Given the ever-changing tax laws, many people are focused on creating or optimizing retirement accounts. There are multiple options for these accounts, but one of the most popular options is a Roth IRA, which allows you to withdraw your earnings tax and penalty-free once reaching the age of 59 ½. However, income restrictions can prevent high-income earners from contributing to Roth IRAs. The good news is that using the so-called “Backdoor” Roth IRA strategy, high earners can legally take advantage of Roth IRA tax benefits. In this article, we’ll explore what the Backdoor Roth conversion entails and why it could be a smart move for high-income earners.
What is a Backdoor Roth IRA?
Despite its name, a Backdoor Roth IRA isn’t a separate, formal Roth account, but a strategy that involves using a Traditional IRA to bypass the usual Roth IRA income restrictions.
There are a few steps to take to implement this strategy. Let’s break them down:
Step 1: Contribute to a Traditional IRA
To start, open a Traditional IRA account and begin contributing after-tax money to it. For high-income earners, there’s no reason to worry about income limits as Traditional IRA accounts have no income restrictions for contributing money. Since the goal is to utilize the Backdoor Roth IRA strategy, it’s essential to make non-deductible contributions, meaning you won’t (and probably can’t if you’re a high earner) deduct the contributions from your taxes.
Step 2: Convert the Traditional IRA to a Roth IRA
After making your after-tax contribution to the Traditional IRA, convert it into a Roth IRA. While a Roth IRA conversion is a taxable event, you’ve already paid taxes on the contributed money.
One common misconception about converting a Traditional IRA to a Roth IRA is that you need to wait a certain period of time between the contribution and conversion. But, this is not the case. You can convert your Traditional IRA to a Roth IRA immediately after making a contribution.
Step 3: Navigating the Pro-Rata Rule
Though not an actionable step, the Pro-Rata Rule is important enough to include it as one. The Pro-Rata Rule dictates how conversions are taxed and is based on the ratio of pre-tax dollars to after-tax dollars in all your Traditional IRAs. The total sum of these accounts on December 31 of the year in which you do the conversion step (Step 2) must be zero to avoid a “pro-rata” calculation that can eliminate most of the benefit of a Backdoor Roth IRA. Make sure to thoroughly plan out when you convert your Traditional IRA account into a Roth IRA.
Step 4: Fill out Form 8606
Keeping track of your contributions is important, as is reporting it on your taxes. Make sure to use Form 8606 to report your nondeductible contributions to the IRS. Accurately documenting these contributions is crucial.
Step 5: Repeat Next Year
Finally, repeat these steps every year to continue taking advantage of Roth IRA tax benefits.
Why is a Backdoor Roth IRA worth considering?
There are quite a few benefits to utilizing this strategy, including tax-free withdrawals and no required minimum distributions. Unlike a Traditional IRA, qualified distributions from a Backdoor Roth IRA are completely tax-free. Traditional IRAs have Required Minimum Distributions (RMDs) after age 73, whereas with a Roth IRA, you are not required to withdraw any money yearly. This allows for greater control over your income and taxes during retirement.
Another benefit is tax diversification during retirement. Tax diversification is important because it allows you to have more control over your taxable income each year.
Key Deadlines
For the Backdoor Roth IRA process, there are a couple of key deadlines to keep in mind. IRA contributions for a specific tax year must be made between January 1 of that year and April 15 of the following year, even if you file for an extension.
There is also the Backdoor Roth IRA Conversion Deadline. The conversion step has much more flexibility. It can be done immediately, even on the same day as the contribution, or delayed for months, years, or even decades. There’s no set deadline for Roth conversions. However, it’s recommended to complete a conversion of a Traditional IRA sooner rather than later to avoid the Pro-Rata Rule.
Many people choose to make their IRA contributions and complete the Roth conversion in the first week of January each year since this approach maximizes tax-free compounding potential. While minimizing the time between contribution and conversion is not required, doing so simplifies the paperwork and ensures everything happens within the same calendar year.
Tax Considerations
While the Backdoor Roth IRA can be highly beneficial, being mindful of the complexities that might arise during the process is important. When executed correctly, a Backdoor Roth IRA conversion incurs no additional taxes. Since the money you contribute to a Traditional IRA has already been taxed as income, it isn’t taxed again when you make a non-deductible IRA contribution and then convert it to a Roth IRA. Essentially, once the initial tax is paid, the funds will not be taxed again, allowing for tax-free growth and withdrawals. This means that in retirement your money can be withdrawn tax free, as long as the money has been in the account for at least five years.
The most important tax implication to be aware of is the Pro-Rata Rule. The Pro-Rata Rule can be confusing to navigate, so you may want to consult with your tax attorney or investment professional for clarification before converting your Traditional IRA to a Roth IRA.
Wrapping Up
Overall, even though there might be additional steps in the first year due to addressing certain complexities like the Pro-Rata Rule, the Backdoor Roth IRA process may be worth it in the long term. Utilizing this strategy can lead to more tax-free savings, helping to secure a comfortable and reliable retirement.
