A backdoor Roth IRA allows you to get around income limits by converting a Traditional IRA into a Roth IRA. You are may be restricted by income limits when contributing directly to Roth IRA, if your income is beyond certain limits, but there are no income limits to convert from a traditional IRA to a Roth IRA. If you own Roth IRAs, you have to pay upfront taxes, but after all the taxes are paid, all of the growth and any withdrawals would be tax-free for the Roth owner.
The current tax law allows anyone, regardless of income, to convert – from traditional IRA to Roth IRA, without any income restrictions. After the conversion is done, the money converted will be considered as income, which would trigger a taxable event. It could also place the user in the higher tax bracket, according the year conversion is done.
The advantage of a Roth conversion is that you will pay your taxes today so any withdrawal in future would be tax-free. The availability of backdoor Roth IRA is subject to tax policy and can change anytime.
So, is backdoor Roth IRA right for you?
Backdoor Roth comes with two positive features –
- If the owner of Roth account die after holding the account for at least four years, the entire Roth account can be inherited by the owner’s beneficiary without being subject to taxation.
- There is no minimum distribution limit during the lifetime of the account owner.
As with traditional IRA, Roth IRAs were created to enable senior citizens to save money for their retirement. But there is income limit of making up to $120,000 a year, depending on your filing status to be eligible for a Roth IRA. The backdoor Roth facilitate those with higher wages to take tax free distributions in the retirement years as well the ability to pass the entire amount of money to beneficiary after the death of the Roth owner, if they had hold the account for at least four years.
There is no income limit, so everyone is able to roll as much money from their traditional IRA into their Roth IRA as they want. There is no limit on how much you can roll over into a Roth. It is important though, when doing this that the conversion will be considered as income and there was no tax paid at the time of traditional IRA. With Roth IRA taxes are paid upfront but distributions are tax-free. A back door Roth is beneficial for those with higher wages.
Financial expert Ed Slott has four warnings for backdoor Roth prospective clients –
- The client must have earned income; otherwise they will not qualify for non-deductible IRA contribution
- If the client is 70 and half years old, the backdoor strategy won’t work because traditional IRA contributions have age limits
- The pro-rata rule will still apply. This means that some of your conversion may be taxable so your Roth conversion may or may not be tax free depending on whether you have other IRAs.
- The funds that are converted to the Roth IRA would be considered as converted funds, not Roth IRA contributions. These clients must wait five years for penalty-free access to those funds because the funds went in as conversions.
Another attractive feature of a Roth IRA is there are no minimum distribution requirements during the life time of the account holder. This allows the entire amount to pass down to beneficiaries without any tax deductions.