Due to the unique tax benefits they offer, Roth IRAs are a favorite tool of finance professionals and their clients alike. Roth IRA contributions are made with after-tax dollars, but the account’s funds are able to grow and be withdrawn tax-free as long as certain conditions are met.
While this may sound like an account without any downsides, there are restrictions to who can utilize these types of accounts—and these restrictions are entirely dependent on a person’s income level. For example, in 2022, those making over $144,000 were not eligible to contribute to a Roth IRA. Fortunately, that is where a backdoor IRA comes in.
What is a Backdoor Roth IRA?
A backdoor Roth IRA is not its own type of IRA account, but is instead a term for how individuals who have incomes too high to qualify for a Roth IRA may use a Traditional IRA as a work-around. By navigating around the restrictions put on an IRA, high income earners can still take advantage of these hefty tax savings.
How to Use a Backdoor Roth IRA
First, Contribute to Your Traditional IRA. Each year, those under 50 can contribute $6,000 to their traditional IRAs, which utilizes post-tax dollars directly from a bank account.
Second, Do Not Invest This Contribution. Typically, the funds in a traditional IRA will be invested so they will grow. Since you’re planning on moving the money, this growth is undesirable, as it would then become taxable.
Third, Make the Conversion. With your same brokerage account, move the funds from the traditional IRA into your Roth IRA. As long as there hasn’t been growth on the account, you won’t have to pay additional taxes to do this.
Fourth, Invest the Funds. Be sure your Roth IRA is set up on an investment plan that matches your goals so that you can grow your funds accordingly.
Fifth, Enjoy the Rewards. When you’re ready to utilize your investment, as long as it has been 5 years from your initial Roth IRA contribution and you’re over 59 ½, you can withdraw the money tax-free.
If you would like to learn more about backdoor Roth IRAs and laying the groundwork for your financial future, get in touch with us today to schedule a complimentary consultation!
The pro-rata rule would apply if the traditional IRA being converted had any existing pre-tax contributions. The pro-rata rule dictates that when an IRA contains both nondeductible and deductible funds, each dollar withdrawn (or converted) from the IRA will contain a percentage of tax-free and taxable funds