What Is a Backdoor Roth IRA? Everything You Need to Know

Investing in your future is all about strategy. One way you can build up your retirement nest egg is through an individual retirement account (IRA). However, there are limits on how you can use an IRA depending on your income.

If you earn too much to be eligible for a Roth IRA, you can transform your traditional IRA into a Roth IRA through a backdoor Roth IRA.

So, what is a backdoor Roth IRA? Our team at the Oxford Gold Group is here to explain your options.

What Is a Backdoor Roth IRA?

A backdoor Roth IRA is not an official type of IRA. It is a retirement plan strategy if your income makes you ineligible for a Roth IRA. High-earners can convert an existing traditional IRA into a Roth IRA and subsequently benefit from the tax advantages of a Roth IRA. This strategy provides many benefits to high-earners like you, including the protection of your wealth.

At first glance, this might sound like a “loophole” with questionable legality. However, backdoor Roth IRAs are completely legal. As long as you meet the tax requirements, backdoor Roth IRAs are legally permissible as per the Internal Revenue Service (IRS).

How Does a Backdoor Roth IRA Work?

The backdoor Roth IRA process involves transferring assets in your traditional IRA to a Roth IRA. This makes it possible to contribute to a Roth IRA through the “backdoor” a traditional IRA provides, even if you aren’t eligible to contribute to a Roth IRA directly.

Now that you know the basic answer to “What is a backdoor Roth IRA?” we can explore how this strategy works, its benefits, and if it’s the right choice for you.

Who Should Consider This Strategy?

man choosing strategy for his investments

What is a backdoor Roth IRA, and who should open one? If your current income exceeds the contribution limits for a Roth IRA, you should consider using a backdoor IRA. This is especially true if you’re an investor looking for retirement distributions that would not be subject to income tax. However, before you make any decisions, speak to your professional financial adviser.

If you have a traditional IRA, when you turn 73 years old, you have to begin meeting the minimum distribution requirements. Based on the amount of savings in your IRA, you must withdraw a certain amount from your IRA every year. However, with a Roth IRA, you are not subject to minimum distribution requirements, except for inherited savings.

One of the most important things to consider when converting your traditional IRA funds into a Roth IRA is timing. When do you wish to access these funds? While there is no minimum distribution requirement for a Roth IRA, you’ll pay penalties if you withdraw from the Roth IRA account within five years of the conversion.

You will owe taxes upfront on your contributions to your Roth IRA. To put this in perspective, assume you are ineligible for a Roth IRA because your income exceeds its limits.

However, you have a traditional IRA account with $100,000 in it. With an average income tax rate of around 20% among the top 10% of taxpayers in the United States, you would pay $20,000 in taxes upfront if you converted this full amount from a traditional IRA to a Roth IRA. While this is a large amount to pay initially, your $100,000 can then grow tax-free for years to come.

The average annual rate of return on the stock market was between 10% and 12% at the end of 2023. So, even if you don’t make any additional contributions, that $100,000 would grow enough to make up for that initial $20,000 in taxes several times over.

On the other hand, if you decide to keep the $100,000 in your traditional IRA account, you must pay taxes on the $100,000 and any investment growth when you begin making withdrawals in retirement. Ultimately, you’ll end up paying much more in taxes.

Who Shouldn’t Consider This Strategy?

Despite the many potential benefits, a backdoor Roth IRA isn’t for everyone. For example, having an employer-sponsored retirement plan, such as a 401(k) plan, can complicate matters. You are moving pre-tax contributions to a traditional IRA, which may lead to complications with the pro rata rule, which we’ll explain later.

Similarly, even if you have tax-deductible contributions in your 401(k), your employer may contribute a pre-tax amount. Confirm with your employer whether they contribute a pre-tax or after-tax amount before pursuing a backdoor Roth IRA.

Roth IRA Income and Contribution Limits

man showing his income

A backdoor IRA is a strategy for those who exceed the Roth IRA’s income and contribution limits. In 2023, the income limit for Roth IRAs will be $153,000 for single filers and $228,000 for married filers filing taxes jointly. For 2024, this amount will increase to $161,000 for single filers and $240,000 for married filers filing jointly.

If your annual income exceeds these numbers, you cannot contribute to a Roth IRA directly. However, using the backdoor IRA, you can still benefit from one.

A contribution limit, on the other hand, is the amount the IRA limits you to contribute to a Roth IRA every year. For 2023, this amount is $6,500 for those under 50 and $7,500 for those over 50. This amount will also increase in 2024, making the contribution limit for people under 50 $7,000, and $7,500 for those over 50. These limits are currently the same as traditional IRA limits.

However, there is no limit to the amount you can convert from a traditional IRA to a Roth IRA, which can help you grow your retirement fund faster.

Traditional IRA vs. Backdoor Roth IRA

a notebook about the difference of traditional and roth ira

If you’re unfamiliar with retirement accounts and investment methods, you may wonder why people go through the trouble of converting their traditional IRA to a backdoor Roth IRA. Some essential differences between these two accounts show why a backdoor IRA is worthwhile.

Traditional IRAs

It’s easiest to answer the question, “What is a backdoor Roth IRA?” when you know how traditional IRAs work. A traditional IRA allows you to contribute funds toward your retirement with pre-tax dollars. This means you defer your income taxes on those contributions until you begin making withdrawals upon retirement. A traditional IRA has no income limits, so anyone can open one.

A traditional IRA is typically a good option for those who expect to be in a lower tax bracket during retirement since you pay taxes on your distributions rather than your contributions.

Roth IRAs

Roth IRAs are also retirement investment tools, but they have more limitations. You must have an income below the specified Roth IRA income limit to open or directly fund one.

With a Roth IRA, you pay taxes on your contributions upfront, so you can later make withdrawals without paying taxes. This can be beneficial, as your contributions will grow over time, which could mean paying more taxes if you don’t have a Roth IRA.

Backdoor Roth IRAs

As of 2010, the IRS doesn’t have income limits that prevent anyone from converting a traditional IRA to a Roth IRA. Therefore, if you’re in a high tax bracket, you can still take advantage of the tax benefits of a Roth IRA through a backdoor IRA. This way, when you start making withdrawals after retirement, they won’t be taxed, allowing you to retain as much wealth as possible.

When you pursue a backdoor IRA transfer, you cannot recharacterize the funds as traditional IRA funds again. Before 2018, those who used backdoor IRAs could recharacterize converted funds. However, the Tax Cuts and Jobs Act (TCJA) banned this strategy.

Now, when you convert funds from a traditional IRA to a Roth IRA, this change is permanent, which is why you should be sure this is the right investment strategy for you by talking with a financial adviser.

Benefits of a Backdoor Roth IRA

a man saving money with a piggy bank

A backdoor Roth IRA can transform your financial future. Consider these benefits to know if this is the right investment decision for you.

No Required Minimum Distributions

Roth IRAs do not have required minimum distributions. This is important to note, as required minimum distributions can have a significant impact on your retirement funds. Of course, the more you can keep in your account, the more your investment will grow over time. A required minimum distribution requires you to take funds out of your account, preventing growth.

Additionally, if you miss withdrawal deadlines for a traditional IRA or fail to meet the distribution requirement, you can face a tax penalty of up to 50%. This can significantly impact your retirement fund and cause you to lose some of your hard-earned investments.

Tax-Free Gains and Withdrawals

Since you pay taxes on your contributions to a Roth IRA, the funds will grow tax-free. Then, when you retire and make withdrawals, you won’t owe income tax.

This is especially beneficial for high earners. If you wait to pay taxes on your withdrawals, you could pay much more than you would on your contributions. However, you should note that if you convert your traditional IRA funds into a backdoor Roth IRA, you have to pay that income tax at once.

Estate Planning

Estate planning allows you to secure the future of your assets, your legacy, and your loved ones’ financial future. When you draft your will, you can designate a beneficiary to inherit your retirement account.

While you can do this with any retirement account, including a traditional IRA, a Roth IRA is the most valuable to a beneficiary. Since you already paid income tax on your contributions, your beneficiary can inherit these funds without an income tax obligation.

Challenges of Backdoor Roth IRAs

Backdoor Roth IRAs have many benefits, but you should consider the drawbacks too. You will pay a significant amount in taxes upfront, so plan for that accordingly with your financial adviser.

These conversions can also put you in a higher tax bracket for the year, which means you have a higher tax obligation. You must evaluate your funds and work with a financial adviser to decide if this is a good long-term investment.

There is also the five-year rule to consider, which we will explain later. Essentially, this rule restricts you from making immediate withdrawals from your converted funds. Once they are in a Roth IRA, making withdrawals within five years of the conversion leads to penalties. This could present an issue if you’re close to retirement or face a financial crisis and unexpectedly need to withdraw funds.

How To Create a Backdoor Roth IRA

a photo illustrating the beginning of financial stability

What is a backdoor Roth IRA, and how do you set one up? Deciding to pursue a backdoor Roth IRA is one thing; actually creating one is another. This process can appear complex, but taking it in steps simplifies it.

There are three approaches to creating a backdoor Roth IRA:

  • You can contribute money to an existing traditional IRA. Then, roll over those funds to a Roth IRA, which allows you to contribute as much as you want.
  • You can convert your entire existing traditional IRA into a Roth IRA.
  • You can roll over funds from an employer-based 401(k) plan directly into a Roth IRA.

To pursue any of these options, you need to follow the steps to ensure you do everything correctly and comply with all IRS rules and guidelines. Your custodial bank or brokerage for your IRA should also be able to guide you through these steps. Alternatively, if you have an employer-managed plan, you can receive assistance from the firm that manages the account.

1. Open a Traditional IRA and Make a Contribution

You must secure the funds in a traditional IRA account before converting them. Since you contribute to a traditional IRA, you don’t have to pay taxes on this contribution yet. You can fund a traditional IRA with:

  • Cash
  • Checks
  • Direct bank deposits

You can also move other retirement funds directly into a traditional IRA. Choosing how much you want to contribute to save for retirement depends on your income and overall wealth, but remember to keep contribution limits in mind. If you exceed a contribution limit, you must either recharacterize the funds or apply the excess contribution to the following year. Otherwise, you must pay a 6% penalty fee.

2. Open a Roth IRA

With your funds in a traditional IRA, your next step is to open a Roth IRA. To do this, you’ll need your social security number and your tax identification number (TIN) handy. You can go to your existing bank or brokerage and begin the process online. At this point, you’ll also name a beneficiary for the account.

This is an essential step and something you should keep in the back of your mind as you experience major life changes such as divorce, marriage, and family deaths. Keeping this beneficiary up to date prevents this account from being subject to probate after you pass away, ensuring your beneficiary can access the assets without any hassle.

Since you are ineligible to contribute to a Roth IRA directly due to your higher income, you don’t need to choose investments or set up a contribution schedule at this stage. Once the account is open, you can move on to conversion.

3. Choose Your Assets

With both accounts prepared, you can move on to converting your traditional IRA funds to Roth IRA through a backdoor IRA. To do this, contact your broker to request the conversion, specifically listing the assets you want to move. Remember that you must pay taxes on these assets upfront when you transfer them to a Roth IRA, so choose carefully.

4. Transfer Your Contribution to the Roth IRA

Finally, submit the conversion form to your broker, who will begin the conversion process. Depending on the broker and your exact request, you may pay fees for moving certain assets. Typically, brokers can complete backdoor Roth IRA conversions in a couple of days. Larger conversions may take a couple of weeks.

5. Pay Your Taxes

Prepare to pay taxes on your contribution amount. It’s smart to calculate your tax obligation before the conversion and set aside the amount. This will be due when you file your annual tax return. As you continue to use a backdoor Roth IRA to convert traditional IRA funds, you will pay income tax on each of the contributions.

Transfers With Backdoor Roth IRAs

elderly discussing roth transfers with a trustee

What is the backdoor Roth IRA transfer process? When you make a transfer with a backdoor Roth IRA, you have three methods you can use: same-trustee transfer, trustee-to-trustee transfer, and a 60-day rollover transfer. Let’s go over how each transfer works.

Same-Trustee Transfers

A same-trustee transfer involves opening a Roth IRA with the same bank with which you have an existing traditional IRA. This makes the transfer process simpler, as you just need to notify your bank that you’d like to make the transfer and how much you want to convert.

Trustee-to-Trustee Transfers

You can also choose to open a Roth IRA with a different institution through a trustee-to-trustee transfer. After you open your Roth IRA at a new institution, notify your traditional IRA provider that you want to make a direct transfer to your Roth IRA provider. Your providers usually do this through a wire transfer from one institution to another.

60-Day Rollover Transfers

If you decide to go through a rollover transfer process, your IRA provider will issue you a check with your requested amount. This check is payable to the Roth IRA account, not to you directly. You must deposit this into your Roth IRA within 60 days. Missing this deadline can lead to penalties. Moving funds directly from one account to another is often more secure.

Regardless of the transfer method, ensure you communicate clearly with all institutions involved and comply with IRS guidelines.

Tax Implications of a Backdoor Roth IRA

stack of coins and a calculator for computing tax

No matter what transfer type you choose, you will have a tax obligation for any pre-tax money in your traditional IRA after the conversion. When you contribute money to a traditional IRA, you typically claim that contribution as a deduction on your tax return. Since you didn’t pay taxes on that amount when contributing, you must pay when you make the transfer for your backdoor Roth IRA.

Remember that you don’t just owe money on your initial contribution to your traditional IRA — you owe taxes on the growth too. For example, if you initially contributed $1,000 to the account and that grew to $6,000, you would owe taxes on the full $6,000 when you transferred it to your Roth IRA through a backdoor IRA.

If you have any after-tax contributions in your traditional IRA, the IRS will use the pro-rata rule to determine your tax obligation. Depending on the growth of your existing traditional IRA, this can put you in a higher tax bracket for the year, causing you to have a higher tax obligation.

The Pro Rata Rule

When you transfer funds from your traditional IRA to a Roth IRA, the IRS requires that you do this pro rata. “Pro rata” is a Latin term that means “in proportion.” For legal purposes, the pro rata rule requires you to transfer your assets from one account to another in proportional amounts.

When you make your transfer, the IRS will look at all of your traditional IRAs combined to determine what portion is pre-tax assets and what portion is after-tax assets. The resulting ratio determines how much of your conversion is taxable. The pro rata rule prevents you from converting after-tax assets only.

For example, if your accounts consist of 80% pre-tax assets and 20% after-tax assets, regardless of the amount you transfer or which assets you choose, the IRS will tax 80% of your transfer. It’s also worth noting that the IRS applies the pro-rata rule at the end of the tax year, not the time of conversion. Therefore, in the above example, 80% of your total annual conversion would be taxable, not 80% of each conversion.

The pro rata rule can make backdoor IRAs more costly if you have multiple traditional IRAs, particularly if you have a mix of pre-tax and after-tax money. You can talk to a tax professional to decide if a backdoor Roth IRA is the right choice for you based on the pro rata rule.

The Five-Year Rule

Another rule to keep in mind when you’re considering a backdoor Roth IRA is the five-year rule. If you plan to withdraw from your Roth IRA soon or if you want to use it as an emergency fund within the next few years, a backdoor Roth IRA may not be the right choice for you.

You cannot withdraw money from your Roth IRA after you convert your funds for five years, even if you’re already 59 ½ or older. This rule is in place because the IRS expects you to use your Roth IRA strictly as a retirement fund, and withdrawing early defeats its purpose.

The five-year rule applies to each conversion, so each conversion has a five-year waiting period before you can withdraw those funds penalty and tax-free. Therefore, the IRS requires you to withdraw the oldest contributions first. When you withdraw any money from a Roth IRA, the IRS requires you to first withdraw direct contributions (if you have them), then conversions, then earnings.

If you do not comply with the five-year rule, the IRS will deem your withdrawal an unqualified distribution. Unqualified distributions are subject to taxes. The rate at which the IRS taxes these distributions depends on your tax bracket. The higher your tax bracket, the more you must pay as a penalty for early withdrawal.

This rule applies to inherited backdoor Roth IRAs too. If you designate a beneficiary for this account, they will not be able to access the funds until the account is five years old. If they make an early withdrawal, they will owe taxes on that amount.

Add Gold to Your Backdoor Roth IRA With Oxford Gold Group

Now that you know the answer to “What is a backdoor Roth IRA?” you can decide whether this is a good option for you. Once you decide to open an IRA, you then need to decide how you want to fund it. One way to build up your retirement nest egg and diversify your investment portfolio is through a gold IRA.

A gold IRA or precious metals IRA allows you to use gold and other IRS-approved precious metals as investments rather than just traditional money. A gold IRA has the same contribution and distribution limits as a traditional IRA, but it must be a separate account. You can fund your gold IRA with gold coins, gold bars, mining stocks, mutual funds, or exchange-traded funds.

Here at Oxford Gold Group, we want to help you secure a strong financial future. We are dedicated to providing the tools you need to understand your investment options. We can answer questions like, “What is a backdoor Roth IRA?” and more.

To begin structuring your gold IRA, contact us at 833-600-GOLD for more information, or browse our available gold bars and coins.

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