What is a Backdoor Roth IRA?
A Backdoor Roth IRA is a strategy for individuals to contribute to a Roth IRA, even when their income exceeds the IRS’s income limits for direct Roth IRA contributions. This strategy involves making a non-deductible contribution to a Traditional IRA and then converting that contribution to a Roth IRA. This process is entirely legal and is a valuable tool for high-income earners who wish to take advantage of the tax-free growth and tax-free withdrawals in retirement that Roth IRAs offer.
Why Use a Backdoor Roth IRA?
The primary reason to use a Backdoor Roth IRA is to bypass the income limits set by the IRS for direct Roth IRA contributions. For 2021, the income limit for a full contribution to a Roth IRA is $125,000 for single filers and $198,000 for married couples filing jointly. If your income exceeds these limits, you are not allowed to contribute directly to a Roth IRA. However, there are no income limits for converting a Traditional IRA to a Roth IRA, which is where the Backdoor Roth IRA strategy comes into play.
How Does a Backdoor Roth IRA Work?
Step 1: Make a Non-Deductible Contribution to a Traditional IRA
The first step in the Backdoor Roth IRA process is to make a non-deductible contribution to a Traditional IRA. This means you contribute post-tax dollars to the IRA, and you do not get a tax deduction for the contribution.
Step 2: Convert the Traditional IRA to a Roth IRA
The next step is to convert the Traditional IRA to a Roth IRA. This can typically be done online through your brokerage account. When you convert the Traditional IRA to a Roth IRA, you will owe taxes on any earnings in the account. However, since you made a non-deductible contribution, you will not owe taxes on the amount of your contribution.
Considerations for a Backdoor Roth IRA
While a Backdoor Roth IRA can be a great strategy for high-income earners to contribute to a Roth IRA, there are a few important considerations to keep in mind.
The Pro-Rata Rule
The IRS’s pro-rata rule states that if you have any other pre-tax IRAs (such as a deductible Traditional IRA, SEP IRA, or SIMPLE IRA), the amount you convert to a Roth IRA will be considered a mix of pre-tax and post-tax dollars. This could potentially increase your tax liability.
Five-Year Rule
When you convert a Traditional IRA to a Roth IRA, you must wait five years before you can withdraw the converted amount penalty-free. This is known as the five-year rule.
Tax Planning
It’s important to consider the tax implications of a Backdoor Roth IRA. You may want to consult with a tax advisor to ensure you understand the potential tax liability and to plan accordingly.
In summary, a Backdoor Roth IRA is a valuable strategy for high-income earners to contribute to a Roth IRA and take advantage of its tax benefits. However, it’s important to understand the rules and potential tax implications before implementing this strategy.