Helping You Understand Backdoor Roth IRAs
Roth vs. Traditional IRA
A Roth IRA differs from a traditional IRA. The traditional IRA gives the earner an immediate tax break because they can take a tax deduction for their contributions in the year they are made, and no taxes are due until the money is withdrawn. When withdrawals are made, usually after retirement, the account holder will owe taxes on both the dollars invested and their earnings.
What are the benefits of a Roth IRA?
What makes a Roth IRA so attractive to investors is the potential tax savings. If you think you’ll be in a higher tax bracket when you retire than you are now, or in the same tax bracket then a Roth IRA may be more beneficial than a traditional IRA. The reason: You’ve already paid taxes on your contributions, so if you are in the same or higher tax bracket it won’t result in a high tax bill when it’s time to enjoy your hard-earned money in retirement.
Another reason the Roth IRA is attractive is rising inflation. Inflation erodes the value of money over time. Giving your money an opportunity to grow tax-free and receive tax-free income could be one of your best financial decisions.
Other benefits of a Roth IRA include:
No required minimum distributions: Account holders of Roth IRAs are not subject to the required minimum distributions required of traditional IRA or 401(k) accounts.
Beginning in 2023, Traditional IRA RMDs must start at age 73. This means account holders don’t have to take distributions from a Roth IRA at any point while they’re alive, unlike with traditional IRAs or 401(k)s. However, it’s worth noting that inherited Roth IRAs are subject to RMDs, unless you’re inheriting it from a spouse. There are special rules in those circumstances.
- No income tax on inherited Roth IRAs: If you pass a Roth IRA to an heir, they enjoy tax-free withdrawals as long as the account was held for at least five years at the time of the account holder’s death.
- Easy withdrawals: You can withdraw the money you contributed any time, without taxes or penalty. (You may be taxed or penalized if you withdraw investment earnings.)
- Double dipping: You can contribute to a Roth IRA in addition to an employer retirement account like a 401(k).
- Flexible timing: You can choose when and how much you contribute to a Roth IRA. For example, you could contribute the full limit on the first day of the year or split up your contributions throughout the year.
- Extra time to contribute: You have until that year’s tax deadline to contribute for the previous calendar year — for example, if you still want to make Roth IRA contributions for 2022, you can do so until April of 2023.
- Tax-free distributions: Once you hit 59½, and have held the account for at least five years, you can take distributions, including earnings, from a Roth IRA without paying federal taxes.
- No age limit to open: You can open a Roth IRA at any age, as long as you have earned income (you can’t contribute more than your earned income).
How do you invest in a Roth IRA?
Investing in a Roth IRA is pretty straightforward once you’ve met the income requirements to contribute. Next, decide whether you want to do passive or active investing, or a combination of both. Now choose the Roth IRA provider and investing approach with your advisor.
What is a Backdoor Roth IRA?
A backdoor Roth IRA is a strategy rather than an official type of individual retirement account. It is a technique used mostly by high-income earners—who exceed Roth IRA income limits—and wish to convert their traditional IRA to a Roth IRA.
The backdoor Roth IRA strategy is not a tax dodge. When you transfer the assets from a traditional IRA into a Roth IRA, you owe taxes on all funds, the principal, the earnings, and appreciation that have not been taxed previously.
If the IRA has been funded solely with tax-deductible contributions, then the entire value of the assets transferred will be taxed. However, you could make partial-transfers spread over several years if it is more tax efficient. Once 100% of the funds have been transferred and taxes paid, the transaction is complete.