The best way to take advantage of current low-income tax rates and set yourself up for years of tax-free income in retirement is to fund a Roth IRA. However, individuals with high incomes are not permitted to contribute directly to a Roth IRA. For them, the only way into a Roth is through the back door, using a strategy dubbed the backdoor Roth. In this blog post, we will go over what a backdoor Roth IRA is, its limit, and how to do a Roth IRA conversion. So keep your distance!
What Is a Backdoor Roth IRA?
A “backdoor Roth IRA” is a type of conversion that allows people with high incomes to fund a Roth IRA despite income limit restrictions imposed by the IRS. You put the money you’ve already paid taxes on in a traditional IRA, then convert the funds you contributed into a Roth IRA, and you’re done. Even if you didn’t qualify to contribute to a Roth, you can still enter through the back door, regardless of your income.
That’s good news because your money grows tax-free, which is a nice perk when it comes time to withdraw it in retirement.
How Does a Backdoor Roth IRA Work?
To initiate a backdoor Roth IRA conversion, make a nondeductible contribution to a traditional IRA first. Unlike a Roth IRA, the traditional IRA has no income limit for nondeductible contributions.
The nondeductible IRA contribution will then be converted to a Roth IRA contribution. If there are no earnings on the converted funds, the conversion is not taxable. If you convert pretax IRA funds into a Roth, on the other hand, you pay taxes on the converted amount at your current ordinary income rate.
Your eligibility to make regular Roth IRA contributions is an important consideration based on your modified adjusted gross income (MAGI) and tax-filing status (single, married filing jointly, married filing separately). This determines whether or not you are eligible to contribute to a Roth IRA.
If you file as a single person, your MAGI for the tax year 2022 must be less than $140,000 to contribute to a Roth IRA. You can only contribute in full if your income is less than $125,000. That earning between $125,000 and $140,000 can contribute less as their income rises.)
If you are married and file jointly, your MAGI for the tax year 2022 must be less than $208,000. (You can only contribute fully if your combined income is under $198,000. Contribution thresholds are also lower for that earning between $198,000 and $208,000.)
If your current MAGI is higher than the limit for your tax filing status, you may be able to use a backdoor Roth conversion to save for retirement.
Backdoor Roth IRA Limit
The IRA contribution limit for 2022 is $6,000 per person, or $7,000 if the account owner is 50 or older. Backdoor Roth IRA contribution limits will increase to $6,500 in 2023 or $7,500 for those 50 and older. So, if you want to open an account and then convert it to a Roth IRA using the backdoor IRA method, that’s the most you can contribute for those tax years.
It’s important to remember that you can make IRA contributions until the tax deadline, so if you make your contribution after New Year’s Day, you can effectively make two years’ worth of contributions at once.
Backdoor Roth IRA Taxes
When you convert a traditional IRA to a Roth IRA, any amount you received as a tax deduction from the traditional IRA is considered taxable income.
Assume you contributed $5,000 to a traditional IRA in 2022 and claimed the deduction on your 2022 tax return. If you then convert the account to a Roth IRA in 2023, the account value at the time of conversion (even if it exceeds $5,000) will be considered taxable income, which you must report (and pay tax on) on your 2023 tax return.
However, if you make a nondeductible traditional IRA contribution or immediately convert the account after making a traditional IRA contribution, there will be no taxes due on the conversion.
I use the word “generally” because there is another issue if you have additional traditional IRA assets. The IRS will not allow you to claim the conversion as coming entirely from the nondeductible IRA. Instead, you must include a portion of the conversion in your taxable income based on the proportional value of your nondeductible and other traditional IRA assets. That is generally undesirable, so if you have substantial retirement assets in deductible traditional IRAs, you should think twice before attempting a backdoor Roth.
How to Do a Backdoor Roth IRA
To complete a backdoor Roth IRA conversion, you must proceed methodically to avoid extra penalties or taxes. Follow these three steps carefully:
Step 1: Establish and Fund a Traditional IRA.
Begin by establishing a new traditional IRA. If you already have a traditional IRA, there’s no reason you can’t use it for a backdoor Roth IRA conversion; however, keep in mind that the funds you’ve saved in it may have an impact on the amount of taxes you owe. This is due to the IRA aggregation and pro-rata rules, which we’ll discuss later.
When funding a new traditional IRA, the key is to make non-deductible contributions (i.e., the money you’ve already paid taxes on and will not seek a deduction for). You must also file IRS Form 8606 detailing your non-deductible contributions.
Step 2: Recognize the Process of Converting a Roth IRA
Check with your IRA provider about the paperwork needed for a Roth IRA conversion. If your traditional IRA and Roth IRA are with the same account provider, the process may be as simple as a same-trustee transfer.
If you have different providers for each IRA, a trustee-to-trustee transfer—in which one company wires money to another—should not be difficult.
You can still set up a backdoor Roth IRA if your IRA provider refuses to manage the transfer and simply hands you a check. However, you must deposit the check within 60 days into a new Roth IRA account. Otherwise, it may be considered an early withdrawal, with tax and penalty implications.
Step 3: Change your Traditional IRA to a Roth IRA
Convert your new traditional IRA to a Roth IRA right away. If you do the conversion as soon as possible, your non-deductible contributions to your new traditional IRA won’t build up investment gains. If this happens, you’ll have to pay taxes on these gains when you convert your traditional IRA to a Roth IRA.
However, there is no time limit on when you can convert a traditional IRA to a Roth IRA. If you had existing funds in an old traditional IRA and wanted to minimize potential taxable gains, you could wait until later in the year to see how your balance settles.
Most brokerages can assist you with a Roth IRA conversion, especially if you opened your traditional IRA with them. If this is your first time opening a traditional IRA, look for a brokerage that offers traditional and Roth IRA options that meet your needs.
You can contribute up to $6,500 ($7,500 if you’re 50 or older) to your traditional and Roth IRAs in 2023. Previously, the limit on IRA contributions was $6,000, with a maximum of $6,500 for those 50 and older.
To lower the tax risks of a backdoor Roth IRA, make your annual contribution all at once and then convert it to a Roth right away.
Benefits of a Backdoor Roth IRA
Why would taxpayers want to go through the extra steps involved in doing the backdoor Roth IRA dance, aside from avoiding the limits? There are several compelling reasons.
For starters, Roth IRAs do not have required minimum distributions (RMDs), so account balances can generate tax-deferred growth for as long as the account holder is alive. You can withdraw as much or as little as you want at any time, or you can leave it all to your heirs.
Another reason is that a backdoor Roth contribution can result in significant tax savings over time because Roth IRA distributions, unlike traditional IRA distributions, are not taxable.
The main benefit of a backdoor Roth IRA, as with Roth IRAs in general, is that you pay taxes upfront on your converted pretax funds, and everything after that is tax-free. This tax benefit is best if you think tax rates will go up in the future or if you think your taxable income will be higher in the years after you set up your backdoor Roth IRA than it is now. This is especially true if you plan to take money out of your account after you retire.
Should I do a Backdoor Roth IRA?
As you can see, the backdoor Roth strategy can be beneficial for transferring funds to a tax-free account. With the possibility that tax rates will rise in the future, investing in Roth IRAs now could pay off in the long run. But not everyone should use it. As a result, you should ask yourself (or your financial advisor) whether a Roth IRA is right for you. If you earn too much to contribute directly to a Roth IRA, the answer may be no.
Consider it this way: If you are currently in a low tax bracket (say, 10% or 12%), contributing to a Roth IRA and avoiding paying taxes in retirement can make excellent financial sense. But if you are in a high tax bracket and can get a tax deduction for a traditional IRA, a traditional IRA may be a better choice from a tax savings point of view.
Because there is no way of knowing what U.S. tax brackets will look like by the time you’re ready to retire, a Roth IRA provides greater tax certainty. Other advantages of the Roth IRA include no required minimum distributions (RMDs) and the ability to withdraw contributions whenever you want.
Is backdoor Roth still allowed in 2023?
The answer is yes, you can make a backdoor Roth IRA contribution and a backdoor Roth conversion every year. The 2023 contribution limit is $6,500 ($7,500 if you are 50 or older).
Is there any downside to a backdoor Roth IRA?
Yes. A backdoor Roth IRA conversion, in whole or in part, may be taxable. You may have to pay federal, state, and local taxes on earnings that have been converted and contributions that are tax deductible. Conversions may cause you to fall into a higher tax bracket for the year.
Who qualifies for Backdoor Roth IRA?
Only those with modified adjusted gross incomes below $214,000 (married filing jointly) or $144,000 (single) can contribute to a Roth IRA in 2022.
What is the backdoor Roth loophole?
a strategy for people whose income is too high to qualify for regular Roth IRA contributions. Simply transfer funds from a traditional IRA to a Roth IRA. There are no income or contribution limits, so anyone can transfer funds from a traditional IRA to a Roth IRA.
What is the income limit for backdoor Roth?
These limits are $214,000 for married couples filing jointly for the 2022 tax year. $144,000 for single filers.
Is it a good idea to do a backdoor Roth IRA?
Yes. If you don’t have any money in traditional IRA accounts, a backdoor Roth is a smart way to save for retirement that will be tax-free. It may also make sense if you already have some savings in traditional IRAs.
Conclusion
If you’re considering using the backdoor Roth IRA strategy, do the math and think about the tax implications, particularly if you’re converting the entire balance of a traditional IRA. You might owe a lot of money in taxes.
Even so, there are benefits to the backdoor Roth IRA strategy, particularly for high earners. Roth IRAs do not require RMDs, so you can keep them indefinitely and pass them down to your heirs. Another reason is that a backdoor Roth contribution can result in significant tax savings over time because Roth IRA distributions, unlike traditional IRA distributions, are not taxable.
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- Best Tax-Free Investments In 2023
- BACKDOOR ROTH: How It Works & Benefits
- Best Ways To Invest Money: Top 7 + Options In 2023 & Best Practices
- ROTH 401(K): Withdrawal Rules and Comparisons
- TAXABLE BROKERAGE ACCOUNT: Understanding Taxable Brokerage Account And How It Works
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