Roth IRAs provide the advantage of tax-free growth on earnings and tax-free withdrawals during retirement. Nevertheless, there’s a catch: If your income exceeds the thresholds established by the IRS, you are ineligible to make direct contributions to a Roth IRA.
However, individuals with high incomes can still find a way in through a strategy known as the “backdoor Roth IRA.” While this method is relatively straightforward, understanding the associated tax implications is essential.
What exactly is a backdoor Roth IRA?
The key advantage of Roth IRAs compared to traditional IRAs lies in paying taxes upfront. In exchange, the returns you accumulate remain tax-free, and you aren’t required to pay income taxes upon withdrawal. With Roth IRA accounts, you can deposit money annually and pay income taxes in the year of deposit. In contrast, traditional IRAs or 401(k)s offer an immediate tax advantage because you are not obligated to pay income taxes on deposits until you withdraw the money. However, when funds are withdrawn from these accounts, you owe taxes on earnings and the initially invested amount.
To qualify for direct contributions to a Roth IRA, your income needs to fall within a specific threshold defined by your modified adjusted gross income (MAGI). Based on taxpayer status, individuals whose earnings exceed the specified income limit are restricted by IRS regulations from opening or funding Roth IRA accounts.
The backdoor method offers a viable solution for individuals whose income exceeds the threshold for direct contributions to a Roth IRA.
Traditional IRAs can be converted to Roth IRAs by all individuals, according to the IRS, making it a viable entry point even for high-income earners. Banks, brokerages offering IRAs, and the financial services company associated with your employer’s 401(k) retirement plan can guide you with the practical aspects of opening such accounts.
It is worth highlighting another viable option, which involves making after-tax contributions to a 401(k) plan and transferring those funds to a Roth IRA. Remember that a backdoor Roth IRA is not a means to evade taxes; rather, it offers the future tax advantages of a conventional Roth IRA account.
Considerations for tax implications
A backdoor Roth IRA grants the same tax advantages as a Roth IRA, meaning you won’t owe additional taxes when you withdraw the money post-retirement. However, when opening a backdoor Roth IRA, you will be subject to paying taxes on the transferred funds in that tax year.
When deciding whether to open a backdoor Roth IRA, ponder the following questions:
- “Where can I derive the greatest value or the most tax-advantaged savings?”
- “Does it practical to opt for a tax deduction today if I potentially qualify?”
- “Does it make sense to pay taxes upfront and enjoy tax-free growth for the rest of my life?”
Ultimately, it’s about comparing your current taxes with the future scenario, as Fry emphasizes, stating that there are no significant advantages. Eventually, Uncle Sam always prevails.
The final verdict
While a backdoor Roth IRA is not an officially recognized retirement account, it serves as a means for high-income taxpayers to fund a Roth IRA, even if they exceed the traditional income limits. The backdoor Roth IRA is entirely legal and endorsed by the IRS. Although opening a backdoor Roth IRA initially entails paying taxes, it grants investors the future tax benefits associated with a traditional Roth account.