When it comes to retirement savings, you’re presented with a variety of options, each with its own unique set of advantages and disadvantages. Among them is the Roth Individual Retirement Account (IRA), a powerful tool that offers tax-free growth and tax-free withdrawals in retirement. However, the benefits of a Roth IRA are not accessible to everyone due to income limits set by the Internal Revenue Service (IRS). Fortunately, there’s a strategy known as the “backdoor” Roth IRA that can help higher-income earners also take advantage of this account. In this article, we will delve into the details of what a backdoor Roth IRA is, who it applies to, and how to open one.
What is a Backdoor Roth IRA?
The term “backdoor Roth IRA” is not an official retirement account type but rather a financial strategy that high-income earners use to sidestep the direct contribution limits to a Roth IRA. As of my knowledge cutoff in September 2021, if you are a single filer with a modified adjusted gross income (MAGI) above $140,000 or a joint filer with a MAGI above $208,000, you are ineligible to contribute directly to a Roth IRA.
The backdoor Roth IRA strategy involves making a non-deductible contribution to a Traditional IRA and then converting that Traditional IRA into a Roth IRA. This two-step process effectively bypasses the income limitations associated with direct Roth IRA contributions.
Why Would You Want a Backdoor Roth IRA?
There are several reasons why high earners might want to consider a backdoor Roth IRA:
- Tax-Free Withdrawals: Unlike Traditional IRAs, withdrawals from a Roth IRA during retirement are tax-free as long as certain conditions are met. This can be a significant benefit for those who anticipate being in a higher tax bracket in retirement.
- No Required Minimum Distributions (RMDs): Roth IRAs are not subject to RMDs during the lifetime of the original owner, allowing you to let your investment grow as long as you’d like.
- Potential Tax Diversification: Having funds in a Roth IRA can provide tax diversification in retirement, giving you more flexibility to manage your income tax liability.
How to Open a Backdoor Roth IRA
Before implementing a backdoor Roth IRA strategy, it’s important to consult with a financial advisor or a tax professional, as there are potential tax implications and complications.
Here’s a simplified step-by-step guide on how to open a backdoor Roth IRA:
Step 1: Contribute to a Traditional IRA
Open a Traditional IRA if you don’t have one already, and make a non-deductible contribution up to the annual limit ($6,000 or $7,000 if you’re age 50 or older as of 2021). It’s important to note that this contribution is made with after-tax dollars, so you won’t be able to deduct it on your tax return.
Step 2: Convert Your Traditional IRA to a Roth IRA
After making your contribution, you can then convert your Traditional IRA into a Roth IRA. This is often as simple as completing a form with your IRA provider. However, it’s crucial to understand the tax implications of this step. If you have any pre-tax dollars in ANY of your Traditional IRA accounts, you could be liable for taxes on the conversion under the IRS’s pro-rata rule.
Step 3: Report the Conversion on Your Taxes
Finally, you’ll need to report the non-deductible contribution and the conversion on your taxes. Form 8606 is used to report non-deductible IRA contributions and should be filed with your tax return.
Conclusion
A backdoor Roth IRA is a valuable strategy for high-income individuals to harness the power of tax-free growth and tax-free withdrawals in retirement. However, the process involves multiple steps and potential tax implications. So, it’s always wise to engage the services of a tax professional or financial advisor to guide you through the process and help you avoid any pitfalls. With careful planning, a backdoor Roth IRA can be a powerful addition to your retirement savings strategy.
