Tax-Free Retirement Savings: Backdoor Roth IRA 101
Planning for retirement, financial freedom, or being financially responsible can seem like navigating a maze of financial jargon and complex rules. There are many options and a plethora of things you could be doing, and a backdoor Roth IRA is just one more. What many describe as a path to tax-free retirement saving. You might be familiar with traditional IRAs and Roth IRAs (if you are not, send a message, and I will write about it), but a Backdoor Roth IRA is something I was not familiar with, so what is it, and how can it benefit your retirement/financial planning? Let’s break it down:
Understanding the Basics: What is a Roth IRA?
Before diving into the Backdoor Roth IRA, it is key to understand what a Roth & Traditional IRA is, at least the basics. A traditional IRA is a retirement savings account where you contribute pre-tax income, potentially reducing your taxable income for the year, and your investments grow tax-deferred until you withdraw them in retirement, when they are taxed as income. A Roth IRA is a retirement savings account that enables you to contribute post-tax income, with no upfront tax deduction for your contributions. Let’s break that jargon down — For a Roth IRA, it is like a special savings account for retirement; you put money aside from your job earnings (to save for the “future”), but the money you are putting in comes from your paycheck after taxes have been taken out (so you have already paid taxes on this money). You can now invest these Roth IRA savings in things like stocks, bonds, or mutual funds, and these investments have the potential to grow over time. The best part of the Roth IRA is that when you retire and start taking money out of your Roth IRA, you don’t have to pay taxes on it because you already paid taxes on the money you put in.
The Limitations of Roth IRA Contributions
When I heard/read everything I wrote in the previous paragraph, my first impression was, okay, what is the catch? The catch (if you call it one) is the government has put a limit on how much individuals can contribute per year to a Roth IRA, and there is an income limit. It’s a sweet deal, so of course, it had to be capped somehow. For 2023, the IRS allowed an annual maximum IRA contribution limit of $6,500 annually if you’re under 50 or $7,500 if you’re 50 or older. Regarding the income limit, in 2023, the ability to contribute to a Roth IRA starts to phase out for individuals earning over $138,000, and if you earn over $153,000, you are not eligible. Married couples filing jointly and earning over $228,000 are ineligible.
In 2024, the Roth IRA contribution limits rose to $7,000 for those under 50 and $8,000 for those 50 & older. The income limit to be ineligible to contribute to ROTH IRA also rose for individuals making $161,000 or more & to $240,000 for married couples filing together.
Introducing the Backdoor Roth IRA Strategy
So, what if you earn too much to contribute directly to a Roth IRA? This is where the Backdoor Roth IRA strategy comes into play. The Backdoor Roth IRA allows high-income earners to bypass the income limits on Roth IRA contributions by making nondeductible contributions (after-tax money) to a traditional IRA and then converting those funds into a Roth IRA.
How Does the Backdoor Roth IRA Work?
Here’s a step-by-step guide to executing the Backdoor Roth IRA strategy:
- Open a Traditional IRA: If you don’t already have one, open a traditional IRA with a brokerage firm or financial institution of your choice — Fidelity, Vanguard, etc.
- Make Nondeductible Contributions: Contribute funds to your traditional IRA. Ensure there is no balance in the traditional IRA account and that while the money sits in the traditional IRA account, it is not invested to avoid tax complications.
- Convert to a Roth IRA: Once the funds are in your traditional IRA, you can initiate a Roth conversion, transferring the money into a Roth IRA. This conversion is a taxable event, but since you’ve already paid taxes on the contributions, you won’t owe taxes on them again. You have to wait before initiating this transfer (a holding period), but the IRS does not mandate a specific holding period.
Key Considerations and Caveats
While the Backdoor Roth IRA strategy offers a way for high-income earners to access the benefits of a Roth IRA, there are a few important considerations to keep in mind:
- Roth IRA limit: That total is for all IRA accounts you might have. If you have, for example, a Roth and a traditional IRA, you can put some money in one and some in the other, but the combined contribution in 2024, for example, cannot equal more than $7000 (or $8,000 for those 50-plus). You can contribute to your Roth IRA up until the tax deadline.
- Pro-Rata Rule: If you have existing pre-tax funds in traditional IRAs, the IRS applies a pro-rata rule when calculating taxes on conversions. This means you can’t selectively convert only the after-tax contributions; instead, you’ll need to consider the tax implications of the entire conversion.
- 5-year Rule: Because a backdoor Roth IRA is categorized as a conversion — not a contribution — you cannot access any of the funds held in the converted Roth IRA without penalty for the first five years after conversion.
- Financial Advisor: TLDR: It could also get tricky, so read more before executing a backdoor strategy, and feel free to call your broker to ask as many questions as needed (i.e., calling fidelity etc is free). The Backdoor Roth IRA strategy involves navigating taxes and retirement account rules. Consult with a financial advisor or tax professional who can provide personalized guidance based on your financial situation if you need one.
The Backdoor Roth IRA strategy offers a good opportunity for high-income earners to boost their retirement savings and enjoy tax-free withdrawals in retirement. If the income limit does not limit you, the Roth IRA is something to consider if you are able to do so.
Again, planning for retirement, financial freedom, or just being financially responsible can be tricky but also very possible — a lot of research, figuring out your goals/plans, aligning with your current earnings and potential future earnings can make it a lot easier. Also, having a mentor, creator, or advisor who is very credible and understands the different processes could be another valuable resource.
Knowledge and proactive decision-making are key things needed as you plan. Whether you’re just starting your career or nearing retirement age, exploring strategies like the Backdoor Roth IRA can help you build a secure and tax-efficient retirement stash.
PS: If you are a new college graduate, early in career, or just someone transitioning into a new role, I have another article that can help you on your financial journey here:
