Unlocking the Secret to Tax-Free Retirement: The Backdoor Roth

Roth IRA accounts are a fantastic tax-advantaged retirement account that allows you to grow your money tax-free. Unlike other qualified retired accounts, Roth IRA’s are funded with post-tax income and withdrawals are tax-free. Another significant benefit of Roth IRA accounts is that there are no required minimum distributions for the owner of the account - giving you more flexibility on when you choose to take distributions.

Important Roth IRA Limitations

There are however contribution limitations on a Roth IRA account. First, each individual may only contribute up to $6,500/year to a Roth IRA and an additional $1,000 if you are over 50 years old (2023). In addition, for taxpayers with a filing status of Single, you can only contribute directly to a Roth IRA if your income is below $153,000 (and only the full amount if your income is below $138,000). For taxpayers with a filing status of married filing jointly, those numbers are $228,000 and $218,000 respectively.

Related & Important Note: while there are income restrictions when contributing to a Roth IRA, there are none if contributing to a Roth 401k! So, if your employer offers a Roth 401k option, you may contribute to that to further increase your tax-free growth Roth savings.

The Backdoor Roth

Fortunately, there’s a type of conversion known as a “Backdoor Roth” that can allow you to contribute to a Roth even if your income exceeds those limits. The backdoor Roth is just a two-step process to moving money into a Roth IRA.

Step 1 is to create and fund a Traditional IRA account. These accounts are useful in their own right, particularly if your income allows you to tax-deduct the contribution. However, even if your income is above those limits, you may still contribute to a Traditional IRA account.

Step 2 is to convert your contribution from a Traditional IRA to your Roth IRA. If you do not currently have a Roth IRA account, you’ll need to open one to complete this process. Your IRA administrator will be able to give you the instructions and the paperwork to complete this process and we are more than happy to offer support in making this happen for you.

There are a couple of important items to note:

  • If you have other existing traditional or rollover IRA accounts, you’ll be subject to what’s known as the “pro-rata” tax rule. What that means is that if you have any pre-tax contributions to your traditional IRA accounts, you’ll be responsible for paying a tax on the proportional amount of your conversion. If you have an active 401(k) plan, you may be able to roll an existing IRA back into that 401(k) plan which would allow you to clear these accounts and help ensure that you minimize tax in this process. Again, we can assist in this process.
  • If you deducted your contribution to your traditional IRA, the amount of the conversion will be considered income and taxed as such. Typically, the Backdoor Roth is a strategy for those that are unable to deduct their Traditional IRA contribution.
  • To avoid additional taxation and minimize complexity, we recommend not investing the money while in the Traditional IRA. At least for a short period of time to make the contribution and facilitate the conversion. Simply fund the Traditional IRA and as soon as the funding has cleared, begin the process of converting to a Roth.

We’d love to be your partners in determining if the Backdoor Roth is an appropriate strategy for you and, if so, help you complete this process. Feel free to schedule some time with us to discuss this further by visiting our website at OneDayAdvice.com

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