What is a backdoor Roth IRA?
A backdoor Roth IRA is not an official type of retirement account. Instead, it is a process for high-income taxpayers to fund a Roth, even if their incomes exceed the IRS limits for regular Roth contributions. A Roth IRA or Roth 401(k) allows you to deposit a limited amount of post-tax dollars into a retirement savings account each year, and then allows all of the investment gains to accrue tax free (if used for retirement).
This contrasts a traditional IRA or 401(k) where the taxes are deferred on the deposits until the money is withdrawn. Then, when withdrawals are made, taxes must be paid on both the contributions and the earnings on those contributions.
Because of this, many people prefer Roth IRAs. The problem is that people who earn above a certain limit are not allowed to open or fund a Roth IRA. As a result, the backdoor Roth IRA has become an option for high income earners.
How does it work?
Basically, a backdoor Roth IRA boils down to some fancy administrative work: You put money in a traditional IRA, and then complete a “Roth Conversion” immediately.. 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. There is three main steps to this process:
Put money in a traditional IRA account: Chances are you already have one of these accounts, but if you don’t, you might need to open one up and fund it.
Convert contribution to Roth IRA: Your advisor will walk you through the process and paperwork of converting the funds to your Roth.
Watch out for taxes: Keep in mind, this process is not a tax dodge. Money either needs to be put in the Traditional IRA as a non deductible contribution, or if put in pre-tax, the conversion amount needs to be recognized as taxable since you are converting pre-tax funds to post tax Roth contributions. Also, the IRS has a “pro-rata” rule that you or your advisor needs to be aware of, if you have any other Traditional, SIMPLE, or SEP IRA accounts.
What are the advantages and disadvantages?
There are both pros and cons to doing a backdoor Roth conversion. The main advantage is that it offers an opportunity for those with income higher than the Roth IRA limits to be able to earn money tax-free. This characteristic is most beneficial if you think tax rates are going to rise in the future, or that your taxable income will be higher after you retire than it is now. Along with that, Roth IRAs do not have a required minimum distribution like traditional IRAs have. You can take out as much or as little as you want.
Despite these advantages, it is important to also consider the disadvantages to ensure that doing a backdoor Roth IRA is what’s best for you. One negative to this process is that some of the funds that you convert to a Roth IRA may count as income (depending on if you have any pre-tax contributions or gains in any IRA accounts), which could kick you into a higher tax bracket in the year that you do the conversion. It's generally a good idea to convert just enough that you're not pushed into paying a higher tax rate that year. Along with that, the funds you put into the Roth are considered converted funds, not contributions. That means you have to wait five years to have penalty-free access to your funds if you’re under the age of 59½. Be sure that you do not need the money in 5 years or less or you could owe taxes and a 10% penalty.
A backdoor Roth IRA is a great way to avoid Roth IRA income limits and contribution limits, despite the few disadvantages that you have to be aware of going into the process. If this method interests you or you want to learn more about it, please reach out to us and we would love to answer any questions.