In general terms, a “Roth Conversion” is where a person takes a taxable distribution from a Traditional Individual retirement account (i.e., a Traditional IRA), pays the applicable tax, and then deposits the remainder of the distribution into a Roth IRA.

Traditional and Roth IRAs are taxed differently.

Although there are exceptions and relevant income limitations — and I get into greater detail on contributory versions of both IRAs in other videos (see links, below) — contributions to a Traditional IRA are tax deductible, earnings grow tax deferred, and distributions are taxable. Contrariwise, contributions to Roth IRAs are non-deductible, earnings accrue on a tax-deferred basis, and qualified distributions are tax free (including any gain).

Sometimes, depending on a number of factors, people find it advantageous to move assets out of, and settle up taxes on, a Traditional IRA. One way of doing this is via a Roth Conversion.

A “Backdoor Roth” is essentially nothing other than a Roth Conversion. The term is sometimes used in contexts where a person would like to have assets inside of a Roth IRA, but he or she exceeds include limits for contributory Roths, and cannot open one the usual way. In this case, a person can obtain a Roth by converting funds that are held in a Traditional IRA.

The Internal Revenue Service also provides for in-plan or in-service Roth Conversions within employer-sponsored plans (such as 401(k)s). However, employer participation is not mandatory. You need to check with your plan administrator for details

Disclaimer: I am not a financial adviser or tax preparer. This video is intended for general informational or entertainment purposes only. Nothing herein should be construed as financial, insurance, investment, legal, retirement, savings, tax, or any other kind of advice. What is presented is given as-is, in good faith, but without guarantees or warranties or any kind. For personalized evaluations and recommendations, consult licensed professionals in your area.

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IRA Roth Conversions & ‘Backdoor Roths’: Basics of How They Work

Individual retirement accounts (IRAs) are popular retirement savings vehicles that offer tax advantages to individuals. One type of IRA, the Roth IRA, allows for tax-free withdrawals in retirement, making it an appealing choice for many individuals. However, not everyone is eligible to contribute to a Roth IRA due to income limits. For those individuals, there is an option to convert traditional IRA assets into a Roth IRA through a process called a “Roth conversion” or to make use of a “backdoor Roth.”

What is a Roth conversion, and how does it work?

A Roth conversion involves moving assets from a traditional IRA or a qualified retirement plan, such as a 401(k), into a Roth IRA. This conversion can be advantageous for individuals who expect their tax rate to be higher in retirement or for those who want to leave a tax-free inheritance to their heirs.

When you convert assets from a traditional IRA to a Roth IRA, the amount converted is included in your taxable income for the year of the conversion. This means that you will owe income tax on the amount converted in the year of the conversion, but once the funds are in the Roth IRA, they can grow tax-free and be withdrawn tax-free in retirement.

It’s important to note that when you convert assets from a traditional IRA to a Roth IRA, you cannot undo the conversion, so it’s essential to carefully consider the tax implications before making a conversion.

What is a backdoor Roth, and how does it work?

For individuals who are ineligible to contribute to a Roth IRA due to income limits, the “backdoor Roth” strategy is an alternative option. This strategy involves making a non-deductible contribution to a traditional IRA and then converting those funds to a Roth IRA.

Since there are no income limits for making non-deductible contributions to a traditional IRA, individuals can contribute to a traditional IRA and then convert those funds to a Roth IRA, effectively creating a “backdoor” way to fund a Roth IRA.

It’s important to note that when using the backdoor Roth strategy, any existing traditional IRAs you have will be subject to the pro-rata rule, which may complicate the tax treatment of the conversion. It’s essential to consult a financial advisor or tax professional to fully understand the implications of this strategy before proceeding.

In conclusion, Roth conversions and the backdoor Roth strategy are two methods that can help individuals take advantage of the benefits of a Roth IRA, even if they are ineligible to contribute directly due to income limits. While these strategies can offer significant tax advantages, they also come with complex tax implications that require careful consideration. It’s highly recommended to seek guidance from a financial advisor or tax professional before proceeding with either of these strategies to ensure that it aligns with your overall financial plan and tax situation.