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What is a Backdoor Roth IRA?

By   ·  2 minute read

The backdoor Roth IRA isn't an official individual retirement account type; instead, it's a strategic approach employed by high-income earners exceeding Roth IRA income limits. This technique involves converting a traditional IRA to a Roth IRA.

Contrary to being a tax loophole, the backdoor Roth IRA strategy incurs taxes on all previously untaxed funds—principal, earnings, and appreciation—when transferring assets from a traditional IRA to a Roth IRA.

If the traditional IRA is funded exclusively with tax-deductible contributions, the entire transferred asset's value is subject to taxation. Following Roth IRA rules, no further taxes are owed upon withdrawals.

Understanding Backdoor Roth IRAs

A Roth IRA allows taxpayers to allocate after-tax dollars from their annual earnings to a retirement savings account. This differs from a traditional IRA, where contributions offer an immediate tax break, with taxes due upon withdrawal.

High-income earners face Roth IRA eligibility challenges due to income limits. The backdoor Roth IRA provides a workaround for the income and contribution limits imposed on Roth IRAs. Roth IRA Income Limits in 2024 stipulate that individuals cannot contribute to a traditional Roth IRA if their Modified Adjusted Gross Income (MAGI) exceeds certain thresholds:

  • $161,000 or higher for single filers
  • $240,000 or higher for those married filing jointly or qualifying as a widow or widower

However, these limits do not apply to backdoor Roth IRA conversions.

Creating a Backdoor Roth IRA

Three methods exist to establish a backdoor Roth IRA:

  • Contribute to a traditional IRA and roll over funds to a Roth IRA.
  • Convert the entire traditional IRA to a Roth IRA.
  • Roll over a 401(k) account to a Roth IRA if the employer's plan allows conversions.

Tax Implications of a Backdoor Roth IRA

Tax payments apply to previously untaxed funds during an IRA transfer or conversion to a Roth IRA. After-tax contributions to a traditional IRA, however, remain untaxed upon transfer to a Roth IRA.

Considerations include potential tax bracket shifts and a pro-rata rule to prevent taxing after-tax contributions. Converted funds, subject to a five-year waiting period, differ from regular Roth IRA contributions in terms of penalty-free access.

Benefits of a Backdoor Roth IRA

Beyond circumventing income and contribution limits, a backdoor Roth IRA offers advantages such as no required minimum distributions (RMDs), tax-deferred growth, and tax-free distributions. The upfront tax payment on converted funds provides flexibility and potential long-term tax savings.

The backdoor Roth IRA strategy requires careful consideration of tax implications. Despite potential tax obligations, its advantages, especially for high earners, include prolonged Roth IRA holdings and substantial tax savings over the years.

Ready to get started? Schedule a consultation with Preferred Trust today: https://info.preferredtrustcompany.com/preferred-trust-consultation