As you may already be aware, a Roth IRA is a type of retirement plan that is intended for people who fall within a lower pay grade than those who are eligible for a traditional IRA. Backdoor Roth IRAs are essentially traditional IRAs or 401(k)s that have been converted to Roth IRAs.
A backdoor Roth IRA is a method for those with higher incomes to bypass the income cut off. Unlike a Roth IRA, a backdoor IRA is not officially a retirement account. It’s just an informal name given for this procedure that allows people in a high-income tax bracket to fund a Roth IRA. The process is sanctioned by the IRS, so it is not really a method of saving on tax payments.
Why do people choose backdoor Roth IRAs?
The contributions made to a traditional IRA is tax-deductible but taxes apply when a withdrawal is made. With Roth IRAs, the contributions are taxed but the withdrawals are tax-free. With a backdoor Roth IRA, your returns are tax-free when you eventually withdraw it after you retire.
Creating a Backdoor Roth IRA
Here is how you create a backdoor Roth IRA:
- Step 1: Contribute to a Traditional IRA
To get your foot in the door, you will have to actively contribute to an IRA. If you don’t have an IRA, you will have to open one and transfer money into the account.
- Step 2: Convert your IRA to a Roth IRA
Converting your traditional IRA to a Roth IRA can be done by rolling over funds from a traditional IRA to a Roth IRA. There’s no limit on annual contributions for transfers from a traditional IRA to Roth IRA.
- Step 3: Calculate the taxes you owe
Since traditional IRA contributions are tax-deductible, when you convert it to a Roth IRA, you will have to return the amount that was deducted on your contributions. When filing your taxes, you will have to pay tax on the amount that is in your Roth IRA.
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Pros and Cons of a Backdoor Roth IRA
- Converting to a Roth IRA helps you lower the amount you pay on taxes in the future
- You can withdraw the amount in your account at any time, without having to pay taxes on the amount.
- You can also choose not to take the minimum distributions that are applicable to when you turn 72 like you do with traditional IRAs. You can choose to keep the funds in your account and pass it on to your beneficiary.
- Perhaps the biggest disadvantage to converting your traditional IRA to a Roth IRA is that you end up paying a lot in taxes. Depending on the amount that you transfer or roll over into a Roth IRA, you might actually move into a higher tax bracket.
- You have to wait 5 years before making a withdrawal even if you are over 59 and a half years old.
- Calculating how much you owe in income taxes can be complicated to figure out and you may need to hire a professional to help you crunch the numbers.
Should you convert your traditional IRA to a Roth IRA?
A Roth IRA can be extremely useful when you foresee the amount you owe in taxes increasing in the future. It can also be helpful if you think you will fall under a higher tax bracket around the time you retire.
If you are already someone who is in a higher income bracket, and you are not eligible to hold a Roth IRA, the backdoor Roth IRA might help you move your money to a tax-free account.
However, you should refrain from adding too much money into your converted Roth IRA because you may end up paying more in taxes.
One thing that you should keep in mind is that once you convert your traditional IRA to a Roth IRA, you can’t switch it back. Make sure to do your research and crunch the numbers before making that decision.