How to open a tax-free backdoor Roth IRA


Backdoor Roth IRAs are available to anyone with sufficient taxable income to cover the required contribution. Getty Images/iStockphoto

Is your income too high to contribute to a Roth IRA? Don’t rule it out yet. Using a backdoor Roth IRA, you can lawfully transfer your yearly earnings into a Roth IRA account, regardless of your income.

If you are interested in building your long-term investments, you should investigate your Roth IRA alternatives on a reputable website. See how it could fit into your current retirement plan.

Still uncertain as to how a Roth IRA fits into your entire financial plan? Continue reading to learn more.

How does a backdoor Roth IRA function and what is it?

Who can directly contribute to Roth IRAs without incurring penalties is restricted by income limits. However, regular IRAs have no income restrictions. As a holder of a traditional IRA, you can convert your account to a Roth IRA regardless of your income level. If your income is too high to qualify for a Roth IRA, you can contribute to a traditional IRA and convert it to a Roth IRA. This is the alternative route.

Backdoor Roth IRAs are available to anyone with sufficient taxable income to cover the required contribution. Backdoor Roth IRAs make little sense unless your income exceeds the Roth IRA income restrictions, which for single taxpayers now begin at $129,000.

The primary distinction between a Roth IRA and a backdoor Roth IRA is how the funds are deposited. Here’s a quick summary:

Roth IRA: Contributions are made directly to the account.
Backdoor Roth IRA Contributions are made to a regular IRA, which are then converted to a Roth IRA.
Is a backdoor Roth IRA advantageous?

The tax-free growth provided by a backdoor Roth IRA is the primary advantage of this account. You pay taxes on contributions up front, but qualifying withdrawals in retirement are tax-free.

If you wish to add to your retirement portfolio or convert an existing IRA, then you should get started immediately.

Also, once you become 72, you will no longer be compelled to take mandatory withdrawals (as you would with a traditional IRA). Roth IRAs are typically most enticing to people who anticipate a higher tax rate in retirement compared to the present.

Does a Roth IRA with a backdoor trigger taxes?

The conversion of a traditional IRA to a Roth IRA is subject to taxation. With typical IRAs, you receive an upfront tax break (through deductions) and pay taxes on withdrawal. Roth IRAs work the opposite way. Contributions are made using monies that have already been taxed, and qualifying withdrawals are tax-free.

If you deducted all of your contributions to your conventional IRA, you will be required to pay taxes on the whole amount you convert. This amount will be added to your annual gross income and taxed at the rate applicable to your tax bracket.

The pro rata rule

If you want to convert a portion of your conventional IRA and have a mix of pre-tax and after-tax funds in the account, the tax implications become more complex. In this instance, the pro rata rule applies. The IRS will examine the ratio of pre-tax money to after-tax dollars in all of your IRAs. Then, your conversion will be taxed based on the pre-tax percentage of your IRA savings.

Avoiding a sneaky Roth IRA conversion when

You can convert to a Roth IRA immediately after contributing to a regular IRA. This is a smart idea because it eliminates the opportunity for deductions and prevents taxable interest from accruing. However, there are some instances in which you may wish to avoid doing so.

A backdoor Roth IRA conversion may not be the ideal option when converting a considerable amount of pre-tax funds. The conversion may place you in a higher tax rate and result in a substantial tax bill.

In 2022, for instance, if your taxable income is $400,000, your tax rate will be 35%. If you convert a pre-tax balance of $50,000 to a Roth IRA via the backdoor, you will owe $17,500 in taxes on the conversion alone. Whether that makes sense for you depends on your willingness to pay the tax cost and the long-term benefits you stand to get from the conversion.

If you intend to pay your tax bill with an early distribution from your Roth IRA, you should normally avoid a Roth IRA conversion. Typically, doing so incurs a 10% tax penalty and can significantly reduce your account’s growth potential.

Options to the Backdoor Roth IRA

If a backdoor Roth IRA is not suitable for you as a high-income earner, there are other investment options to explore.

Investing in a Health Savings Account (HSA), a brokerage account, real estate, or a Roth 401(k) plan are examples (k). You could also max out your 401(k) pre- and post-tax contributions. All can help your nest egg develop, avoiding it from gathering dust in a savings account.

A financial counselor can also assist you in exploring alternative possibilities and determining the optimal course of action.


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