Lots of people have heard about a backdoor Roth IRA and wonder if it’s a strategy for them. Frequently asked backdoor Roth IRA questions below.
4 Common Questions about a Backdoor Roth IRA
Many people have heard about a backdoor Roth IRA but wonder what it is, whether it might be right for them, and how exactly to do it. Here are some frequently asked questions about the backdoor Roth strategy.
1. What is a backdoor Roth IRA?
Roth IRAs are a type of individual retirement account with a unique tax feature. They allow a user to make after tax contributions and in return, qualified withdrawals can be made without owing taxes. This means that any growth that occurs in the account can be tax-free. Compare this to a traditional IRA, which allows pretax contributions, and taxes owed on all withdrawals.
A backdoor Roth IRA is a way to make contributions to a Roth IRA for someone above IRS income limitations. Please note that the following is meant for informational purposes only; consult with your tax and financial advisor on your particular situation.
2. What is the potential benefit of a backdoor Roth IRA?
One problem with Roth IRAs is that there are income limitations regarding who can contribute to one. According to the IRS (link opens in new tab), for 2023 a married filing jointly (MFJ) tax filer with income above $218,000 and single tax filer with income above $138,000 has limits on the amount they can contribute to a Roth IRA, with no contribution permitted for MFJs above $228,000 or singles above $153,000. A backdoor Roth IRA strategy can permit people with incomes higher than this to still contribute to a backdoor Roth.
Generally, a Roth IRA can be beneficial for a person who believes they will pay more in taxes in retirement than they are paying now. It can also be beneficial for a person who is already saving as much as they can in pretax accounts.
3. How does a backdoor Roth IRA work?
The backdoor Roth IRA requires several steps which can be complicated and must be followed carefully to avoid tax penalties.
Here’s a video showing how to do it on the Vanguard platform.
Basically, the steps involved are:
- Open a Roth IRA account at your chosen broker.
- Open a traditional pretax IRA account at your chosen broker.
- Fund the traditional IRA account (note annual limits on IRA contributions per the IRS; $6,500 in 2023 for those under 50). Do not invest – just keep the contribution in cash.
- Some time after the traditional IRA account is funded (some advisors recommend 30 days), transfer the funds to the Roth IRA. Some brokerage firms offer a simple way of doing this through a one-click button or other method.
- Invest.
4. Who might a backdoor Roth strategy NOT be good for?
- Those who are under the income thresholds for contributing to a Roth IRA. If you’re under the income threshold (see above), then you can simply contribute directly to a Roth IRA.
- Those who need access to the funds within 5 years (there can be added penalties for withdrawing money from a Roth IRA within the first 5 years of opening).
- Those who are not maxing out their employer retirement savings plan contributions. If you’re not maxing out your workplace retirement plan, consider whether it makes sense to increase your contributions there before going down the backdoor Roth path. Many employer-sponsored plans also include some type of employer match or contribution based on how much you contribute. Also check whether your employer permits Roth 401k contributions.
- Those who believe their tax bracket will be lower upon retirement. This is a more complicated issue, as it’s more a matter of whether you believe it’s advantageous for you to pay taxes now, or pay taxes later. There’s a saying, only two things in life are certain: death and taxes. With a Roth IRA, you pay taxes now on the contributions. If you’re in a high marginal tax bracket right now, but expect that in retirement you’ll be in a much lower tax bracket, it might not make sense for you to pay higher taxes now just to get your money into a Roth IRA.
- Those who don’t want to deal with the complications and rules associated with doing a backdoor Roth IRA correctly.
- Those who don’t have any earned income, whether due to retirement or other circumstances.
Learn more about whether a backdoor Roth IRA might be good for you by talking to your tax professional or financial advisor. Remember, none of the information here is intended as investment advice or a recommendation of what you should do in your specific situation.
Don’t have a financial advisor? Reach out to see if we might be a fit for working together.
