One often-overlooked obstacle in retirement is taxes. When you’re retired and you begin to withdraw funds from your traditional IRA or your traditional 401(k) or 403(b), you’re going to owe income taxes on that money. For many, whose additional retirement savings come on top of Social Security, this also likely means that a significant portion of your Social Security benefits will also be subject to income tax.
Income taxes can present a real challenge for folks on a limited retirement budget. It’s much easier to make it financially if you’re not facing an annual income tax bill that strips away 10% to 20% of your annual income.
Roth IRAs don’t have this problem. Money in a Roth IRA comes directly from your checking account, meaning you already paid income taxes on it. And once the money is in your Roth IRA, it will grow over time, and when you start withdrawing it in retirement, the withdrawals are entirely tax free!
The biggest catch here is that a Roth IRA has income limits. To contribute, your modified adjusted gross income must be below $140,000 if you’re single, and below $208,000 if you’re married (in 2021; the amounts vary each year). If your income is above that level, you’re not eligible to directly contribute to a Roth IRA.
Anyone eligible for a Roth IRA can open a Roth IRA for themselves, and there are many great options for opening your own Roth IRA, but only people below a certain income level can make contributions to a Roth IRA.
What if you aren’t eligible to contribute to a Roth IRA due to your income level, and your workplace doesn’t offer Roth retirement accounts? Furthermore, what if you have old traditional IRA or 401(k) investments that you wish were in a Roth IRA? There’s a solution for both problems, and that’s the “backdoor Roth.”
What is a backdoor Roth?
A “backdoor Roth” refers to the strategy of making contributions to a traditional 401(k) or traditional IRA and then converting those funds into a Roth IRA. Once the money is in the Roth IRA, you then wait until retirement, and then withdrawals from that account are free from income tax.
Why wouldn’t you just contribute to a Roth IRA directly? There are some advantages to a 401(k) over a Roth IRA, plus high income earners can’t directly contribute to a Roth IRA.
What’s the catch? In order to execute this “backdoor Roth,” you need to pay income taxes on the amount you convert. It’s treated as taxable income, so you’re going to have a large income tax bill on the year you make the conversion.
Let’s say you have $10,000 in an old 401(k). If you use a “backdoor Roth” strategy and convert it into a Roth IRA, you’ll have $10,000 more in taxable income this year, which could devour your tax return or even require you to make a tax payment to the IRS. However, when you’re retired, the money you take out of your Roth IRA, including the gains, will be tax free, so you’ll owe no income tax on it when you withdraw it and any other income you earn will stay in a lower tax bracket.
Who might find a backdoor Roth useful?
Why would you do this?
One good reason to do it is if you have a year where your income is quite low. For example, if you go through a period of unemployment, you’ll likely be in a very low tax bracket for the year, so your tax rate on the money you moved into the Roth IRA will also be low.
Another reason to do it is that you anticipate tax rates being higher in retirement than you’re paying right now. Predicting future tax rates is a guessing game, as it relies both on knowing what those tax brackets might be and what your own income might look like. Some people may want to simply “future proof” themselves.
Yet another reason is to take advantage of the rules of a Roth IRA. One advantage of a Roth IRA is that you do not have to begin taking contributions at age 70, which happens with a traditional IRA. Converting it lets you get around that rule.
How to execute a backdoor Roth
A “backdoor Roth” happens when you move the money from a pre-tax investment account, like a 401(k) or traditional IRA, into a post-tax Roth IRA. Here are three common scenarios in which this might happen, and how you can pull each one off.
Make contributions to a traditional IRA, then roll it into a Roth IRA
If you’re in a situation where you are above the income limit for a Roth IRA but want to contribute to one nevertheless, you can make contributions to a traditional IRA, then roll the money in the IRA over to a Roth IRA. This process is described in IRS Publication 590-A.
Here’s how it works.
If you don’t already have a traditional IRA, you open an account with the brokerage of your choice. Then, make contributions to that traditional IRA from your checking account. Each year, you can contribute up to the annual contribution limit (in 2021, that limit is $6,000 for people under 50 and $7,000 for those 50 and over) for a traditional IRA.
When you’re ready, during a year when it makes the most sense for you, withdraw whatever portion you want to convert to a Roth IRA from your traditional IRA. Then, within 60 days, deposit that amount into your Roth IRA.
At the end of that tax year (in other words, the following spring), you will owe taxes on all of the traditional IRA contributions that you claimed a tax deduction for, as well as the earnings.
It’s as easy as that, and if you have your traditional IRA and Roth IRA at the same investment house, they can handle the middle steps on your behalf.
Convert a traditional IRA into a Roth IRA
What if you have an old IRA that you contributed to in the past, during a different phase in your life, and now you’d just like to turn it into a Roth IRA? You can do that!
If you have a traditional IRA and you want the whole balance to become a Roth IRA, your investment firm can make that conversion for you upon request. Again, you’ll owe income taxes the following spring on any contributions that you claimed deductions on in the past, as well as any earnings in that traditional IRA before you converted it, so you’ll need to account for those.
Make contributions to a 401(k), then roll it into a Roth IRA
Another option is to move money from a traditional 401(k) or 403(b) to a Roth iRA. This process is similar to that of converting a traditional IRA to a Roth IRA described above, except that you’ll owe taxes on the full balance that you transfer (since all contributions to a traditional 401(k) or 403(b) are tax deductible).
Again, the easiest way to do this is identify a brokerage with which you want to host your Roth IRA, then sign up for an account and request help from them in making this rollover possible. Make sure that you are accounting for the income taxes when doing this, however. It might be a good time to do it when you have a windfall available to you to cover the tax bill.
Too long, didn’t read?
A “backdoor Roth” is a retirement tax strategy that lets you convert money in a traditional 401(k) or traditional IRA into a Roth IRA. The reason for doing this is simple: When you’re retired, money withdrawn from a Roth IRA is entirely tax free, whereas you’ll likely have to pay taxes on withdrawals from other accounts. The disadvantage is that you’ll likely have to pay taxes now, when you actually do the conversion. It provides an option for people who might be in the right situation to handle a tax bump now (say, in a low income year) or are wary of high taxes when they reach retirement age.
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Source: thesimpledollar.com