You probably already know the basics of a traditional IRA (you invest pre-tax income — you can currently contribute up to $6,000 in 2021 — and must take required minimum distributions after age 72). You also may already know the details of a Roth IRA (you invest after-tax money — currently up to $6,000 in 2021 — and you don't pay taxes on gains when you withdraw money after age 59 ½, as long as it's been in your account for five years).
The sticky wicket: If you earn more than $140,000 as a single tax filer or $208,000 as a married filing jointly tax filer, you can't contribute to a Roth IRA.
If you fall into that earnings-above-$208,000 category, you may have heard of something called a "Backdoor Roth IRA," which allows you to transform your traditional IRA into a Roth IRA. Let's go over the details of a Backdoor Roth to make sure that it’s right for you, because it might not make sense based on your financial situation.
How Does a Backdoor Roth IRA Work?
A Backdoor Roth involves converting your traditional IRA into a Roth IRA. You can maneuver around the Roth income restrictions and contribute even if you're making more than $140,000 per year as a single filer.
First, you open up a traditional IRA account and contribute up to $6,000 (or $7,000 if you’re older than 50). Then, as soon as the funds go into your traditional IRA, transfer or “rollover” your money into a Roth IRA. You'll have to do this before your money earns interest to be considered non-taxable.
Tax alert! You can't sidestep taxes, of course. Note that you will still need to pay taxes on any money that hasn't been taxed through your traditional IRA. In other words, let's say you contributed $6,000 to a traditional IRA and then converted all of it to a Roth IRA. You'll owe taxes on the $6,000.
However, once you convert the money into a Roth IRA, you won't pay taxes on your withdrawals as long as you're 59 ½ and have had the Roth IRA for a minimum of five years.
Benefits of Tapping into a Backdoor Roth
Sounds pretty good, doesn't it? Let's go into the reasons going the Backdoor Roth route might make sense for your financial future.
- No required minimum distributions (RMDs): First and foremost, you're not required to withdraw money from a Roth IRA. If you want to leave it long past age 72, you can. This can mean exponential tax-free growth.
- Inheritance benefits: You can also choose to leave the money in your Roth for your children or another beneficiary after you die.
- Ideal if you anticipate a higher tax bracket in retirement: You may want to opt for a Backdoor Roth if you can keep the funds in a Roth IRA for the long term or if you anticipate ending up in a higher income tax bracket upon retirement.
Get some advice from a tax professional before you choose this route, however. They may look at the loophole differently, based on your personal circumstances and financial situation.
Drawbacks of Choosing a Backdoor Roth IRA
On the other hand, you'll need to consider a few disadvantages before you jump into a Backdoor Roth. Let's take a look at a few downsides to choosing a Backdoor Roth IRA.
Drawback 1: You must follow the pro rata rule.
It's important to know the IRS’s pro rata rule, which has you look at your IRA assets as a whole. What hasn't been taxed gets subjected to your ordinary tax rate.
Here's what this means. Let's say you have $6,000 of untaxed money in your traditional IRA and convert it to a Roth IRA. You'd owe money on the entire $6,000 as well as any money you've accrued through your traditional IRA. Imagine if you had $100,000 or more in your account. You could get taxed for the full amount!
However, you won’t be taxed on the money you roll over if the funds in your traditional IRA have already been taxed.
These potential extreme tax bills may make you want to skip a Backdoor Roth altogether.
Drawback 2: Higher income tax bracket alert!
Your withdrawal could put you into a higher income tax bracket, so make sure you convert just enough so you don't pay a higher tax rate. Again, talk to your tax professional about the implications a Backdoor Roth IRA could have on your tax situation.
Drawback 3: You could pay a penalty if you can't meet the withdrawal requirements.
If you know you'll need the money in less than five years, don't go through with a Backdoor Roth. You'll owe taxes and a 10% penalty if you don't wait five years to withdraw the money. In addition, if you make IRA withdrawals before age 59½, you may have to pay a 10% penalty in addition to income tax — unless you make the withdrawals under certain circumstances.
Drawback 4: You'll pay if you accidentally procrastinate on making your conversion.
You have to convert your traditional IRA to a Roth IRA immediately. Immediately. If you dink around and don't move the money from a traditional IRA into a Roth, you could earn money. If you have earnings, you may have to pay taxes when you convert to a Roth. If you accumulate enough earnings and then convert your entire account balance, you’ll end up having to pay taxes.
Does a Backdoor Roth IRA Make Sense for You?
If you've always been envious of the folks who can contribute to a Roth IRA, a Backdoor Roth might sound like a perfect way to become one of the never-pay-taxes group. However, you need to pay attention to the requirements before you can enjoy tax-free growth in a retirement plan.
You'll need to open a traditional IRA account to get started if you don't already have one. You can open a traditional IRA in less than five minutes at a major discount brokerage like Vanguard, Fidelity, Interactive Brokers and more. If you learn more about the Backdoor option, you may find that it doesn't work for you and you can just keep the cash in a traditional IRA instead.7 Large-Cap Stocks to Help Navigate a Volatile Market
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