TWI#48 - Secrets of the Rich: Backdoor Roth IRA

Today at a glance: 

1. High earners can contribute to a Roth IRA indirectly through a backdoor Roth to boost their retirement savings.
2. Roth IRAs are attractive because they don't require minimum distributions and offer tax-free distributions.
3. No required minimum distributions simplify record-keeping and taxes in Roth IRAs.
4. You can create a backdoor Roth by contributing to a traditional IRA and converting it to a Roth IRA to avoid taxes on earnings.
5. A backdoor Roth IRA may not be suitable for those needing the contributed money within the next five years.

Even if you're not a high earner, you too can benefit from opening a Roth IRA, so long as you meet the required income limits.

If you meet the required limits, simply open a Roth and make contributions.

However, if you are a high earner, then the only way to get your hands on a Roth is the backdoor strategy.

Discover how this clever tax loophole can help you maximize your retirement savings and potentially save thousands in taxes over time.

Let's explore the ins and outs of setting up a backdoor Roth IRA! 

Why Roth IRAs Are a Better Choice

Roth IRAs come with several advantages over traditional IRAs that can be particularly appealing:

No Forced Withdrawals: Unlike traditional IRAs, Roth IRAs don't require you to take out a minimum amount of money as you get older.

This means your savings can keep growing without being tapped into, which is beneficial if you have other sources of retirement income and want to leave your Roth savings as an inheritance.

Simplified Financial Management: The absence of required minimum distributions (RMDs) makes it easier to manage your finances.

You won't need to worry about calculating and taking out specific amounts of money each year, leading to less paperwork and a smoother tax preparation process.

This can save you time and reduce stress during retirement.

Tax-Free Distributions: When you eventually withdraw money from your Roth IRA, including any earnings it generated, you won't owe any additional taxes.

This can be advantageous, especially for those who expect taxes to increase in the future.

Some people prefer paying taxes upfront on their contributions (as with a Roth) rather than facing taxes on distributions later (as with traditional IRAs or 401(k)s).

Others choose to diversify their contributions, including both pre-tax and post-tax options, to have flexibility in managing their taxes.

What Is a Backdoor Roth IRA?

A Backdoor Roth IRA isn't a special kind of savings account.

It's more like a smart money move used by folks who make a lot of money.

These high earners have too much income to put directly into a regular Roth IRA, so they use this trick.

Here's how it works: Imagine you have a piggy bank called a traditional IRA.

When you want to use the Backdoor Roth trick, you move your piggy bank money into a new Roth IRA.

But here's the thing: when you move the money, you have to pay some taxes on it. It's like paying a fee to use the Backdoor Roth trick.

If your piggy bank only had money you didn't pay taxes on before, you'll have to pay taxes on all of it when you move it.

But after that, you won't need to pay more taxes when you take the money out.

So, a Backdoor Roth IRA is like a clever money strategy for high-earning folks to save more for the future.

It's not about dodging taxes; it's about using the rules to your advantage.

How to Create a Backdoor Roth IRA

Making regular contributions to a Roth IRA has some rules about how much you can earn.

In 2023, if you're single and earn between $138,000 and $153,000, or if you're a married couple filing taxes together and make between $218,000 and $228,000, you can contribute to a Roth IRA.

But here's the thing: a regular IRA doesn't have these income limits. This is where the Backdoor Roth IRA can be useful.

Step 1: Start Saving in a Traditional IRA

In 2022, you can put up to $6,000 into a Traditional IRA or the amount you earned, whichever is less. In 2023, this limit goes up to $6,500.

If you have a spouse who works, they can also contribute to a Traditional IRA for you, even if you don't have income, as long as the total contributions don't go over your combined income.

If you're 50 or older, you can add an extra $1,000 each year. So, if both you and your spouse are over 50, you can save a total of $15,000 in your Traditional IRAs in 2023.

If your income is too high to put money into a Roth IRA, it's probably also too high to deduct your Traditional IRA contributions from your taxes if you or your spouse have a retirement plan at work.

In that case, you'll be adding money to your Traditional IRA after taxes.

Step 2: Quickly Switch Your Traditional IRA to a Roth IRA

Why the rush? Well, if you leave your money in the Traditional IRA, it might grow more, and that means you'll owe taxes on those earnings when you make the switch.

If your earnings increase a lot and you convert the entire balance later, 

you might end up with too much in there, and you'll need to fix it by paying taxes.

Also, any money that hasn't been taxed in the Traditional IRA will be taxed during the switch.

To keep things simple, don't delay the move.

Step 3: Repeat the Process, If You Want

Every year, if you can't fully contribute to a Roth IRA through the regular way, use the backdoor Roth method.

Follow the Rules

Make sure to follow the IRS rules for your Roth IRA. Here are four simple tips:

1. If you have a Traditional IRA with tax-deductible contributions, follow the pro-rata rule. It's easiest if all your Traditional IRAs, SEP IRAs, and SIMPLE IRAs have a zero balance.
2. Don't take money out of your Roth IRA for at least five years if you're under 59½. Otherwise, you might face a 10% penalty unless you qualify for certain exceptions.
3. Be careful not to transfer money personally between your Traditional IRA and Roth IRA. It could lead to an unexpected tax bill. Instead, use a trustee-to-trustee transfer if they're at different banks or a same-bank transfer if they're at the same bank.
4. Remember to complete IRS Form 8606, Nondeductible IRAs, when you file your tax return.

A backdoor Roth IRA isn't right for everyone.

If you're not familiar with the basics, it can cause issues. Here are situations where it might not be a good idea to set up a backdoor Roth:

1. If you'll need the money you're putting into the backdoor Roth within the next five years, you'll face a 10% penalty if you withdraw it.
2. If you're unsure about the process and worry about making expensive tax mistakes, think about getting help from a financial planner or tax advisor.
3. If you think the pro-rata rule applies to you but are uncertain about calculating your tax liability, it's better to seek professional assistance.
4. If you've moved a 401(k) balance from a previous job into an IRA during the same year, doing a backdoor Roth might lead to unexpected taxes.