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The Roth individual retirement account (IRA) is a great option for those looking to save for retirement. The major advantage of Roth IRA is that it allows for tax-free withdrawals in retirement, which can be a great financial benefit. However, not everyone is eligible to directly contribute to a Roth IRA due to the contribution limits or income restrictions.

This is where a “backdoor” Roth IRA comes in. A backdoor Roth IRA allows individuals to contribute to a Roth IRA even if their income exceeds the limits for direct contributions. Here’s how it works:

Step 1: Contribute to a non-deductible traditional IRA. If you are not eligible for a direct Roth IRA contribution due to income restrictions, you can still contribute to a traditional IRA. However, it must be a non-deductible traditional IRA, which means you do not get an upfront tax deduction.

Step 2: Convert the traditional IRA to a Roth IRA. After the contribution has been made, you can convert the traditional IRA to a Roth IRA. This can be done at any time, but note that you will have to pay income taxes on any pre-tax contributions and earnings in the traditional IRA that have not yet been taxed.

Step 3: Be aware of the pro-rata rule. If you already have pre-tax money in any traditional IRAs, the pro-rata rule will apply. This means that the taxable amount of the conversion will be based on the proportion of pre-tax money in all of your traditional IRA accounts. For example, if you have $10,000 in pre-tax traditional IRA contributions and $2,000 in non-deductible traditional IRA contributions, and you convert $2,000 to a Roth IRA, then 83.3% of the conversion would be taxable ($10,000 + $2,000 = $12,000; $10,000/$12,000 = 0.833).

Step 4: Reap the benefits of the Roth IRA. Once the conversion is complete, you now have a Roth IRA with tax-free withdrawals in retirement. Roth IRAs also have no required minimum distributions, so you can choose to leave your money in the account for as long as you’d like.

The “backdoor” Roth IRA can be a great option for those who are not eligible for direct contributions to a Roth IRA. However, it’s important to consult with a financial advisor, accountant, or tax professional to determine if this strategy is right for you. They can help guide you through the potential tax implications and ensure that you are adhering to IRS rules and regulations.