If you’re thinking about building your nest egg, Roth options can be extremely valuable.

When it comes to Roth IRAs, one of the biggest advantages is that they allow qualified investors to enjoy tax-free withdrawals of their money after retirement. Backdoor Roth IRAs allow high-income earners to bypass Roth income limits.

What is a Backdoor Roth IRA?

A backdoor Roth IRA essentially allows you to convert your a non-deductible traditional IRA contribute to a Roth IRA even if your income is too high to contribute to a Roth IRA. When done correctly, a Backdoor Roth Conversion has no tax consequences.

How does a Backdoor Roth IRA work?

To do a Backdoor Roth IRA conversion, you first make a non-deductible contribution to a traditional IRA. Unlike a Roth IRA, a traditional IRA has no income ceiling for contributions.

Then you convert the non-deductible IRA contribution into your Roth IRA. If there is no gain on the converted funds, the conversion is a tax-free event (unlike if you converted a pre-tax IRA to a Roth, in which case you pay taxes on the converted amount at your current ordinary income rate) .

An important factor is your suitability based on your Modified adjusted gross income (MAGI) and tax return status (married, married filing jointly, married filing separately). It will determine if you are is eligible to contribute to a Roth IRA.

  • If you file as a single person, your MAGI must be less than $140,000 for the 2022 tax year to contribute to a Roth IRA. (You can only make the full contribution if your income is less than $125,000. Those with income between $125,000 and $140,000 can contribute gradually less as their income increases.)
  • If you’re married and filing jointly, your MAGI must be less than $208,000 for the 2022 tax year. (You can only make the full contribution if your combined income is less than $198,000. Incomes between $198,000 and $208,000 also have progressively lower thresholds).

If your current MAGI exceeds the limit, given your tax filing status, you can use a Backdoor Roth conversion for your retirement savings.

4 Easy Steps to Complete a Backdoor Roth IRA in 2022

You can perform a Backdoor Roth Conversion by following these four steps:

1. Open and fund a new traditional IRA or contribute to an existing traditional IRA.

You can open an IRA at most financial institutions, both physical and online. In 2022, you can contribute up to $6,000 to a traditional IRA, or $7,000 if you’re 50 or older.

2. Research how a Roth IRA conversion works.

This is where it may be wise to seek help from a financial advisor. Consider consulting a tax professional and your financial advisor before performing Backdoor Roth Conversion.

3. Convert your contributions to a Roth IRA.

The principal will not be taxed as normal Roth IRA Conversion, but the salary will be taxable. Therefore, it makes sense to do the conversion as soon as possible to minimize the taxable income. Note that if your employer offers a Roth 401k, you can transfer the funds to it if you want.

4. Repeat these steps annually.

You can continue to do this as long as this strategy remains appropriate for your financial situation.

Key Considerations for Backdoor Roth IRAs

Here are some important points to consider before doing a Backdoor Roth IRA.

  • Is Backdoor Roth IRA Allowed in 2022? The Build Back Better Act would end backdoor Roth IRAs starting in 2022. However, with that legislation now on the back burner, the strategy remains alive and well, at least for now.
  • Tax Consequences of a Backdoor Roth IRA: There may be some cases where you will need to pay taxes on a Backdoor Roth IRA, such as:
    • If you included pre-tax IRA assets in the conversion. If you withdraw your traditional IRA contributions and then decide to convert your traditional IRA to a Roth IRA, you will have to pay taxes on the pre-tax assets. When it comes time to file your tax return, be prepared to pay income tax on the pre-tax dollars you’ve transferred to the Roth.
    • If you have other pre-tax IRA assets left after the backdoor conversion. This is known as the rule of proportion.
  • Proportional rule: One of the most important rules pertaining to the Backdoor Roth Conversion is the proration rule. This is an IRS rule that determines what amount is taxable (or not) when you convert IRA dollars from a traditional IRA to a Roth IRA. Simply put, if you try to convert after-tax traditional IRA contributions to a Roth IRA but have existing pre-tax IRA dollars, you’ll be taxed on a pro-rata basis.

The IRS will consider all of your IRA accounts together when determining your tax when converting from a traditional IRA to a Roth IRA. For example, if all of your IRAs combined are 80% pre-tax money and 20% after-tax money, that 80/20 ratio determines what percentage of the after-tax money you convert to a Roth will be taxable.

For this particular example, no matter how much money you convert or which pre-tax IRA account you withdraw money from, 80% of the amount you convert to a Roth will be taxable. The IRS applies the prorating rule to your total IRA balance at the end of the year, not at the time of the conversion.

  • Five-year rule: This rule imposes a five-year waiting period before earnings or converted IRA funds can be withdrawn from the account. To withdraw earnings from a Roth IRA without paying taxes or penalties, you must be at least 59 1/2 years old and have held the account for at least five tax years. If the funds are withdrawn earlieryou may have to pay taxes on any earnings and potentially incur a 10% penalty if you are 59½ or older.
  • Transfers from Backdoor Roth IRAs: Note that the conversion must be one of the following:
    • Rollover if you withdraw funds from your IRA and deposit the money into a Roth account within 60 days;
    • A trustee-to-trustee rollover, in which the IRA provider sends your funds directly to the Roth IRA provider; or
    • “Same Trustee,” where both the traditional and Roth IRAs are held at the same financial institution.

Is Backdoor Roth IRA Worth It?

Backdoor Roth IRA limits may not be right for everyone’s financial situation, depending on several factors. For example:

  • You may not need a Backdoor Roth IRA if you can reach your maximum retirement savings goal through your workplace retirement account and don’t expect to need additional savings for your retirement plan.
  • If you already have pre-tax money in a traditional IRA, the conversion may be tax-advantaged because of the proration rule.
  • It should be noted that inherited IRAs are not included in the proportional calculation.
  • You must be prepared to keep the funds in your newly created Roth IRA for at least five years before withdrawing the money.
  • You may want to keep money in a traditional IRA if you’re in a high tax bracket now and expect to be in a lower tax bracket when you retire.
  • If you are planning to move to a low state income tax or a state with no income tax.

On the other hand, a Backdoor Roth conversion can be considered if:

  • You have already used other retirement savings options.
  • You are a high earner.
  • You are willing to leave the money in the Roth for at least five years (ideally longer).
  • You have no other Roth assets.

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