If you’re a high income earner, or just someone who wants to put away more money for retirement than the IRS thinks you should, you might want to look into a backdoor Roth IRA. This is a legal way to skirt some of the rules around Roth IRA’s so that you can take advantage of the tax-free withdrawals of a Roth. What is a backdoor Roth IRA? How do I set one up? We’ll answer these questions for you.
- Roth IRA’s and Their Limits
- What is Backdoor Roth IRA?
- Why do I Want to Convert to a Roth IRA?
- When a Back Door Roth Might Not Be Such a Good Idea
- How to Do a Backdoor Roth IRA? And What is Step-by-Step at Vanguard?
Roth IRA’s and Their Limits
Roth IRA’s are great for most people planning for retirement. It allows you to pay taxes on your money now, so that you can withdraw that money tax-free when you retire. It’s especially attractive if you think you’ll make more money over time, because that would potentially put you in a higher tax bracket. You’ll pay taxes at your tax rate now, which might save you money in the long term.
As great as Roth IRA’s are, there are a few significant problems with them. Number one, the government limits how much you can contribute to a Roth in any given year—for 2020, the contribution limit is $6,000 ($7,000 if you’re over 50). It doesn’t take a financial genius to figure out it’s going to be hard to save for retirement with just $6,000 a year, especially since that is your total contribution limit for both traditional IRA’s and Roth IRA’s.
The second problem with Roth IRA’s is that people who exceed the IRS’s income limits are not allowed to participate. If you are married filing jointly your AGI (Adjusted gross income) can’t be over $203,000 and if you’re single your AGI can’t be over $137,000. If your AGI is higher than that, you won’t qualify for a Roth.
What is Backdoor Roth IRA?
What is a high-income earner to do? Open a back door Roth IRA. Since a traditional IRA does not have income limits, you can roll your existing IRA into a Roth. A nice feature is that you can roll over more than the annual contribution limit. You can roll your entire IRA over to a Roth if it suits you. You can only do one Roth IRA conversion a year, however.
However, since your traditional IRA is tax-deferred, you will have to pay taxes on the money when you go to roll it over. It will probably count as income and you’ll be taxed at your ordinary income tax rate. Be careful that this extra income doesn’t push you into the next tax bracket, because then your rate will be higher.
Why do I Want to Convert to a Roth IRA?
As we mentioned, a Roth could come in handy in retirement because you can withdraw the money tax-free. You already paid the taxes when you made the conversion, which could save you thousands if you enter a higher tax bracket as you earn more money.
Since your Roth IRA is an investment account, it should grow over time, tax-free. When you go to take the money out in retirement, you won’t have to pay taxes on those gains. This is a great benefit and it should be the main reason for people to do the Roth IRA conversion. If you do a Roth IRA conversion when you are in your 30s or 40s and do it every year. The money you convert in a Roth IRA account will earn returns for 20-30 years before you reach retirement. With compound interest rate, the investment gain in your Roth IRA account will be substantially more than the initial conversion amount. Not paying capital gain tax on the gain is a huge benefit in retirement.
Another advantage of a Roth IRA is that they don’t have required minimum distributions (RMD). A traditional IRA requires that you take a certain amount each year after you reach age 72 (70 ½ if you reach that before January 1, 2020). If you were hoping to leave this money to your heirs or let it sit in the account and grow, you can’t do that with all of the money. A Roth doesn’t have RMD’s, so you can let the money sit there and earn money for as long as you like.
For high income earners, after doing a backdoor Roth IRA, if you still want to save more for retirement, using your after-tax money and benefiting from tax-free withdrawal of Roth IRA account, you can also consider a mega backdoor Roth IRA. Learn more about what a mega backdoor Roth IRA is and how to set it up step-by-step with a 401K at Fidelity.
When a Back Door Roth Might Not Be Such a Good Idea?
If you’re going to need the money sometime in the next five years, don’t covert to a Roth. The rules say you must own the account for at least five years, or you’ll pay a 10% penalty when you withdraw.
If you have to pay the taxes on the money you’re converting with money from the IRA, you’re sacrificing future investment growth on the money. Obviously, this is not ideal. Yes, you’re going to have to pay taxes on the money sometime, but it’s better if you can do it with a low-growth savings account.
How to Do a Backdoor Roth IRA? And What is Step-by-Step at Vanguard?
It’s actually pretty easy, with a few rules you need to pay attention to. These steps are with Vanguard. However, it is pretty much the same with other brokerage firms.
- Assuming that you already have a traditional IRA account at Vanguard.
- Open a Roth IRA. Alternatively, just use one you already have if you have one.
- If you open a new Roth account, Vanguard will ask you how you want to fund your new Roth account. You just click to transfer and enter your traditional IRA account number.
- If you use the Roth IRA account you have already had. On your Vanguard account, select “Balances and Holding”
- On your Traditional IRA account, you will see a button “Convert to Roth”, click on that button and select the Roth account you want to convert to
- Pay the taxes in either case.
See? Very easy. Except:
The IRS has something called the Pro-rata rule. This requires you to consider all of your IRA’s as the same account. They consider some of that pre-tax money and some post-tax money. If you have $50,000 in a traditional IRA and $50,000 in a SEP IRA, the IRS considers that all one $100,000 account. If it’s made up of 80% pre-tax money and 20% post-tax money, 80% of whatever you convert will be taxed. You can’t just say it was all after-tax money and you can’t convert only after-tax money.
You must also fill out the non-deductible IRA form, 8606 when you file your tax return, because your income was too high for your IRA to be tax-deductible.
Also, different states treat conversions differently, tax-wise. Some exclude the entire conversion, and some don’t.
If all this sounds confusing, consult a tax professional for help.
Ed Slott – a renowned tax expert – on tax benefits of IUL policies
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If your income is too high to qualify for a Roth IRA, you can still take advantage of this retirement source by the back door method. It’s a little more complicated than just opening a Roth the usual way, but you’ll enjoy all of the benefits of a Roth IRA.