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A backdoor Roth IRA is not an official category of individual retirement account but a type of financial plan. High earners whose annual income exceeds the Roth IRA income limit can use this strategy to convert their regular IRA to a Roth IRA.
With Roth backdoor IRA technology, there is no avoiding paying taxes. Let's say you're converting assets from a Traditional IRA to a Roth IRA. In this case, you will be responsible for paying taxes on all payments, including capital, income, and capital gains, which were not taxable in the past.
If the IRA is always funded only by tax-exempt contributions, the entire value of the assets transferred is taxable. However, if you follow the rules, like any Roth IRA, you shouldn't pay additional taxes when you withdraw funds.
Understanding Backdoor Roth IRAs
Taxpayers can use a Roth IRA to put thousands of dollars of annual income into an account dedicated to retirement savings. The donated money is taxed from taxed income donated to a Roth IRA that year.
Ross and Tradition
Traditional IRAs are not the same as Roth IRAs. Because donors can claim a tax credit the same year they contribute, and the money isn't taxed until it's paid out, a traditional IRA offers immediate tax savings to the recipient. When account holders withdraw money (typically after retirement), they are liable to pay taxes on the amount they originally invested and any profits made on those dollars.
The fact that individuals with income above a certain amount are not eligible to open or fund a Roth IRA presents a challenge for high-income taxpayers. If your MAGI exceeds the legal limit, the law starts reducing your deposit amount. In 2022, the amount will be between $129,000 and $144,000 for individual applicants and between $204,000 and $214,000 for joint applicants in the same year.
For individual taxpayers, the 2023 range is $138,000 to $153,000, while for joint taxpayers, the range is $218,000 to $228,000. You will no longer be eligible for the program if your annual income exceeds a specified amount, currently $214,000 for co-applicants and $144,000 for individual taxpayers.
There are no maximum income requirements for contributions to a Traditional IRA. Additionally, since 2010, the IRS has not restricted an individual's ability to convert a Traditional IRA to a Roth IRA based on income. As a result, backdoor Roth IRAs have evolved into tax planning opportunities for high-income taxpayers who could not contribute to a Roth IRA under normal circumstances.
How to Create a Backdoor Roth IRA
There are three ways to set up a backdoor Roth IRA:
You can convert an existing traditional IRA to a Roth IRA by first contributing to the traditional IRA you already have. You can also transfer funds from a traditional IRA to a Roth IRA. You can do this with any amount at one time, even if the amount is higher than the annual contribution maximum.
Complete the rollover of your Traditional IRA into a Roth IRA.
If your employer offers a 401(k) plan that supports switching, you can transfer money from your 401(k) account to a Roth IRA.
Benefits of Using a Backdoor Roth IRA
Why would taxpayers want to take the extra step to implement the Roth IRA dance through the back door rather than allow them to bypass the restrictions? There are several compelling arguments for this.
Because Roth IRAs have no mandatory minimum distributions (often called RMDs), the account balance can grow and be tax-deferred for as long as the account holder is alive. You can withdraw any amount or any amount at any time or leave it entirely to your heirs.
Unlike withdrawals from a regular IRA escapes from a Roth IRA are tax-free, which is another reason why backdoor Roth contributions can lead to significant tax savings for decades.