For those who earn over the income limits to contribute to a Roth IRA, get ready to have your mind blown. Queue Lightbulb!
Quick Roth IRA refresher course
Roth IRAs are funded with post-tax dollars and grow tax-free! You can trade as much as you want inside of the account and even transfer to other IRA custodians without any penalties or taxable events.
General rules of a Roth IRA
- You must be over 59 ½ before taking any distributions to avoid a 10% penalty and owing any taxes on your gains. You can withdraw your initial contribution anytime tax and penalty-free.
- The account needs to be established for 5 years from the initial funding event before taking any distributions to avoid taxes on your gains.
General rules for new contributions to a Roth IRA
- For 2020, the maximum contribution to a Traditional or Roth IRA is $6,000 per year if you are under 50 years old and $7,000 per year if you are over 50 years old.
- You can contribute to ANY IRA until April 15th of the following year. (i.e., 2020 contributions can be made until April 15, 2021).
- 2020: If you are single, you must have a modified adjusted gross income under $139,000 to contribute to a Roth IRA, but contributions are reduced starting at $124,000. If you are married filing jointly, your MAGI must be less than $206,000, with reductions beginning at $196,000.
Number 3 on that list is where, in the past, high-income earners have been out of luck when it comes to participating in the incredible TAX-FREE benefits of a Roth IRA. However, that all changed in 2010 when the income limit was permanently removed from Roth IRA conversions. What’s a Roth conversion, you ask? That is where you convert a Traditional IRA or any other pre-tax account into a Roth IRA. That type of conversion does create a one-time taxable event, which adds the amount being converted to your income for that year. The benefit of doing this is that going forward you have tax-free growth in a Roth IRA instead of tax-deferred growth in a Traditional IRA. This may or may not be the right move for everyone. As always, it’s best to consult with a tax professional who is familiar with your situation.
The creation of the Backdoor Roth IRA
Now that you have an understanding of the 2010 conversion law let’s get into the nuts and bolts of how a Backdoor Roth works. For those who earn above the Roth income limit to contribute directly into a Roth IRA, the process works like this.
- Make a new contribution to a Traditional IRA (see contribution rules/amounts above)
- Convert your new Traditional IRA to a Roth IRA. This is a standard process for any IRA custodian. They may charge a small fee for this service because there are additional forms to process. Well worth it!
- Your accountant files an 8606 form to report the contribution as non-deductible. This prevents you from getting double-taxed on your contribution. In other words, you are using after-tax dollars to fund the account and not taking a deduction; therefore, NO additional taxes are owed.
It can’t be that easy, can it?
For most people, it is that easy! However, there are some additional things you need to be aware of to ensure you don’t have any further tax issues from setting up this type of account.
You or your spouse, if you file jointly, cannot have any other pre-tax IRAs. If you do, there is a pro-rata tax calculation that is assessed across the values of all your IRAs. I can go into the details of this, but instead, if you’re in this position, it’s definitely time to consult your tax advisor.
A Roth IRA is a great way to save and grow your wealth tax-free! And now, just about everyone can participate in this incredible program. So for all you high earners, pick your jaws up off the ground and get your Backdoor Roth IRA started.
Disclosure: I am not a licensed financial or tax advisor — consult with a tax professional to determine what is best for you.