How to Set Up a Backdoor Roth IRA

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A Roth IRA can bring tremendous tax advantages, but the trouble is that people with high enough incomes cannot contribute to them in a conventional way. Fortunately, there is another way to gain access for those not eligible, through what’s called a “backdoor Roth IRA.”

This guide will explain exactly what the backdoor Roth IRA strategy is and how you can implement it. We’ll also provide a balanced overview of the potential advantages and disadvantages of this method. Finally, we’ll list the essential things you need to consider before deciding whether a backdoor Roth IRA is suitable for you. Let’s get started.

What Is a Backdoor Roth IRA?

A backdoor Roth IRA is not a particular type of retirement account for people with high incomes. Instead, it’s a way for high earners to get around the income limits on a Roth IRA. Essentially, it’s a strategy that people can use to fund, and benefit from, a Roth IRA even when they don’t qualify for regular contributions.

It typically involves taking the funds from a traditional IRA or 401(k) and then converting them into a Roth IRA. Thus, it is entirely legal and not a form of tax evasion.

How to Create a Backdoor Roth IRA

There are a few different ways you can accomplish a backdoor Roth IRA conversion. However, keep in mind that you’ll need to go about it carefully to avoid incurring penalties or taxes.

Here are the main ways you can create a backdoor Roth:

  1. Open a new traditional IRA: You can open a new traditional IRA account, make a nondeductible contribution to it, and then immediately ask your broker to convert the funds to a Roth IRA.
  2. Use an existing traditional IRA: Alternatively, if you already have a traditional IRA, you can convert funds from it to a Roth IRA. There may be tax implications doing it this way, though.
  3. Rollover a 401(k) contribution: Another option is to make a post-tax contribution to a 401(k) plan and roll the funds over to a Roth IRA.

Here are some essential things to keep in mind when deciding which route to take:

  • When making a nondeductible contribution to a new traditional IRA, have it converted right away before any investment gains accumulate. Otherwise, you’ll have to pay taxes on those gains.
  • Be aware that you cannot exceed the annual contribution limits when funding new traditional IRAs, which currently stand at $6,000 or $7,000 for those 50+ years old.
  • You can convert as much as you want if you use the funds from an existing traditional IRA, as you’re not making a new contribution, meaning the annual contribution limits don’t apply.
  • However, if you’re using tax-deducted funds from an existing traditional IRA, you will have to give that deduction back and pay income tax on the money you converted. Remember, only after-tax funds can go into a Roth IRA.

The Benefits of a Backdoor Roth IRA

Okay, so we’ve looked at what a backdoor Roth IRA is and how you can perform one, but what are the actual benefits of this strategy?

Well, a backdoor Roth brings you very similar advantages as all Roth IRAs, with the main one being it can potentially reduce how much tax you pay in the future.

Any funds you contribute and the gains they produce can grow tax-free in a Roth IRA. Usually, once you pass the age of 59 and a half, you’re able to withdraw as much as you want whenever you want from your Roth IRA, without having to pay any taxes on those funds. However, your Roth IRA account must be at least five years old for this to apply.

Also, as only after-tax dollars can go into a Roth, you can actually withdraw your contributions, but not your gains, before the age of 59 and a half if you need to. However, as a backdoor Roth is considered a conversion rather than a contribution, you have to wait five years before being allowed to withdraw the funds used in each conversion.

Another benefit is that there are no required minimum distributions when you reach the age of 72, meaning you can keep the money in your Roth IRA for as long as you want and even leave it to your heirs.

Things to Consider About a Backdoor Roth IRA

Before you rush to use the backdoor method, you should consider these things, so you can decide if it’s the best move for you:

Contribution Limits

The backdoor Roth is usually only worth considering if your income exceeds the contribution limits on a Roth IRA.

As of 2021, if you have an income higher than $140,000 as a single tax filer or $208,000 as a married couple filing jointly, you won’t be able to contribute to a Roth IRA.

Tax Implications

If you convert a traditional IRA into a Roth, any funds you claimed as a tax deduction would lose that privilege, and you’ll have to pay income tax on them.

If you contribute to a nondeductible traditional IRA and immediately convert the funds to a Roth, you might not have to pay any taxes during the conversion.

However, this depends on whether all of your funds in all of your traditional IRA accounts are nondeductible. Unfortunately, the IRS doesn’t let you use exclusively nondeductible funds during a backdoor Roth conversion.

Instead, it considers all of your traditional IRAs (deductible and nondeductible) to be one account and determines what you owe in taxes on distributions based on that.

Transfer Types

A backdoor Roth conversion must be one of the following types of transfer:

  • Trustee-to-Trustee Transfer: The traditional IRA company you use sends the funds directly to the Roth IRA company.
  • Rollover: You receive funds from your traditional IRA and send them within 60 days to your Roth IRA.
  • Same Trustee Transfer: Your traditional IRA provider is also your Roth IRA provider, so a transfer within the company occurs.

Pro-Rata Rule

A backdoor Roth IRA conversion has to be done pro-rata. The pro-rata rule means that all funds that enter any of your traditional IRAs are combined; the IRS considers them to be one account. Unfortunately, this means you cannot separate the already-taxed dollars from tax-deducted dollars when performing a backdoor Roth.

Should You Do a Backdoor Roth IRA?

A backdoor Roth IRA might be worth doing for some people, but not everybody. Those who may benefit from doing it include:

  • People who have high incomes and cannot contribute funds to Roth IRAs the conventional way.
  • People who want to avoid required minimum distributions after the age of 72.
  • People who don’t want the hassle of paying and filing taxes during their retirement.
  • People who believe that their tax rates are likely to increase in the future and would prefer to pay now and enjoy tax-free growth.

On the other hand, a backdoor Roth IRA might be disadvantageous for:

  • People who already qualify to contribute to a Roth IRA.
  • People with a high percentage of tax-deferred contributions and gains in their traditional IRAs.
  • People who may need access to their converted funds within five years.

Crypto IRA: Alternative Retirement Investments

You can also enjoy the tax advantages a Roth IRA brings for Bitcoin and cryptocurrency investments. However, be aware that many Roth IRA providers do not allow crypto investments yet, so you’ll likely have to open a new account with a specialized Bitcoin IRA company, such as iTrustCapital

They are a leading name in the Bitcoin/crypto IRA space that allows you to set up a Roth IRA account to invest in Bitcoin, cryptocurrencies, and precious metals. Creating an account is relatively quick and straightforward, as long as you meet their minimum requirements. They also let you do backdoor Roth IRA conversions. Visit the iTrustCapital website to learn more about their Crypto IRA account.

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