What is a Backdoor Roth IRA Conversion?
The first time I ever wondered, “What is a Backdoor Roth IRA?” was reading about strategies to pay zero (or lower) taxes in retirement.
A Roth IRA has a backdoor? I had no clue! I just assumed the income level requirements barred anyone making above Roth IRA contribution levels from participating. Not so!
For people that make too much money to contribute to a Roth IRA the standard way, there is a “backdoor” method of contributing. This requires making qualified contributions to a traditional IRA and then rolling these contributions over to a Roth. Of course, you must pay taxes on the contributions when you roll them over.
We will look at backdoor Roth conversions in a little more detail; but first, let’s back up a bit and start with some definitions.
To Start, What is a Roth IRA?
A Roth IRA is an investment vehicle that allows you to invest after-tax money now and withdraw it later in retirement tax free.
In other words, you cannot deduct the money you put into a Roth IRA from your tax base the year you put it in. However, if you follow all the rules, you can take all the money (principal and interest) out of a Roth tax-free.
Roth IRA’s have contribution limits and rules you must follow. To read more about income rules, contributions and withdrawals, please read our article, “Roth IRA Contribution Limits.” In summary, in BOTH 2019 and 2020, your Roth IRA contribution limits are:
- $6,000 for the year.
- $7,000 per year if you are older than 50.
In addition, you can find the official IRS webpage for Roth IRA’s here.
Second, What are the Strategic Uses of a Roth IRA as an Investment Tool?
The purpose of a Roth IRA as an investment tool is to provide a place where your invested funds can grow tax-free. In addition, since you already paid your taxes on your initial investments, you can take out both the money you put in and the interest it accrued tax-free.
These tax free withdrawals are a big deal in retirement. Especially if most of your retirement income is coming from your investments. Every extra dime makes a difference in retirement. Therefore, having access to funds that are not taxed means 10 – 30%+ more cash for you to live off of.
The financial community is always preparing for a rise in income tax levels. Our tax levels have been very low, for a long time. At some point, they are expected to rise. Consequently, it may be better to pay known tax levels on your investments now versus when you withdraw them later at unknown tax levels. A Roth protects you from paying much larger, unknown future amounts of tax by paying taxes now.
Here are Taxable Retirement Accounts:
- Your regular IRA accounts you funded with pre-tax dollars.
- Your social security (Taxed if you have income above a certain amount each year.)
- Any pensions.
- Your real estate income.
- All other mutual funds, stocks and other investments.
These are Your Non-Taxable Retirement Accounts:
- Your Roth IRA withdrawals.
- Any cash loans from qualified life insurance vehicles do not count towards your tax basis. (For example, Whole Life Policies and IUL’s. (Indexed Universal Life).
- A reverse mortgage payment. (Just like cash from a life insurance policy, this is considered a loan and not a distribution.)
Finally, What is a Backdoor Roth IRA Conversion?
Now that you understand how valuable tax-free withdrawals are in retirement, you probably want access to this financial tool.
However, not everyone can use a Roth IRA. If you make more than $124,000 single, or $196,000 married in 2020, you cannot contribute fully to a Roth IRA. Moreover, if you make over $139,000 single, or $206,000 married, in 2020, you cannot contribute at all. Click here to read more on contribution limits.
So, what do you do to get these tax-advantaged withdrawals in retirement? In comes the backdoor Roth IRA conversion. If you make too much money to contribute to a Roth, or if you want to put more money than limits allow, into your Roth IRA, you can use the backdoor.
How Does it Work?
- To start a Backdoor conversion, you first make qualified contributions to a traditional IRA.
- Then, you roll these contributions over to a Roth IRA.
- Of course, you must pay taxes on the contributions when you roll them over.
What Rules Apply to a Backdoor Roth IRA Conversion?
Now, you must pay close attention to the rules set by the IRS when you do a Roth conversion. If you do your conversion incorrectly, you may end up paying more taxes and fees than you bargained for.
First, make sure that you follow Traditional IRA rules for contributions including investing only earned income. Also, make sure you are within the age limits of investing in a regular IRA (70 1/2 as of 2020). Finally, make sure you pay taxes on investments where necessary. Remember, taxes now – at known levels – are better than taxes later – at unknown levels!
Back-door Roth IRA conversions are on the rise as a popular method to lower an investor’s tax basis in retirement. As of now, the government is okay with this as a strategy. We do not know, if this will change at some point, so take advantage of the “backdoor” while you can.
If you are looking for other ways to access tax-free cash in retirement, please read these articles: