A Backdoor Roth IRA Lets You Grow Tax-Free Wealth Even If You’re Over the Income Limit. Here’s a Step-by-Step Guide

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If you are a high income earner, you may think you’re not eligible to invest your money into a Roth IRA because of the income limits set by the IRS, but there’s still a way to do it. You just have to sneak in the back door.

If you’re wondering what that means, here’s what it is. A backdoor Roth IRA is a completely legitimate way to get past the income limits that the IRS sets. This method involves converting a traditional IRA into a Roth IRA, and allows you to still deposit your $6,000 once a year for 2022, and $6,500 a year in 2023.

When it comes to a Roth IRA, a single person making over $144,000 for tax year 2022 is technically not eligible to deposit $6,000, according to these income limits. If you’re married and filing jointly, the limit is $214,000. But a backdoor Roth IRA lets you bypass these rules.

“This is totally legit and the IRS knows about it. I don’t even know why they bother with the income limits,” says personal finance expert Delyanne Barros in this Instagram video

There’s pending legislation, referred to as Secure Act 2.0, that could close this loophole for conversions to Roth IRA investment accounts, but how long it’ll take for bills to get signed into law is anyone’s guess. 

Until reform happens, the backdoor Roth IRA can be a useful way to save for retirement. Let’s take a look at how it works, how to set it up step-by-step, and what to consider about this investing strategy. 

What Is a Backdoor Roth IRA And How Does It Work?

A backdoor Roth IRA isn’t a special type of account. “It’s a strategy to get money into a Roth IRA,” explains Cindi Turoski, CPA, CFP, and Managing Partner of Bonadio Wealth Advisors, a division of The Bonadio Group. 

It’s important to remember that this conversion becomes a reportable tax event. When you transfer the money from a traditional to a Roth IRA, you owe taxes on that money — including earnings and appreciation. But if you follow the Roth IRA rules that the IRS has set in place, you won’t owe any further taxes on the money when you take it out in retirement.

Pro Tip

A backdoor Roth IRA is an excellent way to get more money into your investment accounts if you exceed the current income limits. Be sure to understand the tax consequences, if any. For maximum efficiency, don’t invest your funds until they’re in your Roth IRA account.

How Do I Set Up a Backdoor Roth IRA? 

To get started, you’ll need two accounts: a traditional IRA and a Roth IRA. If your accounts are with the same provider, it should be a straightforward process. If not, you’ll want to call and confirm the steps. Here’s how to do it:

Step 1: Fund your traditional IRA with your $6,000, but don’t invest it yet. 

Step 2: Make the conversion. Convert the traditional IRA to a Roth IRA.

Step 3: Invest. It’s not enough to just convert your money. You need to purchase investments within your Roth IRA account. Experts recommend low-cost, broad-market index funds that provide exposure to multiple industries, which gives you immediate diversification. Here are the best investments for beginners

Step 4: Repeat every year when it’s time to invest.

Why Would I Need a Backdoor Roth IRA vs a Regular Roth IRA?

Quite simply, because of the income limits. A backdoor Roth IRA lets you get around these restrictions. It’s a way for those who would otherwise be disqualified from contributing to a Roth IRA to enjoy the benefits of this type of retirement account. 

You may owe tax when you convert your traditional IRA to a Roth IRA, but it allows your money to grow tax-free and you won’t pay taxes when you reach retirement age, which is currently set at 59 ½, provided you meet the two “five-year rules,” which we’ll cover in a bit. 

How Is a Backdoor Roth IRA Legal in the US? 

If you’re thinking this sounds too good to be true, Congress might agree with you. “Last year, the Build Back Better bill was looking to do away with conversion of any after-tax contributions,” Turoski says. And there’s been recent news of billionaires abusing Roth IRAs for their tax-free benefits. 

Taxes and Backdoor Roth IRAs

If you’re new to backdoor Roth IRAs, make sure you start your traditional IRA with after-tax dollars – and make sure not to invest your money in anything. Instead, just let the cash sit for a short time until you’re ready to make the conversion to a Roth IRA. 

If you’re converting from a traditional IRA that already has earnings on investments, you can still do the backdoor Roth IRA conversion, but you’ll owe tax on the earnings. 

There are two “five-year rules” to keep in mind. The first says that you can’t access your funds in the first five years after a Roth IRA conversion without penalty. That means that when you convert, you start the five-year clock. Typically you can withdraw your contributions without penalty, but for conversions, you must observe the five-year rule. The exceptions to this are if you become disabled, or pass away and leave your account to heirs. 

The second five-year rule dictates that you can’t withdraw Roth IRA earnings unless your first contribution was made more than five years prior, even if you’re over age 59 ½. You can withdraw your original contributions any time, but must wait five years to withdraw any earnings in your account without additional taxes or penalties. 

Keep tax implications in mind to make sure you can afford to pay the amount on however much you convert. As always, consult a tax professional for clarification on your specific situation if you have questions. 

Should You Set Up a Backdoor Roth IRA? 

If you’ve already maximized your contributions in your employer’s retirement plan and you want to save more but are above the current income limits, a backdoor Roth IRA is another way to keep saving for retirement.

Risks of a Backdoor Roth IRA

If you’re already eligible to contribute to a Roth IRA, there’s no point in going through the steps necessary to fund a backdoor Roth IRA. 

But remember, time is of the essence. Lawmakers are aware of these conversion workarounds and whether they’ll get passed or not remains to be seen, but if the account rules change, you’ll want to have already made your conversions into your Roth IRA. That way, your funds get as much time to grow tax-free as possible.