A Roth backdoor is a way for a high earner to contribute more to retirement by converting a traditional IRA to a Roth IRA.
This is a powerful loophole – however, it is not a way to bypass your taxes. You still need to understand all of the tax implications before opting for a Backdoor Roth to make sure it is right for you. So let’s cover:
To learn how a Roth Backdoor works and how to set one up, you first need to understand what an IRA is.
What is an IRA?
IRA stands for individual retirement account. It’s an investment account that gives you powerful tax benefits when you save for retirement.
And there are two types of IRAs:
- Traditional IRA. You can invest with this account before tax Income. They’ll convert your 401k into a traditional IRA when you quit a job. Currently, anyone younger than 70½ years old is allowed to contribute to a traditional IRA. Once you reach that age, you will need to make a minimum withdrawal each year that is a certain percentage of your money.
- Roth IRA. This account uses your after the tax Investing money gives you an even better deal for your investment as you don’t pay any tax on winnings when you withdraw. There are currently no age restrictions for a Roth IRA – However, there are income restrictions.
There is currently a maximum annual investment of $ 6,000 in both accounts ($ 7,000 if you are over 50). A Roth IRA currently has an income limit of $ 135,000 for individual taxpayers and $ 199,000 for married couples joint filing. A traditional IRA has no such limits, which is what makes the Backdoor Roth such an attractive route for high-income earners.
(Since you earn more than the income limit for a Roth, you can go through the “back door” by converting your traditional one to a Roth.)
However, these limits change frequently, so be sure to check these out IRS contribution limits page keep up to date.
How does a Roth backdoor work?
A Roth backdoor is a strategic conversion of your traditional IRA into a Roth IRA. It enables you to bypass Roth income restrictions and contribute to retirement savings even if you make more than $ 135,000 a year.
You can also transfer more than the annual contribution limit to a Roth IRA if the traditional IRA is over $ 6,000.
It’s also a simple two-step process:
- Open a traditional IRA account (more on that later) and contribute up to $ 6,000 (or $ 7,000 if you are over 50).
- Once the funds are in your traditional IRA and before they start accumulating revenue, transfer or “roll” your funds into your Roth IRA. Since they did not accumulate interest, it is considered non-taxable.
Voila! You can now contribute to a Roth IRA regardless of your income.
If you’re still struggling to decide if it’s right for you, here is a handy table:
|A good candidate for a Roth backdoor …||A bad candidate for a backdoor Roth …|
The pro rata rule
The Roth Backdoor does NOT mean you will not be taxed. If you convert your traditional IRA to a Roth IRA, you will be taxed on any deductible IRAs you have when you file your taxes at the end of the year.
This is the pro rata rule – a method of determining what money is taxable if you hold both pre- and post-tax money in ALL IRAs.
For example, if you have $ 6,500 untaxed in your traditional IRA and you convert that into your Roth IRA, you owe money for the entire $ 6,500 along with any funds your traditional IRA accumulates in its investments.
However, you will not be taxed on the money you transfer if the funds are in your traditional IRA already taxed.
Let’s say you have $ 45,000 in a traditional IRA and everything is taxable. One day you decide to put $ 5,000 into a new Roth backdoor. That means you have a total of $ 50,000 for all of your IRAs. How much do you think you would tax?
Since 10% of your IRAs are tax-exempt (5,000 is 10% of 50,000), this means the remaining 90% can be taxed. So if you put $ 5,000 in your Roth, you will be taxed $ 4,500 – which is bad. In this case it might be in your best interest NOT to use Backdoor Roth.
Because of the pro rata rule, you may find that it is not worth transferring your money from your traditional IRA to your Roth IRA (depending on how much post-tax and pre-tax income you have in your account).
However, once the funds are in your Roth IRA, compound interest accrues tax-free. You can withdraw the money tax-free from the age of 59 ½ years and have had the Roth for at least five years.
The (possible) half-life of a Roth backdoor
The Roth Backdoor was made available to all investors regardless of income in 2010. Back then, Congress allowed investors to bypass the Roth IRA income limit through a traditional IRA.
However, the Internal Revenue Service (IRS) has not officially recognized the existence of the Roth backdoor. As with so many tax-related things, if the IRS determines the loophole is against its policies, your ability to contribute about a Roth backdoor may change.
That would mean anyone using a Backdoor Roth could potentially have to pay a hefty fine for contributing too much.
How to Open an IRA Account
If you want to open a Roth IRA or a traditional IRA, you need to open a brokerage account. There are many great ones with fantastic customer service and trustees ready to answer and answer any questions you may have about your investments.
Other factors to consider when looking for brokers:
- Minimum investment fees. Some brokers require you to invest a minimum amount in order to open and maintain an account. This can be a deal breaker for many.
- Investment opportunities. All brokers differ in their investment offer. Some have funds that do better than others.
- Transaction fees. Some brokers charge you a transaction fee in order to invest money in an asset.
Some brokers I suggest: Charles Schwab, vanguard, and E * TRADE.
Not only do these three offer great customer service, but they also have low or no minimum investment fees and are known for their great stock options.
Once your account is set up, your money is just there. You then have to do things:
- First, set up an automatic payment plan (we’ll explain how to do it later) so that you automatically deposit funds into your account.
- Second, you decide where you want to put the money in your account. Technically, you can invest in stocks, index funds, mutual funds, and so on – but I recommend investing your money in an inexpensive, diversified portfolio that includes index funds like the S&P 500. The S&P 500 average return of 10% and is managed with hardly any fees.
For more read my introductory article on stocks and bonds to better understand your options. I also made a two minute video showing you exactly how to choose an IRA. Check it out below.
Make the Smartest Investment Today
There is no such thing as a one-size-fits-all solution.
While the Backdoor Roth seems like a great way to invest in a Roth IRA even if you are over the income limit, there are downsides. For one thing, an investor might not consider the pro rata rule when transferring their money from their traditional IRA to a Roth IRA and end up being taxed more than they thought.
If you are looking to perform a Backdoor Roth, you should consider all of the elements that we have described in this article.
But it can be confusing when you’re new to this world and have no idea how to get started.
That’s why I’m happy to be able to offer you something for free. I have an offer: My ultimate guide to personal finance.
In it, you will learn how to:
- Master your 401k: Take advantage of the free money your business offers … and get rich in the process.
- Manage Roth IRAs: Start saving for retirement on a worthwhile long-term investment account.
- Automate your spending: Harness the wonderful magic of automation and make investing painless.
With this guide, you will be well on your way to living a rich life. And you don’t need fancy get-rich-quick plans or snake oil or other BS “solutions”. All you need is determination and the right systems to help you get the most out of your financial situation and not have to worry about living “frugally” (aka sacrificing the things you love) .
Do you know your earning potential?
Take my Earning Opportunities Quiz and receive a custom report based on your unique strengths and learn how to make extra money in just an hour.