Supercharge your retirement savings with a backdoor Roth IRA

One of the best places to park your retirement savings is Roth IRA. Your contributions grow tax-free to save you money every tax season. The only problem is that high-income earners may not qualify for Roth IRA.

I’m going to let you in on an open secret called the “backdoor Roth IRA.” Despite the semi-illicit name, a backdoor Roth is a legit (and legal) way to make Roth IRA contributions with a high income. Funding this retirement account is one of the best money moves you can make this year.

Admittedly, a backdoor Roth isn’t going to benefit every high-income person. For example, if you have a substantial traditional IRA balance, the upfront tax penalty may not be worth the future tax-free withdrawals.

What is a Backdoor Roth IRA?

A backdoor Roth IRA is essentially converting a traditional IRA into a Roth IRA.

While it’s easy to convert your account, you must decide if a backdoor Roth IRA is for you.

It’s essential to know how a backdoor Roth works to avoid potential taxes and penalties.

Although there are upfront expenses, you enjoy the lifetime tax benefits of a Roth IRA. Under current tax law, all contributions grow tax-free and qualify for tax-free withdrawals.

In 2020, you can contribute up to $6,000 to an IRA or $7,000 if you’re 50 years or older. You pay income tax on the entire contribution amount for the current tax year. But you never pay taxes again when you make qualifying withdrawals.

Funding your backdoor Roth IRA before the federal tax deadline (April 15, 2020) lets you enjoy tax savings for 2019 as well.

Roth IRA Income Limits

If your annual income is low enough, you may still qualify for a regular Roth IRA. The IRS has different annual income limits for individual and joint filers based on your modified adjusted gross income (MAGI).

You’re a perfect candidate for a backdoor Roth IRA when you’re a single filer and make at least $139,000 annually. If you file a joint tax return, a minimum $206,000 annual income disqualifies you from a standard Roth IRA.

When your annual income is below either of these marks, you need to be wary of the IRS income phaseout range. You may still be able to make reduced contributions directly to your Roth IRA. Then you can use the backdoor option to close the contribution gap.

Below are the Roth IRA income phaseouts in tax year 2020 for your tax situation.

Single, Head of Household, or Married Filing Separately

• Can make full Roth IRA contribution (a Backdoor Roth isn’t necessary): $124,000
• Can make partial Roth IRA contributions: Between $124,000 and $138,999
• Don’t qualify for a standard Roth IRA: $139,000 or higher

Married Filing Joints or a Qualified Widow(er)

• Can make full Roth IRA contribution (a Backdoor Roth isn’t necessary): $196,000
• Can make partial Roth IRA contributions: Between $196,000 and $205,999
• Don’t qualify for standard Roth IRA: $206,000 or higher

You should contribute directly to a Roth IRA and avoid the backdoor conversion if your MAGI is below a certain amount. The 2020 tax year income limits are $124,000 for singles and $196,000 for joint filers to make full contributions directly from a bank account to a Roth IRA.

Once you cross your income threshold, a backdoor Roth is necessary to maximize your IRA contribution.

How to Open a Backdoor Roth IRA

Here are the steps to launching your backdoor Roth IRA. Most online brokers offer IRA conversions. You can complete the conversion online by yourself. But if you need help, your broker’s support team can assist as necessary.

What happens if you can’t have your traditional and Roth accounts under the same roof? No worries. You can transfer funds between financial institutions without an IRS penalty.

Step 1: Open a Traditional IRA

If you don’t have one already, step #1 is opening a traditional IRA. For simplicity and to avoid volatility, park your cash into a cash sweep fund. As soon as your funds settle, you can request a Roth IRA conversion.

After your account is active, fund your account up to the annual contribution limit. As a reminder, you can contribute up to $6,000 if you’re under age 50 and up to $7,000 once you’re 50 or older.

If you’re married, you and your spouse can each contribute up to the age-appropriate annual limit.

By default, traditional IRA contributions are tax-deferred for most taxpayers. There is another set of income phaseouts for traditional IRA deductions. But since we’re not claiming this tax deduction, they do not apply to the backdoor Roth IRA. 

Step 2: Convert to a Roth IRA

The second step is converting your traditional IRA balance into a Roth IRA. If you don’t have a Roth IRA account, open a standard account. Brokerages don’t offer a specific “backdoor account.”

Because you have a high income, the only legit way to contribute to a Roth IRA is by converting traditional IRA dollars.

You can convert up to the annual contribution limit for your age.

It can take several business days to complete the conversion depending on your broker. Don’t forget that Roth IRA conversions are irreversible under current tax law.

Step 3: Pay Taxes on Your Contribution Amount

Make sure you report your nondeductible contributions on IRS Form 8606.

This form helps you accurately report your contributions. Improperly reporting your contributions can result in back taxes. This setback is less likely to occur if you don’t have a traditional IRA yet.

IRA conversions get complicated if you have an existing traditional IRA balance in your name. The IRS uses pro-rata rules to calculate your tax liability. Even though you’re converting new money, the IRS treats the annual conversion in proportion to your existing traditional IRA funds.

In short, a portion of your past tax-deferred contributions converts and is taxable.

For example, if your new contribution is 10% of your traditional IRA balance, then 90% of your backdoor contribution will be from existing funds. 

Step 4: Invest Your Backdoor Roth IRA Funds

You’re ready to buy high-quality investments once your converted funds settle. As your backdoor Roth IRA funds grow tax-free, you might focus on more aggressive assets that would raise your tax liability in a non-Roth account.

A three-fund portfolio also suffices if you prefer simplicity and cost-efficient investing. 

Is a Backdoor Roth IRA Worth It?

A backdoor Roth IRA can be worth it if you’re comfortable with paying the upfront tax liability on your converted balance. After all, you can make tax-free withdrawals in your retirement years.

Here are a few additional suggestions to ponder when pursuing a backdoor Roth IRA:

You Don’t Have a Large Traditional IRA Account Balance

A backdoor Roth IRA may not be worth the tax penalty if you have a large traditional IRA or SEP-IRA balance. Due to the pro-rate contribution rules, you pay taxes on your tax-deferred contributions today.

If possible, see if you can roll your current traditional IRA dollars into an employer’s 401(k) or solo 401(k). Not all plans accept these rollovers, but it’s pursuing.

When your traditional IRA balance is small, the pro-rata taxation can be discomforting. However, at least it’s temporary. Once your existing traditional IRA balance is zero, the pro-rata rules no longer apply.

You Can Continue Making 401(k) Contributions

If you happen to have a solo 401(k) or an employer-provided 401(k), you can continue contributing to these accounts for tax-advantaged investing. You can also keep funding your health savings account (HSA).

With a traditional IRA, you may not be able to claim the upfront tax deduction if you participate in an employer retirement plan.

Tax-Free Withdrawals in Retirement

All Roth IRA withdrawals are tax-free when you reach age 59 ½ and your first contribution was at least five years ago.

There are other particular circumstances for penalty-free early withdrawals such as buying or house or paying for college. But if you’re pursuing early retirement, a bulk of your nest egg needs to be in taxable accounts.

Make sure you also invest in taxable accounts to avoid unnecessary early withdrawal penalties on your backdoor Roth IRA.

Make a Prior-Year Conversion Before Filing Your Taxes

You have until the federal tax filing deadline each tax year to make IRA contributions. In most years, that magic date is April 15. If you haven’t filed your taxes for 2019 yet, you have until April 15, 2020, to complete a backdoor Roth IRA conversion.

You can start making contributions for each new tax year beginning on January 1.

Make Backdoor Roth IRA Contributions Each Year

You can make backdoor Roth IRA contributions each year. Keep an eye on the annual contribution limits.

If your annual contribution limit is $6,000, that’s the most you can put into all of your IRA accounts. You might put the entire amount into your backdoor Roth. Or, you may put some into a self-directed IRA to invest in alternative assets.

Backdoor Roth IRA Conversions Are Final

All Roth IRA conversions are final under current tax rules. While there’s usually a grace period to rescind IRA over-contributions, you can’t turn Roth dollars back into traditional dollars.

If at all possible, make your entire backdoor Roth IRA contribution at once. Lump-sum contributions reduce the potential confusion of reporting your nondeductible contributions.

A backdoor Roth IRA is one of the most exciting ways to save for retirement. This account requires more legwork than other retirement accounts. However, tax-advantaged investing makes it easier to maximize your passive income.

 

This article was written by Jim Wang from Forbes and was legally licensed through the NewsCred publisher network. Please direct all licensing questions to legal@newscred.com.