Are you ineligible for a Roth IRA because of your high earnings? Consider a backdoor Roth IRA conversion.
Roth IRAs have income limits, which make many people ineligible for them. Fortunately, there’s a way to convert an IRA to a Roth IRA down the road. This backdoor IRA conversion requires you to open a traditional IRA and convert it in the future.
The Roth IRA Conversion
The steps for the Roth IRA conversion are simple:
- Open a traditional IRA, funding it up to the annual limit ($6,000 for 2020)
- Immediately convert your account to a Roth IRA. Your IRA administrator will provide the required paperwork.
The biggest consideration in an IRA conversion is the taxes. If you immediately take advantage of the Roth IRA conversion, you won’t have earnings in your traditional IRA. The only taxes you’ll owe are the deduction you took (if any) on your taxes for the IRA contribution. If you converted right away and didn’t take the tax deduction, you won’t have to worry about this.
Reasons for the IRA Conversion
Why might you want to convert your IRA to a Roth IRA? Here are a few reasons:
- Your earnings grow tax-free. That means a lower tax liability when you withdraw your funds during retirement.
- You don’t have to worry about Required Minimum Distributions (RMDs) as would occur with a traditional IRA. You aren’t forced to take withdrawals at any point with a Roth IRA.
- Your heirs can inherit the money tax-free as long as you owned the Roth IRA for at least five years.
What you Must Consider
While the backdoor IRA sounds appealing, you must consider how you convert the funds and the pro-rata rule.
How you Convert
You can convert the account in one of three ways:
- Rollover – You withdraw the funds from your traditional IRA and roll them over into the Roth IRA. You must deposit the funds within 60 days to avoid penalties.
- Direct transfer – You can have your trustee do a direct transfer to the new trustee, with the money never touching your hands.
- Same trustee transfer – If you keep your IRA with the same institution, you simply convert and don’t have to worry about timeframes.
Pro Rata Rules
The Pro Rata Rules are what keep many people from converting their IRA. The IRS looks at your total IRA balance and determines how much of it is pre-tax money and how much is after-tax money. The pre-tax percentage is what determines how much of your Roth IRA conversion is taxable. For example, if you have IRAs with 50% pre-tax and 50% after-tax money, 50% of the amount converted to a Roth IRA is taxable.
Also, consider the affordability of your tax liability. Can you afford to pay the taxes or will you take the money from your IRA? This could leave you with further penalties (10% early withdrawal penalty) plus the loss of future earnings on the money.
The backdoor IRA conversion makes it possible or even high-income earners to take advantage of the Roth IRA tax-free growth. Look at the big picture before making a decision to determine if it’s the right choice for you.