A Roth IRA account is a powerful and popular tool for retirement savings. It offers tax advantages such as tax-free growth on your investments and tax-free withdrawals during retirement. However, depending on your income, you may not be able to contribute directly to a Roth IRA account.
What is a Backdoor Roth IRA?
Despite how it sounds, a Backdoor Roth IRA is not actually a type of retirement account. Instead, it is a strategy that investors can use to convert money from a traditional retirement account into a Roth IRA. The use of the term “backdoor” in the title refers to the fact that this strategy is typically employed by investors who are not eligible to contribute directly to a Roth IRA due to their income level. With a Backdoor Roth IRA, these contribution rules are circumvented.
Who Benefits from a Backdoor Roth IRA?
A Backdoor Roth IRA can be a valuable tool for someone who wants to take advantage of the tax benefits offered by this type of account but is not eligible to contribute directly to a Roth IRA.
Tax Implications of a Backdoor Roth IRA
A Backdoor Roth IRA can be an excellent means for taxpayers who may not be eligible to contribute to a Roth IRA through other means. However, there are some tax implications that you should be aware of.
Previously deducted contributions will be taxed
The tax benefit of contributions to a traditional retirement account differs from the tax benefit of contributions to a Roth IRA. As a result, you may be converting previously deducted funds from your taxable income into a Roth IRA. While this is permissible, it means that you will have to pay taxes on the converted funds.
Planning for the pro-rata rule
If you have contributed to a traditional retirement account with both deductible and non-deductible contributions, the tax implications of a Backdoor Roth IRA conversion can be a bit more complicated. “Taxation can become complicated if a portion of your IRA assets has already been directed to tax and another part has not been directed to tax,” Figueroa states. “You cannot isolate the portion that has already been directed to tax for your conversion to avoid taxation. The IRS follows the pro-rata rule, which requires the conversion of IRA assets on a percentage basis.”
Your long-term tax rate may be higher
Many financial experts recommend the Roth IRA because of its amazing tax benefits. However, depending on your situation, you may end up paying more tax on your income in the long run with a Backdoor Roth IRA compared to leaving the funds in a traditional retirement account and paying taxes on them during retirement.
Watch for the five-year rule
Roth IRA accounts enjoy what is known as the “five-year rule,” which states that you must wait at least five years after your first contribution to the account before you can make any tax-free and penalty-free withdrawals. Since you have already paid taxes on your contributions, you can withdraw those contributions (not your investment earnings) without paying penalties after those five years have passed.
Is a Backdoor Roth IRA a Good Idea?
A Roth IRA is one of the most popular and highly recommended retirement accounts. Once you have paid taxes on your contributions, you will not pay taxes on the money in your account again. For many investors, choosing a Roth IRA over a traditional retirement account is a no-brainer.
But
Many people who take advantage of the backdoor Roth IRA do so because their high income prevents them from contributing directly to these types of accounts. Additionally, since converting your retirement funds to a Roth account means paying taxes on them, it may not make sense for people who are already facing a high tax burden.
So how can you determine whether a backdoor Roth IRA is the right option for you? “For taxpayers who do not meet the requirements for deductible savings but want to save more, a backdoor Roth IRA is a great option if they have the income necessary to contribute,” according to Figueroa.
However, according to Figueroa, it’s not all clear-cut for high-income earners who have not already taken advantage of tax-deductible investment accounts, like their 401(k). “A backdoor Roth IRA is better than contributing to a traditional retirement account.
Source: https://www.thebalancemoney.com/tax-implications-of-a-backdoor-roth-ira-5270483
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