When planning for retirement, an individual will often look at opening a traditional IRA or a Roth IRA. For many, the latter is an attractive option, as it allows individuals to make tax-free qualified withdrawals. Because Roth IRAs are funded with after-tax dollars their contributions are not tax-deductible.
Roth IRA Limits
Though many people might want to open a Roth IRA, they may not be eligible due to their income level or contribution limits. For those who file as a single person, their modified adjusted gross income must be less than $140,000 for the 2021 tax year or less than $144,000 for 2022 in order to contribute to a Roth IRA. A taxpayer who is married and filing their taxes jointly must have modified adjusted gross income of less than $208,000 for 2021 or $214,000 for 2022.
What is a Backdoor Roth IRA?
Yet there is a way that a person who makes more than these amounts can have a Roth IRA. This is where the so-called “backdoor Roth” comes into play. A backdoor IRA is created by converting an existing traditional IRA to a Roth. No income limits apply to this process; hence, the name “backdoor Roth” since it allows taxpayers with higher levels to benefit from a Roth IRA even though they would not be eligible to open one in the standard fashion.
How to Set Up a Backdoor Roth IRA
Creating a backdoor Roth IRA is a simple process. The first step is to make a non-deductible contribution to your traditional IRA. This contribution must be reported at tax time on the IRS Form 8606, Nondeductible IRAs. This form will help track your basis, which will be important later when you start taking distributions.
After making the non-deductible contribution, you then convert the traditional IRA balance to a Roth IRA. You will owe tax on any earnings in the traditional IRA that occurred before converting, but from that point on the assets are Roth IRA assets and are not subject to future tax.
For anyone who earns more than the aforementioned amounts, creating a backdoor Roth IRA should be a serious consideration. With a backdoor Roth IRA, you effectively have tax-free growth forever—or until you decide to withdraw money from the account.
Illustration of a Backdoor Roth IRA
To illustrate the impact a backdoor Roth IRA can have, consider the potential growth for a 40-year-old who opens a traditional IRA, converts it to a Roth IRA, and contributes $6,000 every year. These $6,000 contributions grow tax-free forever. So, between the ages of 40 and 65, this person will never pay taxes on those earnings. Then, when they decide to pull the funds out of the account, they will not have to pay taxes on that money. And a taxpayer who starts investing $6,000 a year into a backdoor Roth IRA at the age of 40 may have close to $500,000 by the time they turn 65.
Serious Benefits for High Earners
Ultimately, creating a backdoor Roth IRA can have serious benefits for high-earning individuals who are unable to open a Roth IRA because of earning limits. To learn more about the potential benefits of a backdoor Roth IRA and to better understand the process, consult with one of our experienced advisors who can guide you through each step.