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Individual retirement accounts (IRAs) are popular investment tools for Americans to save for retirement. But did you know there is a way to contribute to a Roth IRA even if you exceed the income limits? This technique is known as a Backdoor Roth IRA and has become popular among high earners.

What is a Roth IRA?

Before explaining Backdoor Roth IRA, it is essential to understand what a Roth IRA is. A Roth IRA is an individual retirement account that allows you to make contributions with after-tax dollars. The significant advantage of a Roth IRA is that all withdrawals, including earnings, are tax-free in retirement.

However, there are income limits for Roth IRA contributions. In 2021, individuals with adjusted gross incomes (AGIs) over $140,000 and married couples filing jointly with AGIs over $208,000 are not eligible to contribute to a Roth IRA directly.

What is a Backdoor Roth IRA?

A Backdoor Roth IRA is a method of funding a Roth IRA with contributions from a traditional IRA. This method is available to those who exceed the Roth IRA income limits. Here is how a Backdoor Roth IRA works:

1. Contribute to a Traditional IRA: Anyone can make contributions to a traditional IRA, whether or not they qualify for a deduction.

2. Convert Traditional IRA to Roth IRA: After making non-deductible contributions to a traditional IRA, you can convert the balance to a Roth IRA.

3. Pay Taxes on Conversion: The conversion from traditional to Roth IRA is a taxable event. However, you only owe taxes on any earnings or pre-tax contributions since you already paid taxes on the non-deductible contributions.

Benefits of a Backdoor Roth IRA

The main advantage of a Backdoor Roth IRA is that it allows high earners to contribute to a Roth IRA and enjoy the tax benefits. With a traditional IRA, contributions are tax-deductible, but withdrawals are taxed at retirement. In contrast, a Roth IRA offers tax-free withdrawals in retirement, making it an attractive option for those looking to minimize their tax burden.

Another benefit of a Backdoor Roth IRA is that it allows for tax-efficient estate planning. Unlike a Traditional IRA, Roth IRAs do not have Required Minimum Distributions (RMDs) during the account owner’s lifetime. This means that the account can grow tax-free for as long as the account owner lives and can be passed on tax-free to heirs.

Risks of a Backdoor Roth IRA

One potential risk with a Backdoor Roth IRA is the pro-rata rule. This rule states that when you convert from a traditional IRA to a Roth IRA, you cannot choose which funds to convert. Instead, the IRS requires you to prorate your conversion based on the total balances of all your IRAs. This includes any pre-tax contributions, which could trigger a tax liability when you convert to a Roth IRA.

Conclusion

A Backdoor Roth IRA can be an excellent option for those who want to contribute to a Roth IRA but exceed the income limits. However, it is important to understand the rules and risks before using this technique. If you are not sure if a Backdoor Roth IRA is right for you, consult a tax professional or financial advisor.