A Roth IRA is very much the same as a traditional IRA, except you fund it with cash that has previously been taxed — which means there isn’t a tax break on the front end. In 2020, you can invest up to $6,000 each year, or $7,000 if you are age 50 or older, in an individual retirement account (IRA).
However, with a Roth IRA, the vital component is that there is no tax liability on the funds you withdraw during your retirement. Additionally, a Roth IRA isn’t subject to the required minimum distribution rule after an account holder turns 70-and-a-half.
The hang-up. To qualify for a full Roth IRA contribution, you cannot earn above $196,000 if you are married and filing jointly (those with incomes between $196,000 and $206,00 can make a reduced contribution) or $124,000 a year if single (those making over $124,000 but less than $139,00 can make a partial contribution).
This limitation puts high-earners at a disadvantage when it comes to realizing the tax advantages of this type of retirement account. That is when a LIRP or life insurance retirement plan can be useful. There is no contribution limit and no early withdrawal penalty.
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The Roth IRA Limitation Work-Around
To alleviate the qualification limitations on a Roth IRA, an individual could invest in a conventional IRA (irrespective of your income), and consequently convert the conventional IRA to a Roth IRA without worrying about the eligibility limits and consequently take advantage of the income tax savings provided in a Roth IRA.
This strategy may appear unlawful to investors that have an issue with non-compliance, but it isn’t. The government removed the income limits attached to the IRA conversion in 2010, which produced this incredible Roth IRA loophole, and as a result, the Backdoor Roth IRA.
How to Setup your Backdoor Roth IRA
Despite the fact that the Backdoor Roth IRA is completely lawful, there are specific actions that need to be undertaken in order not to be contrary to the rules. Additionally, if your annual income is under the 2020 eligibility limit mentioned above, you can stop reading since you can keep up contributing to your Roth IRA.
- Deposit some funds in a conventional IRA account.
If you don’t currently own a traditional IRA, you will need to establish one and go ahead and deposit money into it. If you will be opening a traditional IRA so you can convert to a Backdoor Roth IRA, you can invest in the account with after-tax dollars without any concern for paying taxes on that investment and the earnings in retirement.
- Convert your conventional IRA to a Roth IRA.
The account manager of the traditional IRA will provide you with the guidance and required forms necessary for the conversion.
- You must then take care of the tax liability on any untaxed contributions if you held an established traditional IRA.
Because only after-tax money can fund your Backdoor Roth IRA, if you are converting an established traditional IRA that’s funded with pre-tax dollars, you will want to pay the income taxes on those contributions the same as anybody else who contributes to a Roth IRA.
- Pay your tax liability on whatever earnings in your traditional IRA prior to the conversion.
If your pre-existing IRA account includes any gains, you should pay the taxes on them when you convert it to a Roth IRA and then be certain to report it on your next federal return.
The Advantages of investing in the Backdoor Roth IRA
Undoubtedly, the most significant advantage of the Roth IRA is that the moment it is funded with after-tax money, it will never be taxed anymore. When the time comes time to take out your money, neither the contributions you made nor the earnings on the contributions are taxable.
Furthermore, if you find yourself in a financial squeeze, you can take out any of the contributions you’ve made absolutely tax-free. To take out earnings, however, you must be at least age 59 ½ and your account must be least five years old.
However, even with this rule, there are legitimate ways to take qualified withdrawals when you do not satisfy the minimal age and account limitation.
The Upsides and Downsides Associated with the Backdoor Roth IRA
Have you ever noticed that when the Fed gives (allows) you something creative and useful, there are always strings attached and drawbacks to deal with? Regretfully, the Backdoor Roth IRA has disadvantages that come with the significant tax advantages of owning one.
Here are pros you can look forward to and the cons to be concerned with:
|Your contributions and your earns will grow tax-free||You’re required to pay taxes when you do the conversion which could be significant|
|You are allowed to withdraw your contributions in the account for any reason and at any time without tax liability.||It’s possible that your conversion may not benefit you if your tax rate is lower in the future.|
|There is no RMD requirement.||In order to take withdrawals that are tax-free, you must wait for the account to be five-years-old (even if you are 59 ½ or older)|
|Individuals and married couples who are generally ineligible for a Roth IRA can use the backdoor method to set up an account with a tax-free pool of money.||Calculating your taxes can get complicated if you have a SEP or Simple IRA that you will not be converting.|
The Backdoor Roth IRA Tax Bill
When you undertake a Roth IRA conversion using the backdoor, you must consider how you plan to pay the taxes and when you have to pay them.
Most investors don’t recognize that they cannot wait until filing their income taxes to cover the tax liability on the conversion. You have to submit a check as part of your projected quarterly tax payment.
The most effective way to cover the tax liability associated with the conversion is to utilize funds from a separate account like a savings account or by cashing out CDs. The worst way is to take money from the retirement account that you are converting in the first place. Here’s why it makes no financial sense:
Paying taxes from your IRA fund, rather than from a different account, will impact your future earnings. Using the example above, suppose you convert a $100,000 conventional IRA. After paying the tax liability, you end up adding only $76,000 into the new Roth IRA account. In the years ahead, you will lose out on the interest that you would have earned on that money.
While $24,000 may not seem all that significant, when you consider the compounded interest on that money over 20 years, that $24k would have grown to $112,000 by itself at an interest rate of 8%. That is a substantial chunk of money to abandon to pay a tax bill.
The Bottom Line
Even while the Backdoor Roth IRA appears to be an effective strategy to invest in a Roth IRA even though you surpass the income limitation, there are disadvantages. For instance, the investor might not factor in the Pro-Rata provision when moving their money from a traditional IRA into the Roth IRA, and find themselves being taxed considerably more than they expected.
If your intentions are to go through with a Backdoor Roth IRA, make certain you give consideration to all of the aspects we’ve mentioned in this article.
Frequently Asked Questions
What is a Roth IRA?
A Roth IRA is very much the same as a traditional IRA, except you fund it with cash that has previously been taxed — which means there isn’t a tax break on the front end.
What are the steps to set up a back door Roth IRA?
The steps to set up a back door Roth IRA are:
1. Deposit some funds in a conventional IRA account.
2. Convert your conventional IRA to a Roth IRA.
3. Take care of the tax liability on any untaxed contributions if you held an established traditional IRA.
4. Pay your tax liability on whatever earnings in your traditional IRA prior to the conversion
Are there any disadvantages to a back door Roth IRA?
One disadvantage to a back door Roth IRA could be that the investor might not factor in the Pro-Rata provision when moving their money from a traditional IRA into the Roth IRA, and find themselves being taxed considerably more than they expected.