Backdoor Roth IRA
A backdoor Roth IRA is a strategy that allows individuals with high income to convert traditional IRA contributions into a Roth IRA, even if they are above the income limit for direct Roth IRA contributions. This strategy is for those who plan to retire early and live off their retirement. It’s not advantageous if you are earning and being taxed at a high rate in the future, so this strategy is not for everyone who plan to work beyond the traditional retirement age.
Nonetheless, the income limit for contributing to a Roth IRA in 2023 is $153,000 for single filers and $228,000 for married filing jointly. However, there is no income limit for converting a traditional IRA to a Roth IRA.
To execute a backdoor Roth IRA, an individual first makes a non-deductible contribution to a traditional IRA and then converts that contribution to a Roth IRA. This conversion can be done immediately after the contribution is made or at any point in the future.
Here is a illustration of how a Backdoor Roth IRA works. Imaged sourced from here.
Here are some additional details and things to keep in mind when considering a backdoor Roth IRA:
The pro-rata rule: The pro-rata rule can affect the tax consequences of a backdoor Roth IRA conversion. If you have existing pre-tax IRA balances, the IRS requires you to convert all IRAs proportionately. This means that you can't just convert your non-deductible IRA contributions to a Roth IRA without also converting some of your pre-tax IRA balances. This can trigger a tax bill, so it's important to take this into account when considering a backdoor Roth IRA.
Taxes: When you convert a traditional IRA to a Roth IRA, you will owe taxes on any pre-tax contributions and earnings. This can be a significant tax bill if you have a large traditional IRA balance, so it's important to be prepared for the tax consequences of a backdoor Roth IRA conversion.
Timing: If you're considering a backdoor Roth IRA, timing is important. You'll need to make your non-deductible contribution to a traditional IRA and then convert it to a Roth IRA within a short timeframe to avoid having the earnings on your contribution subject to taxes. Talk to a financial advisor to make sure you're following the right timeline for your backdoor Roth IRA conversion.
Contribution limits: The contribution limit for a backdoor Roth IRA is the same as for a regular Roth IRA. In 2022, you can contribute up to $6,000 ($7,000 if you're over age 50) to a Roth IRA or traditional IRA. Be careful not to exceed these limits, as excess contributions can result in tax penalties.
Eligibility: To do a backdoor Roth IRA, you must have earned income and not be subject to required minimum distributions (RMDs). If you're over age 72, you'll need to take RMDs from your traditional IRA before doing a backdoor Roth IRA conversion.
Consider a Roth 401(k): If you have access to a Roth 401(k) through your employer, you may be able to contribute to it directly instead of doing a backdoor Roth IRA conversion. Roth 401(k) contributions have higher contribution limits than Roth IRAs, so this may be a better option if you have a high income.
In conclusion, a backdoor Roth IRA can be a beneficial strategy for individuals with high income who are ineligible for direct Roth IRA contributions. By making non-deductible contributions to a traditional IRA and then converting them to a Roth IRA, individuals can take advantage of the tax-free growth and withdrawals offered by a Roth IRA. However, it's important to be aware of the potential tax consequences and to consult with a financial advisor or tax professional before executing a backdoor Roth IRA to ensure it's the right strategy for your individual circumstances.
