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Backdoor Roth IRA – how to benefit from this tax loophole

by Roshani

What is a backdoor Roth IRA?

A backdoor Roth IRA is a tax loophole that someone with a higher income can use to contribute to a Roth account.

What is a ROTH?

A Roth is a tax-advantaged retirement account where you contribute income after paying taxes on them. The money grows and just like a 401K or a traditional IRA, you can start withdrawing the money at age 59 ½. Let’s say you opened a Roth account and contributed $100K into it and over the years, the money grew to be $150K. Normally, you would have to pay taxes on the $50K. But, in a Roth account, you don’t pay any taxes and at age 59 ½, you can withdraw the full $150K tax-free.

What are the income limits for a Roth?

While anyone with an earned income can contribute to a Roth, there are limits as to how high the income can be. For 2020, the IRS allows only those people with modified adjusted gross incomes below $206,000 (married filing jointly) or $139,000 (single) to contribute directly to a Roth IRA. In 2019, the limits were $203,000 (married filing jointly) or $137,000 (single).

Why is a Roth account so powerful?

Besides the tax-advantage mentioned above, where your contributions grow tax-free, the other advantage of a Roth account is its flexibility.

In a traditional retirement account like an IRA, while you can start withdrawing money at age 59 ½, you are required to withdraw at age 70 ½. On the other hand, in a Roth IRA you are never required to withdraw and can keep your investments growing. In fact, you can even pass it to your heirs and have them withdraw without paying any taxes!

Due to its flexibility, a ROTH can grow much more substantially as the contributions compound over the years and through retirement and can be withdrawn completely tax-free.

While a ROTH is powerful, in some cases, a traditional IRA might be more suitable. To find more about what types of accounts are suitable in different scenarios, read here.

What are the uses of a backdoor roth IRA?

There are two main ways to use a backdoor roth IRA:

  • To contribute to a Roth IRA for someone who cannot do so directly because they have a higher income than the IRS limit
  • To convert a traditional IRA to a Roth IRA. You will owe taxes on the conversion

How do I use a backdoor roth to contribute to a roth IRA?

Step 1: Open a traditional IRA account with your broker

Step 2: Contribute after-tax dollars to the traditional IRA, up to the limit the IRS allows  

Step 3: Immediately, open a Roth IRA and transfer the money from the traditional IRA to the Roth IRA

Step 4: Complete any paperwork needed to properly code the Roth conversion. Your broker can help with this

Will you owe any taxes?

In the scenario above, since you contributed after-tax dollars and are converting right away, you will not owe any taxes on this conversion. If you already had any money in the IRA account, that money might have grown. As a result, you will owe some taxes when you transfer it to your Roth IRA.

Even if you have a different IRA account elsewhere, as long as you have money in it, the IRS will take that into account into consideration when computing your taxes due for the conversion. So, a backdoor Roth IRA works best when you have no funded IRA already. In this way, you can put money into it every year and transfer it to a Roth IRA subsequently.

Why convert a traditional IRA to a Roth? 

  • If you convert a traditional IRA to a Roth account, the money  grows and you will not pay any further taxes on it. In other words, the money grows tax-free
  • Since you are not required to withdraw from a Roth account, it gives you more flexibility than a traditional IRA. For example, you can decide how much you want to spend from it at retirement. Or, you can pass it to your heirs and they can withdraw the money tax-free

In what scenarios is a backdoor roth conversion most advantageous

When you convert your traditional IRA to a Roth IRA, you pay taxes on the conversion. So, it is best to do these conversions in a low tax year. Here are some scenarios where you might have a low tax year:

  • If you are taking a break from work, or are in a period where your income for the year is very low: In this case, you will be paying taxes on the conversion but because you will likely fall in a low tax bracket for the year, your taxes will also be low
  • If you plan to make a charitable donation: When you make a charitable donation, you receive a deduction that lowers your taxable income. With the new Tax Cuts and Jobs Act, the tax deductions from charitable donations have increased. So, in a year where you plan to make substantial charitable donations, you may also fall in a lower tax bracket. Hence, if you convert your traditional IRA to a Roth in that year, your taxes will also be low. This strategy will require careful coordination. So, be sure to consult with your accountant before taking any steps

What are other things to consider when doing a Roth conversion?

  • If you need to withdraw money from your IRA to pay taxes for the conversion and you are under the age of 59 1/2, you may owe a 10% penalty on the withdrawal
  • Any money that you convert from a traditional IRA to a Roth falls under the Roth five-year Rule. So, if you withdraw the money within this time period, you may end up owing taxes on it and also need to pay the 10% penalty. So, if you need to withdraw the money from your Roth IRA before the five-year period, a conversion may not be a good idea
  • The taxes you will owe from the conversion could potentially put you in a higher tax bracket. This is the reason why it is important to do a Roth conversion in a low tax year

Steps to do a Roth conversion

If you are looking into converting your traditional IRA to a Roth, talk to your accountant first. Ask them to do a tax projection based on your projected income to see what the impact of the conversion will be.

There might be factors that you haven’t considered and you don’t want to be taken by surprise at tax time. The consultation might come at a cost but it is worth it.

Next steps for you

Each year, you can contribute to your Roth IRA until April 15 of the following year, or the tax filing deadline. This means that if you haven’t already contributed to a Roth for 2019, you can still do so until April 15 of this year.

  • For 2019, you can contribute up to $5,500 ($6,500 if you’re age 50 or older)
  • For 2020, you can contribute up to $6,000 ($7,000 if you’re age 50 or older)
  • If your income is under the IRS income limits as described above, open a Roth account and contribute directly for both 2019 and 2020
  • If your income is over the IRS income limits, you could do a backdoor Roth IRA and contribute for both years
  • To invest the money in your Roth, you can either hire an advisor or do it yourself

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