Having a large nest egg in a Roth IRA means you can enjoy tax-free income in retirement. Roth retirement accounts, like a Roth IRA, are funded with after-tax dollars (money you’ve already paid income taxes on), and in retirement, your withdrawals are completely tax-free.
Unfortunately, the Roth IRA has an income limit that restricts high-income individuals from contributing. If you make too much money, you can’t take advantage of the tax benefits that a Roth IRA gives you in retirement. The good news is that there’s a fairly simple workaround that’s actually more common than most people think: The backdoor Roth IRA.
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What is a backdoor Roth IRA and how does it work?
A backdoor Roth IRA isn’t a type of account, it’s a strategy for getting money into a Roth IRA when your income exceeds the annual income limit. With a Roth IRA, you cannot make contributions if your income is too high.
Roth IRA income limits for 2022
- If your income is $129,000 or less, you can contribute up to the maximum Roth IRA contribution limit of $6,000 ($7,000 if age 50+).
- If your income is over $129,000 but less than $144,000, your contribution limit gets reduced.
- If your income is over $144,000, you cannot contribute at all.
Roth IRA income limits for 2023
- If your income is $138,000 or less, you can contribute up to the maximum Roth IRA contribution limit of $6,500 ($7,500 if age 50+).
- If your income is over $138,000 but less than $153,000, your contribution limit gets reduced.
- If your income is over $153,000, you cannot contribute at all.
If your income is over $144,000 in 2022, you cannot make contributions to a Roth IRA that year. If your income is over $153,000 in 2023, you cannot make contributions to a Roth IRA that year. Learn more about the Roth IRA income limits.
However, its sister account, the traditional IRA, does not have income limits that restrict high income earners from making contributions.
In a backdoor Roth IRA, you would make your contributions to a traditional IRA and then immediately convert the funds into a Roth IRA. It’s almost silly that an income limit for a Roth IRA even exists when there’s such a popular, easy method to work around it.
The income limit on the Roth IRA only applies to contributions. You cannot contribute to the plan if your income is too high. The rule does not apply for conversions and rollovers, allowing high income earners to contribute to a Roth IRA by using a backdoor.
Also read: Roth IRA vs Traditional IRA
You can several different transfer options to choose from when moving the funds from your traditional IRA to your Roth IRA.
- Same trustee transfer – If your plan provider for your traditional IRA and Roth IRA are the same, the simplest method is the “same trustee transfer”. Your plan provider will simply move the funds from your traditional IRA to your Roth IRA.
- Direct rollover – If your plan provider for your traditional IRA and Roth IRA are different, a direct rollover could be performed. Your traditional IRA plan provider will send the money directly to your Roth IRA plan provider.
- Indirect rollover – This is the least recommended method because it opens you up to penalties. In an indirect rollover, your traditional IRA plan provider will send you the money first (withholding 10% of the funds). Once you receive the money, you’ll have 60 days to deposit the money in full to your Roth IRA. 10% of the funds get withheld, and you’ll have to come up with the withheld amount on your own from other sources in order to make the full deposit. This method is only recommended if you need a short-term loan by accessing your funds, since the IRS lets you do whatever you want with the money as long as it’s deposited within 60 days.
Also read: Transfer vs Rollover: Main Differences
Will I have to pay taxes for a backdoor Roth IRA?
Yes, you will have to pay taxes since a traditional IRA and Roth IRA are funded differently.
- A traditional IRA is funded with pre-tax dollars that you haven’t paid taxes on yet. Instead, the contribution amount gets deducted from your taxable income when you make a contribution.
- A Roth IRA is funded with after-tax dollars that you already paid taxes on.
Therefore, when you convert funds from a traditional IRA into a Roth IRA, you’ll have to add the amount that gets converted to your taxable income for the year. For example, if you convert $5,000 from a traditional IRA to a Roth IRA, you’ll have to report the conversion and the $5,000 would be considered as taxable income on your next tax return.
How much can I put into my Roth IRA each year using a backdoor?
You can put in up to the IRA contribution limits for the year. A traditional and Roth IRA both have contribution limits of $6,000 for 2022 and $6,500 for 2023. If you’re at least 50 years of age, your limits are $7,000 for 2022 and $7,500 for 2023. Contribution limits are aggregated between both accounts.
If you want to do a backdoor Roth IRA, you can put in up to $6,000 ($7,000 if age 50+) for 2022 and $6,500 ($7,500 if age 50+) for 2023.
How do I set up a backdoor Roth IRA?
To implement the backdoor Roth IRA strategy, you’ll need to have both a traditional IRA and Roth IRA. You can technically establish both accounts during the backdoor IRA process, but it can be simpler if you create them beforehand.
Once you have both accounts, here’s how it works.
- Make your contributions to a traditional IRA. You can contribute up to $6,000 ($7,000 if age 50+) for 2022 and $6,500 ($7,500 if age 50+) for 2023.
- Immediately convert your contributions to a Roth IRA. Don’t invest your money just yet, since we need to convert it to the Roth IRA.
- Prepare to pay taxes on the converted amount on your next tax return.
- Invest the money.
Once the money gets converted to your Roth IRA, you can start investing the money. All of your earnings are now tax-free, even when you make withdrawals in retirement.
When can I withdraw from a Roth IRA?
A Roth IRA typically lets you withdraw your contributions (not earnings) from your account at any time, without any penalties or taxes. You can withdraw earnings from your Roth IRA when you reach the age of 59½ and your Roth IRA is at least 5 years old (at least 5 years must have passed since you made your first contribution).
When can I withdraw my conversions?
Withdrawals of conversions or rollovers are treated differently from earnings or contributions, and follow a separate 5-year rule. Once your conversion is successful, the 5-year clock starts. Once the 5 year period is over, you can withdraw the amount of the conversion without penalties or taxes, but not the earnings.
Therefore, a backdoor Roth IRA could be a suitable option if you plan on withdrawing the funds after 5 years. Since a traditional IRA does not allow you to take any money out until after the age of 59½, making the same withdrawal from a traditional account would result in an early distribution penalty of 10% plus income taxes.
No RMD for a Roth IRA
Another benefit of doing a backdoor Roth IRA is that you have no required minimum distributions. With a traditional IRA, you’re required to start taking distributions each year once you turn 73 years old. You must take continue taking distributions every year until your account is emptied. With a Roth IRA, you do not have any RMD rules and can keep your money compounding tax-free as long as you’re alive.
Also read: Can I Rollover An IRA to a Solo 401k?
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