The recent economic downturn has made it difficult for many investors to make the most of their retirement savings. That's why the concept of a backdoor Roth IRA has become increasingly popular. The backdoor Roth IRA is a retirement savings strategy where you can contribute after-tax funds (nondeductible) to a traditional IRA and then convert them to a Roth IRA, thus bypassing the income limits of a Roth IRA contribution.
Known colloquially as a backdoor Roth IRA, it's not so much an account as a means to cleverly access an account via conversion. While there are income limits for contributing to a Roth IRA, there are no such limits for converting a traditional IRA to a Roth IRA. That's why the backdoor Roth IRA strategy can be a great way for high-income earners to benefit from the tax savings of a Roth IRA.
In addition, Roth IRA contributions are subject to income limits (discussed below). This means that even for those who are eligible to contribute to a Roth IRA, the amount of the contribution may be limited. Fortunately, there is a way to make an indirect contribution by using the Backdoor Roth.
To open a backdoor IRA account, the investor often initially opens a traditional IRA. While both traditional and Roth IRA accounts provide retirement savings opportunities, they differ in how they are taxed. With a traditional IRA, contributions are made with pre-tax dollars and withdrawals are taxed as income in retirement. With a Roth IRA, contributions are made with after-tax dollars, and withdrawals are not taxed in retirement.
The backdoor Roth IRA strategy allows investors to take advantage of the tax benefits of the Roth IRA even if they are not eligible to contribute directly to one. To do this, investors must first contribute to a traditional IRA and then convert it to a Roth IRA. The key point to remember is that the contribution must be nondeductible, meaning that taxes have already been paid on it.
There are a few considerations that investors should keep in mind when executing the backdoor Roth strategy. First, it is important to remember that all of the funds in the traditional IRA must be converted to a Roth IRA in order for the strategy to work. Any funds in the traditional IRA that are not converted will be subject to taxes and penalties.
Second, it is important to understand that the backdoor Roth IRA strategy is not necessarily tax-free. While it can be a great way to save on taxes in the future, investors may be subject to taxes on the conversion. This is because any earnings in the traditional IRA that are converted to a Roth IRA will be subject to taxes.
Finally, investors should be aware of the “step transaction doctrine”. This doctrine may apply if investors attempt to make a backdoor Roth IRA conversion and then immediately convert back to a traditional IRA. In this case, the IRS may treat the two transactions as one, thus invalidating the conversion.
In addition to the considerations above, investors should also be aware of the “pro-rata rule”. This rule states that investors must prorate their existing IRA accounts when making a conversion. This means that any existing traditional IRA funds will be taxed as income when converting to a Roth IRA.
Back-door Roth IRA. Despite legislative rumblings that this maneuver would be disallowed, as of now certain clients whose high incomes precluded them from contributing to a Roth IRA can make a nondeductible contribution to a traditional IRA and then convert it to a Roth IRA.
In these instances, the investor can take advantage of the “backdoor Roth IRA” maneuver by funding the traditional IRA and then converting it to a Roth IRA. The investor should be aware, however, that income taxes may be due on the conversion.
My question is about Mega Backdoor Roth IRA contributions. I currently max out a 401(k) at my W2 employer—$20,500 in 2022 with pre-tax contributions. Can I make an after-tax contribution to my 401(k) and then convert it to a Roth IRA?
Yes, you can make a contribution to your 401(k) and then convert it to a Roth IRA. However, you should note that the contribution must be made on an after-tax basis, meaning that you will be taxed on it when you make the conversion. Also, you should be aware that the IRS has placed limits on the amount that can be converted. At present, you can only convert up to $6,000 of after-tax contributions to a Roth IRA.
A backdoor Roth IRA is a retirement savings strategy where you can contribute after-tax funds (nondeductible) to a traditional IRA and then convert them to a Roth IRA, thus bypassing the income limits of a Roth IRA contribution. It can be a great way for high-income earners to benefit from the tax savings of a Roth IRA, but there are a few things to consider before executing the strategy.
