Backdoor Roth IRA: Breakdown and How To Create One

Backdoor Roth IRA Breakdown

Even if your salary is too high for a Roth IRA, a backdoor Roth IRA allows you to convert a conventional IRA to a Roth.

A “backdoor Roth IRA” is a sort of conversion that permits high-income individuals to avoid the Roth’s income constraints.

Simply stated, you contribute to a standard IRA, convert your contributions to a Roth IRA, pay some taxes, and you’re done. Even if you didn’t qualify to contribute to a Roth, you may still enter via the back door, regardless of your income.

That’s fantastic news since your money grows tax-free, which is a nice bonus when it comes time to withdraw your money in retirement.

Income restrictions for Roth IRAs

In terms of Roth IRA income restrictions, the government enables persons with modified adjusted gross incomes of less than $208,000 (married filing jointly) or $140,000 (single) to contribute to a Roth IRA in 2021.

If your income exceeds the cap, a backdoor Roth may be a viable option for you. (For additional information on Roth IRA income and contribution restrictions, see this article.)

How to Set Up a Backdoor Roth IRA

Here’s a step-by-step method on converting a backdoor Roth IRA:

  1. Put money into a traditional IRA. You may already have an account, or you could start one and fund it. (If you need to create an account, check CNBC’s recommendations for the best IRA providers.)
  2. Convert your contribution into a Roth IRA. The instructions and paperwork will be sent by your IRA administrator. If you don’t already have a Roth IRA, you’ll open one during the conversion.
  3. Get ready to pay your taxes. Roth IRAs are only funded using after-tax money. So, if you deducted your traditional IRA contributions and subsequently converted your traditional IRA to a backdoor Roth, you’ll have to pay that tax deduction back. Prepare to pay income tax on the money you converted to a Roth when you submit your tax return. Also, see below for more information on the pro-rata rule, which plays a significant role in calculating your tax bill.
  4. Prepare to pay taxes on your conventional IRA profits. If the money in your conventional IRA has been lying there for a while and there have been investment gains, you will owe tax on those gains when tax time comes around.

Remember to follow the rules

To avoid fines, keep the following guidelines in mind:

Types of Transfers
One of the following conversions must be used:

  • a rollover, in which you receive funds from your IRA and deposit them into your Roth within 60 days,
  • a trustee-to-trustee transfer, in which the IRA provider transfers funds directly to your Roth IRA provider, or
  • a “same trustee transfer,” in which your funds are transferred from your IRA to your Roth at the same financial institution.

Backdoor Roths and the pro-rata rule

The IRS mandates pro-rata rollovers from regular IRAs to Roth IRAs. This is how it works: The IRS will consider all of your conventional IRA accounts when calculating your tax obligation on a conversion from a traditional IRA to a Roth IRA.

If all of your conventional IRAs are made up of, say, 70% pre-tax money and 30% after-tax money, that ratio affects how much of the money you convert to a Roth is taxed. In this scenario, regardless of how much money you convert or whatever IRA account you withdraw funds from, 70% of the amount converted to the Roth will be taxed. The IRS will not enable you to convert merely after-tax funds.

A note on timing: the IRS applies the pro-rata rule to your entire IRA value at the end of the year, not at the moment of conversion.

Is it worthwhile to open a backdoor Roth IRA?

A backdoor Roth IRA is generally not a good idea if…

  • The only way to pay the taxes owing is with money from your IRA withdrawal. Not only are you foregoing any future investment gain on that money, but there’s also the possibility that you’ll owe the 10% early withdrawal penalty if you’re under the age of 59-1/2.
  • You’ll need the money in five years or less. Money converted from an IRA to a Roth IRA is subject to a Roth five-year rule: if you don’t wait five years to remove it, you may face taxes and a 10% penalty.
  • The withdrawal from your IRA will place you in a higher tax rate. It’s often a good idea to convert just enough so that you don’t have to pay a higher tax rate that year.

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Francesca Castillo