- The Backdoor Roth IRA can help you save for retirement
- IRA and Solo 401k plans are the best for retirement savings
- Be aware of UBTI
How The Backdoor Roth IRA Can Help You
Although the Roth Individual Retirement Account (IRA) is one of the best retirement savings strategies, it’s not open to all. But through the Backdoor Roth IRA, you can now get around the income limits on Roth IRA and enjoy its tax advantages.
The backdoor method gives an alternative to the direct Roth IRA strategy. You open a traditional IRA, make your contribution, and then convert the funds to Roth IRA at a later date.
However, this approach may not assure you of a tax dodge; it can even incur higher taxes. Read on to know more about the Backdoor Roth IRA.
What Is The Backdoor Roth IRA?
First, you have to understand that the backdoor Roth IRA is not an account, but a strategy. It is a legal method for high-income earners to fund a Roth even when their income exceeds the IRA approved limit for Roth contribution.
A Roth IRA or Roth 401(k) permits taxpayers to contribute a few thousand dollars into a retirement savings account every year. This contribution is post-tax, meaning that the income on those earnings is paid in the year the money is deposited.
This is however not the case with a traditional IRA or 401(k). The traditional IRA delays the income taxes on the deposits until the money is withdrawn, thereby giving the earner an immediate tax advantage. Whenever the account holder (now retired) makes the withdrawals, they will now owe taxes on both their earnings and the dollar invested.
The challenge here is that the Roth IRA is restricted to people with a specified amount of income, under the regular rules. Once your annual income oversteps a certain limit, you cannot participate at all. The limits vary using taxpayers’ status (single, married filing jointly, etc.)as a metric. They are also modified every year or so for inflation.
Traditional IRAs don’t have income limits. From 2010 till date, the IRS hasn’t placed income limits to restrict who can convert a traditional IRA to a Roth IRA.
Consequently, the backdoor Roth has become an option for higher-income taxpayers who can’t contribute to a Roth the normal way.
Brief History Of the Backdoor Roth IRA
The Taxpayer Relief Act of 1997 reestablished Individual Retirement Arrangements (IRAs) and created Roth IRAs for the first time. As a result of Congressional rules, both traditional IRAs and Roth IRAs had income limits that restricted high-income professionals from contributing or deducting from traditional IRA contributions, and from converting traditional IRAs to Roth IRAs.
The 2006 Tax Increase Prevention and Reconciliation Act included a change in just one of these rules, the prohibition on Roth IRA conversions. Nonetheless, that change did not actually take effect until 2010.
In 2010, Congress passed rules to allow more flexibility and permit retirement savers to convert savings held in a traditional IRA into a Roth IRA, paying taxes on the distributions when they make the conversion.
How Does the Backdoor Roth IRA Work?
Some higher-income earners use this approach, in a two-step process:
- Open a non-deductible traditional IRA and make after-tax contributions.
For 2021, you’re allowed to contribute up to $6,000 ($7,000 if you’re age 50 or older). Make sure you file IRS Form 8606 every year you do this.
- Transfer the assets from the traditional IRA to a Roth IRA.
You can make this transfer and conversion at any point in the future. Some advisors suggest waiting a few months.
Learn More: Can I still do a Backdoor Roth in 2022?
How to do a Backdoor Roth IRA
You can convert a traditional IRA into a Roth IRA in just a few easy steps:
- Open a traditional IRA
- Make an after tax traditional IRA contribution. Do not treat the IRA contribution as tax deductible on your tax return.
- Make an IRA contribution for 2023 of up to $6,500 or $7500 if over 50.
- Notify your IRA custodian that you want to convert the after-tax traditional IRA to Roth.
- Funds are transferred to Roth IRA.
- IRA custodian issues a 1099-R in the following year indicating that a no tax conversion occurred.
Benefits of a Backdoor Roth IRA
The key advantages to using the backdoor Roth IRA strategy are:
- No income limit to start the traditional IRA: Anyone who earns an income is eligible for a traditional IRA.
- Tax-free gains and withdrawals:
Tax-free growth and withdrawals are one thing you are sure to enjoy(but you have to wait till you reach age 59 1/2 to withdraw).
When you convert your traditional IRA funds to a Roth, you pay the taxes upfront, and this will be less than what you’d pay if they were taxed later on.
How a Solo Entrepreneur Can Use It?
A solo entrepreneur can use the Roth IRA, but not through the “backdoor” Roth IRA conversion. Rather, it’s just a conversion of a pre-tax retirement plan to a Roth IRA.
You’d have to take an income tax deduction for SEP-IRA contributions in the year to which the contributions apply.
But there are particular rules for the self-employed. This rule allows for conversion to add back the converted amount as taxable income in the year in which the conversion took place. So as you’re working on quickly building your Roth IRA balances.
In 2014, in addition to making deductible SEP-IRA contributions, you can make a nondeductible Roth IRA contribution ($5,500 or $6,500 if age 50+). If you’re married, you can also make a spousal Roth IRA contribution.
Eligibility to make a Roth IRA contribution phases out between $114,000 to $129,000 of modified adjusted gross income (MAGI) if you’re a single filer, or $181,000 to $191,000 if you’re married filing jointly.
Beyond straight Roth IRA contributions, you might want to consider multi-year conversions from your SEP-IRA so you don’t take the tax hit all at once.
Related: Importance of Investment Diversity
The Backdoor Roth IRA is a great idea as it helps you tap into the opportunity that Roth IRA provides. However, it’s highly recommended that you work with a professional accountant or tax advisor.