special type of account. Also, it is not a means to dodge taxes. You may incur higher taxes at the time of setting it up, however, you will receive the future tax savings of a Roth account. Consult with a professional financial advisor to learn more about how IRAs and backdoor Roth IRAs could fit into your retirement planning and management.
What are the essentials of Backdoor Roth IRAs?
For 2022, the maximum Roth IRA contribution you can make is $6,000 if you are under 50 years of age and an additional $1,000, bringing your total to $7,000 if you are older than 50 years. You also have to adhere to the following modified adjusted gross income (MAGI) to be eligible to contribute to a Roth IRA:
- For single taxpayers, the MAGI is $144,000 for the year 2022.
- For married taxpayers filing jointly or widowed, the MAGI is $214,000 for 2022.
But if you are using a backdoor Roth IRA, these limits become null and void and are not applicable. Additionally, these limits are the reason why investors prefer using the backdoor strategy as the IRS does not impose any income limits on the conversion of conventional IRAs to Roth IRAs.
What are the benefits of a backdoor Roth IRA?
The primary benefits of a backdoor Roth IRA are as follows:
- There are no income limitations
- There is no tax liability
- There are no Required Minimum Distributions (RMDs)
Since a backdoor Roth IRA is not restricted by income limitations, high-income earning individuals can save a considerable amount of money when they convert their traditional IRA to a Roth IRA. While regular Roth IRAs are restricted by income limitations, the same is not the case for a backdoor Roth IRA. This allows investors to contribute a significant amount of their earnings to a backdoor Roth IRA and take advantage of its tax benefits.
As mentioned earlier, in a Roth IRA, an individual can make tax-free and penalty-free distributions subject to certain conditions. This is a tax-deferred account giving it a significant advantage over other retirement accounts.
This is another important benefit of a backdoor Roth IRA wherein you do not have to take out mandatory RMDs. In a traditional IRA and 401(k), retirees need to withdraw distributions each year by April 1 of the year they turn 72 years of age. You are free to withdraw your funds as per your convenience and there is no restriction on the amount of money that can be withdrawn from a Roth IRA. You can also choose to let your money remain untouched in your account and not withdraw any funds or pass it on to your heir.
How is a backdoor Roth IRA created?
There are three ways by which you can set up a backdoor Roth IRA:
- You can open a traditional IRA, contribute money to it, and roll over the contributed funds to a Roth IRA. You can also roll over as many funds as you want at one time, even if it’s more than the annual contribution limit.
- Convert your traditional IRA (in its entirety) into a Roth IRA.
- If your company 401(k) plan allows conversions, convert your 401(k) account into a Roth IRA.
The process of creating a backdoor Roth IRA is explained below:
- First, you have to open a traditional IRA. High-income taxpayers cannot directly invest in a Roth IRA due to income limitations, however, they can invest in a traditional IRA since it has no income ceilings for participation.
- Next, you have to convert your traditional IRA into a Roth IRA. You can do so by either converting your entire traditional IRA to a Roth IRA in one go or rollover as much money as you want at separate intervals.
What are the tax implications of a backdoor Roth IRA?
A backdoor Roth IRA is not a tax dodge and does not involve any form of tax evasion. It is a legal way for high-income taxpayers to circumvent the income limits that normally prevent high earners from owning Roth IRAs. Moreover, when you establish a traditional IRA, the funds contributed to the account are taxable. This means that before you can convert your account to a Roth IRA, you have to pay tax on the funds contributed to the traditional IRA. Additionally, if there is a delay in rolling your traditional IRA to a Roth IRA, any earnings made on the contributed funds to the IRA are also taxed by the IRS.
To conclude
Creating a backdoor Roth IRA may seem a straightforward affair at first however you need to exercise caution and clearly understand the tax implications and how you can best maximize its benefits. You also need to take care when converting your account to ensure there is not a significant lag in time between converting your traditional IRA to a Roth IRA as you may end up paying increased taxes on the converted funds. It is advisable to reach out to a financial advisor to better understand the pros and cons of the backdoor Roth IRA strategy and how to implement it without complications.
To get in touch with a fiduciary advisor who may help you understand the tax implications of backdoor Roth IRAs, their benefits, how they are created, and more, use the free advisor match service. Based on your requirements, the platform scans through registered and qualified advisors to match you with an advisor suited to your financial needs and goals.