What is a Backdoor Roth IRA and How Does it Work?

Highlights:

• Roth IRAs are a valuable tool for building your retirement wealth; however, they aren't available to investors whose income is over a certain amount.
• The term “backdoor Roth IRA” refers to the process of opening a traditional Investment Retirement Account (IRA), then converting the account to a Roth IRA. This strategy allows high-income investors to take advantage of Roth IRA benefits while avoiding Internal Revenue Service (IRS) income limits.
• The conversion process for a backdoor Roth IRA can have serious tax implications. So, it's a good idea to check with a tax professional before committing to this retirement strategy.

Roth IRAs are a valuable tool for building your retirement wealth. However, they aren't available to investors whose income exceeds a certain amount. The backdoor Roth IRA strategy offers high-income earners an alternate strategy. By opening a traditional IRA, then converting the account to a Roth IRA, you can take advantage of Roth IRA benefits, while avoiding IRS income limits.

Although a backdoor Roth IRA may offer certain advantages, the process can be both costly and complex. So, it's important to understand the ins and outs of this retirement strategy.

What is a backdoor Roth IRA?

IRAs, or individual retirement accounts, are tax-advantaged retirement savings accounts that can help provide a reliable stream of income once you retire. These accounts are most commonly divided into two types: traditional and Roth IRAs. Traditional IRAs are funded with pre-tax income, meaning your savings are not taxed until you withdraw them in retirement. Roth IRAs are funded with after-tax income, meaning withdrawals in retirement can be made tax-free.

Roth IRAs are strictly regulated by the IRS and come with income limits that prevent high-income investors from opening one of these accounts directly. That's where the backdoor strategy enters the picture. A backdoor Roth IRA is not a unique type of retirement account. Rather, the term refers to the retirement strategy of contributing to a traditional IRA and then converting the account to a Roth IRA to take advantage of the tax benefits associated with the latter.

Roth IRAs are funded with after-tax dollars. So, you won't owe taxes on withdrawals as long as you're over the age of 59 ½ and have owned your account for longer than five years when you access your savings. These tax-free withdrawals are especially helpful if you expect your income to rise by the time you retire, potentially pushing you into a higher tax bracket.

Unlike traditional IRAs, Roth IRAs don't have required minimum distributions. This means your money can sit in your retirement account for as long as you see fit, making Roth IRA a useful way to pass on your assets to any beneficiaries. Withdrawals made by your heirs will also remain tax-free.

How does a backdoor Roth IRA work?

The conversion process for a backdoor Roth IRA generally involves two main steps. First, open and contribute to a traditional IRA, up to the annual contribution limit. Second, convert some or all of these funds into a Roth IRA. You can generally make this transfer at any point after your traditional IRA has been opened.

This whole process may sound simple, but the conversion can have serious tax implications.

The process triggers taxes on your converted earnings or any deductible contributions. The funds that you convert will be treated as taxable income during the year of the conversion, which can temporarily bump you up into a higher tax bracket and further increase your tax bill. Also, if you withdraw your converted funds less than five years after the conversion event, you may owe a 10% tax penalty.

These potential tax consequences can make a backdoor Roth IRA tricky to pull off on your own. So, it's generally a good idea to consult a tax expert or other financial professional before beginning the process.

How to set up a backdoor Roth IRA

Think a backdoor Roth IRA can help you achieve your retirement goals? Here's the step-by-step process you would typically follow if you decide to open a backdoor Roth IRA.

• Open a traditional IRA. Choose a bank, credit union, investment company or other trustworthy financial institution that offers retirement savings accounts and open a traditional IRA.
• Contribute to your new account. Contribute to your new account with after-tax dollars, following the annual contribution limits set by the IRS.
• Convert to a Roth IRA. Finally, convert some or all of your traditional IRA into a Roth IRA, but make sure you're aware of the tax implications. If you have any earnings in your account, they'll be taxed as income during the tax year in which the conversion takes place.

Once you've opened your new Roth IRA, you'll need to wait five years before making a withdrawal to avoid a 10% tax penalty. These rules can be intimidating, but as long as you understand the financial risk and potential tax implications, a backdoor Roth IRA conversion can be a useful retirement savings strategy.