Setting up a Roth IRA backdoor account is a multi-step process
Where can you set up a Roth IRA backdoor account?
Setting up a Roth IRA backdoor account first requires establishing a traditional IRA at a financial institution such as a credit union, bank, investment broker, or mutual fund provider. Setting up an IRA account online is straightforward. When opening the account, you will have options on how to manage it. Not all investment brokers that support IRA accounts will offer all of the following options, so it may be helpful to first choose the type of account management you want, and then find a broker that offers the services you’re looking for. Here are some options you can pursue:
Managed by a professional: This is the most expensive account management option. It involves having a dedicated professional (human) manager to help you select and manage your investments based on your unique needs.
Self-directed management: When you have a traditional IRA that you manage yourself, you are responsible for selecting and managing investments in the account. A new investor might find this type of management overwhelming, but it comes with lower fees.
Robo-advisor: This allows the account holder to choose from different portfolio options designed to fit various life stages and risk tolerance levels. Instead of human intervention, algorithms determine the best investment options for your IRA. These options also offer lower fees.
Before choosing a brokerage, it may be helpful to answer the following questions while shopping to find the best fit:
What are the fees I will need to pay to open and maintain the account? Does this account require a minimum initial investment or maintaining a certain minimum balance? Can I get customer support in person, by phone, online, or in other ways?
Setting up a Roth IRA backdoor account
To understand how a Roth IRA backdoor account works, let’s review the process:
Open a traditional IRA: Since a Roth IRA backdoor is not an actual type of retirement account, the first step in creating one is to open a traditional IRA that can be converted to a Roth IRA.
Make contributions: After opening a traditional IRA, you will make after-tax contributions (the allowable contribution amount is updated annually).
Note: It is important to submit IRS Form 8606 each year that you make contributions to the traditional account.
Transfer assets from the traditional account: Once you’re ready, you can transfer the assets in your traditional account to a Roth IRA. Advisors typically recommend waiting a few months before taking this step. You will work with your broker to convert your traditional account to a Roth IRA. The institution’s steps required to make this happen can guide you.
Tax implications
You should plan for the taxes you will expect to pay when transferring the assets from your traditional IRA to a Roth IRA. The conversion to a Roth IRA will incur income tax on the gains of your after-tax contributions. Once the assets are in a Roth IRA, they will grow tax-free – one of the main reasons some people choose to pursue a Roth IRA backdoor account.
To calculate the amounts due, you must consider all the assets in your traditional IRA, and you will therefore pay a percentage of taxes on the original tax-deferred contributions and earnings.
Note: It’s a good idea to consult a tax accountant if you need help calculating the amounts you will owe in taxes after the conversion.
Potential issues with Roth conversions
Since Roth IRA backdoor accounts are not a standard practice, they come with some potential issues you should be aware of.
First
And first of all, there are some concerns that the IRS does not officially endorse this practice, as it has not issued official guidance on whether a backdoor Roth IRA conversion violates the one-step rule, which treats several different steps as if they were a single process for tax purposes. While experts are not overly concerned that the IRS will consider this loophole a violation, there are some risks involved, as the account holder could be penalized with taxes on the increase in their Roth IRA.
There are also some apprehensions that if the IRS imposes restrictions on backdoor Roth IRAs in the future, it could result in penalties or a requirement to adhere to a scheduling condition. These concerns are purely hypothetical at this time, but the risk of such changes may not be something you feel comfortable bearing.
Note: Another concern regarding backdoor Roth IRAs arises from the fact that calculating the amounts for which you will owe taxes after the conversion can be quite complex.
Frequently Asked Questions
What is a jumbo backdoor Roth IRA?
When someone refers to a jumbo backdoor Roth IRA, they are essentially talking about the same regular backdoor Roth IRA. “Jumbo” refers to the fact that this trick is used by high-income individuals who exceed the income limits for a Roth IRA and transfer their funds from a company-sponsored 401(k) plan, which has a much higher contribution limit than the standard income limits for a traditional IRA, to a Roth IRA.
How much can you contribute to a backdoor Roth IRA?
How much you can contribute to a backdoor Roth IRA depends on the type of account from which the money comes. If you plan to convert within one year, you will reach the contribution limits for your traditional IRA or 401(k). As of 2022, you can contribute up to $61,000 in total contributions (or $67,500 if you are over 50) into a Roth IRA after transferring money from a 401(k) plan and up to an additional $6,000 in the limit for a traditional IRA.
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Sources:
Morningstar. “Is the Backdoor Roth Still Legit?”
Experian. “Step-by-Step Checklist To Opening an IRA.”
Charles Schwab. “The Backdoor Roth—Is It Right for You?”
IRS. “Retirement Topics – IRA Contribution Limits.”
Source: https://www.thebalancemoney.com/how-to-set-up-a-backdoor-roth-ira-5221187
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