If you’re looking to get ahead on planning for retirement, you’re likely familiar with individual retirement accounts, or IRAs. An IRA is a tax-advantaged vehicle that helps you grow your retirement savings. Roth IRAs are particularly attractive, because you don’t pay taxes on withdrawals in retirement. There’s one problem: you can’t contribute to a Roth IRA directly if you make above a certain income. A backdoor IRA, though, can solve your problem. Here’s how it works.
What is a Backdoor IRA?
A backdoor IRA, in effect, permits account holders to work around income tax limits by converting what was originally a traditional IRA into a Roth IRA. For people with an income above the specified levels, direct Roth IRA contributions are very restricted. However, such income limits do not exist for conversionary accounts. In other words, putting money into a traditional IRA and then transferring the funds to a Roth IRA is a legitimate maneuver. This is called a backdoor IRA, because you are finding another entry-way to add money to your Roth IRA. Anyone who wishes to do so can move the money from a traditional IRA to a Roth IRA, regardless of income.
Though it may sound like a too-good-to-be-true way to sidestep taxes, backdoor IRAs don’t exist as a way to dodge taxes. When you transfer your traditional IRA money into a Roth IRA, you’re required to pay taxes on the money from your traditional IRA.
What Are the Types of IRAs?
If you are considering a backdoor IRA, it is important to understand the two types of IRAs: traditional and Roth. The difference hinges primarily on tax breaks.
With a traditional IRA, you can deduct your annual contributions from your taxes. However, you must pay taxes on your withdrawals in retirement. Traditional IRAs are best suited for people whose current tax rates are likely higher than those they’ll face in retirement. On the other hand, with Roth IRAs, your contributions are not tax-deductible. But come retirement, you won’t face taxes on your withdrawals. Roth IRAs are best suited for those in lower tax brackets who expect to be in higher brackets in the future. You pay taxes on the seeds of savings but not on the crops that have flourished over the years.
Roth IRAs aren’t readily available to everyone, though. If you are single, your modified adjusted gross income (MAGI) needs to be under $135,000 to contribute to a Roth IRA. If you are married filing jointly, you and your spouse must have a household MAGI of less than $199,000 to put money into a Roth IRA.
A backdoor IRA, though, allows for those who exceed the income limits to contribute to a Roth IRA.
How Do You Set Up a Backdoor IRA?
Setting up a backdoor Roth IRA is much simpler than it may initially seem. It’s just an act of conversion. In essence, you’ll be converting your Traditional IRA into a Roth IRA by wholly switching the account and paying the taxes owed on your former traditional IRA contributions, as well as on any gains earned.
Here’s a step-by-step guide. First, put your money in a traditional IRA account. Secondly, you’ll convert that account to a Roth IRA. Then you’ll pay taxes on the contributions to the traditional IRA that haven’t already been taxed (be sure to note the funds you convert to a Roth could count as income for that year). Finally, you’ll pay your taxes on the gains. This chain of events emphasizes the original message above: backdoor IRAs don’t exempt you from paying the taxes all other Roth IRA account holders pay.
Are Backdoor IRAs Legal?
You may be wondering whether Backdoor IRAs are completely legal. Many people have voiced their skepticism on the legality of backdoor Roth IRAs, given its unusual name. But luckily, they are indeed legal.
Though the maneuver has been around for nearly a decade—since 2010—Congress officially deemed the backdoor Roth IRA legal following the Tax Cuts and Jobs Act President Trump signed into law in 2017.
Is a Backdoor IRA Right for You?
Every financial situation is different, meaning one IRA does not fit all. Backdoor IRAs may seem a surefire way to get the benefits of a Roth IRA if you make too much money. Keep in mind that backdoor IRAs are generally geared toward higher-income investors with large savings in traditional IRAs.
On the other hand, who is the backdoor IRA not for? Essentially, anybody who is interested in the strategy solely as a means to get around the income limits set on Roth IRA contributions. Before you decide which way to go, know the risks and the benefits for your personal finances. Be sure to enlist the support of a tax professional.
The Bottom Line
Since its 2010 inception, the backdoor Roth IRA has been a desirable option among high-income individuals. That’s because they otherwise may not have been eligible for money-saving Roth IRA benefits. It would make plenty of sense to want in. But before you convert your assets, be sure you have your ducks in a row. Firstly, be completely clear on the Roth IRA income limits for the year you plan to make the change. Next, find out whether your current job offers an employee retirement plan. This could make a big impact on your ability to get around IRA attribution regulations. Finally, consider keeping your backdoor strategy under wraps. While it is not illegal, there could be economic risks at play for flaunting it. After all, the policy is easily reversible; the Obama Administration was against it.
Tips for Investment
- Currently, the backdoor strategy is booming with popularity among high-earning individuals looking to make Roth IRA contributions. So be sure to talk with your financial advisor before you make the jump.
- If you have access to a workplace retirement plan, you can see how your plan will grow with our 401(k) calculator.
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