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HI, IM COLIN. 🙋🏼‍♂️

I’m a CFP® Professional and started my own virtual financial planning firm in 2018.

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Colin Overweg, CFP®…(read more)

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How the Backdoor Roth IRA Works

Investing for retirement is essential for financial security and freedom. One popular option for saving for retirement tax-free is the Roth IRA. However, not everyone is eligible to contribute to a Roth IRA due to income limitations. But fear not, because there is a way around this restriction called the Backdoor Roth IRA.

So, what exactly is a Backdoor Roth IRA? It is a strategy that allows high-income earners to contribute to a Roth IRA by first making a non-deductible contribution to a Traditional IRA and then converting it to a Roth IRA. This method allows individuals to take advantage of the Roth IRA’s tax benefits regardless of their income level.

Here’s how the Backdoor Roth IRA works:

Step 1: Determine your eligibility – To qualify for a Backdoor Roth IRA, you need to confirm that you are ineligible for a direct Roth IRA contribution due to income restrictions. As of 2021, the income limit for single taxpayers is $140,000, and for married couples filing jointly, it is $208,000. If your income exceeds these limits, you are not eligible to make direct contributions to a Roth IRA.

Step 2: Make a non-deductible contribution to a Traditional IRA – Since you cannot contribute directly to a Roth IRA, you must contribute to a Traditional IRA instead. However, you need to ensure that it is a non-deductible contribution, meaning you don’t claim a tax deduction for the amount contributed.

Step 3: Convert your Traditional IRA to a Roth IRA – Once you have made your non-deductible contribution to a Traditional IRA, you can convert the funds to a Roth IRA. This conversion is a taxable event, meaning you will owe income taxes on the amount converted. If you don’t have any pre-tax funds in your Traditional IRA, the taxes owed will be minimal.

Step 4: Consider the Pro-Rata Rule – If you have other Traditional IRA funds, such as rollover funds from a 401(k), SEP IRA, or SIMPLE IRA, the Backdoor Roth IRA can become more complex due to the Pro-Rata Rule. This rule requires you to consider all Traditional IRA balances when converting to a Roth IRA, making a portion of the conversion taxable. Consulting with a tax professional can help you navigate this situation effectively.

Step 5: Maximize your Roth IRA growth – Once your non-deductible contribution has been converted to a Roth IRA, you can enjoy the potential tax-free growth of your retirement savings. Unlike a Traditional IRA, qualified withdrawals from a Roth IRA are tax-free, providing significant advantages in retirement.

It’s important to note that the Backdoor Roth IRA strategy may not be suitable for everyone. If you anticipate being in a higher income tax bracket in retirement, it may be more beneficial to explore other retirement savings options. Additionally, tax laws can change, so it is crucial to stay informed and seek advice from a financial advisor or tax professional when considering the Backdoor Roth IRA strategy.

In conclusion, the Backdoor Roth IRA is a workaround for high-income earners who are ineligible for direct Roth IRA contributions. By making a non-deductible contribution to a Traditional IRA and then converting it to a Roth IRA, individuals can enjoy the benefits of tax-free growth and qualified tax-free withdrawals in retirement. However, be aware of any potential tax implications and consult with professionals to ensure this strategy aligns with your specific financial goals and circumstances.