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All About a Backdoor Roth IRA

Updated: Jul 21, 2022

If you have never heard of a retirement planning strategy known to many as the “Back-Door Roth,” it is time you find out. What is it? Why is it important? What are the potential traps and how can it benefit you? Read on to find out.

Purpose of a Backdoor Roth IRA

A backdoor Roth IRA lets you convert your traditional IRA to a Roth, even if your income is too high to open a Roth IRA the regular way. A backdoor Roth IRA is a way for people with high incomes to sidestep the Roth’s income limits.

Basically, a backdoor Roth IRA boils down to some fancy administrative work: You put money in a traditional IRA, convert the account to 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.

About those Roth IRA income limits: For 2020, the government allows only those people with modified adjusted gross incomes below $206,000 (married filing jointly) or $139,000 (single) to contribute to a Roth IRA. In 2019, the limits were $203,000 (married filing jointly) or $137,000 (single).

If your income is above the limit, a backdoor Roth might be a good solution for you. Creating a backdoor Roth IRA

Here’s a step-by-step guide on how to make a backdoor Roth IRA conversion:

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

  2. Convert the account 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.

  3. 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.

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

Mind the rules

Keep these rules in mind to avoid penalties:

  • Types of transfers. The conversion needs to be one of the following: 1) a rollover, where you receive the money from your IRA and deposit it into the Roth within 60 days, 2) a trustee-to-trustee transfer, where the IRA provider sends the money directly to your Roth IRA provider, or 3) a “same trustee transfer,” where your money goes from the IRA to the Roth at the same financial institution.

  • The pro-rata rule. The IRS requires rollovers from traditional IRAs to Roth IRAs to be done pro rata. Here’s how it works: When determining your tax bill on a conversion from a traditional IRA to a Roth IRA, the IRS is going to look at all of your traditional IRA accounts combined. If all of your traditional IRAs combined consist of, say, 70% pre-tax money and 30% after-tax money, that ratio determines what percentage of the money you convert to a Roth is going to be taxable. In this example, no matter how much money you convert or which IRA account you pull the money from, 70% of the amount you convert to the Roth will be taxable. You can’t choose to convert only after-tax money; the IRS won’t allow it. And a word about timing: the IRS applies the pro-rata rule to your total IRA balance at year-end, not at the time of conversion.

When a Roth IRA is not the best idea:

  • The only way you can pay the taxes due is with money from your IRA withdrawal. Not only are you sacrificing any future investment growth on that money, there’s also the risk that, if you’re under age 59-1/2, you’ll owe the 10% early withdrawal penalty on that money.

  • You’ll need the money in five years or less. Money converted from an IRA to a Roth IRA falls under a Roth five-year rule: If you don’t wait five years to withdraw it, you could owe taxes and a 10% penalty.

  • The withdrawal from your IRA will push you into a higher income tax bracket. It’s generally a good idea to convert just enough that you’re not pushed into paying a higher tax rate that year.

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