Backdoor Roth IRA might sound dubious, but this IRS tax loophole could help maximize your retirement investments.
Updated Jul 19, 2022
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Saving up for retirement is a major part of planning ahead, but the problem with tax-deferred retirement accounts like a traditional IRA is that you can't predict how much you'll be taxed. Tax policies might have evolved by the time you retire and you could end up owing less or more taxes than you would have if you had paid Uncle Sam upfront decades earlier.
That's why investors who want to pay less tax on their retirement assets open up a Roth IRA. The catch is that Roth IRAs have an income limit, but it's possible to get around this limit with a backdoor Roth IRA contribution. It may sound shady, but a backdoor Roth IRA colloquially refers to a real tax loophole that lets high-income taxpayers convert traditional IRA assets into a Roth IRA
A backdoor Roth IRA is a loophole that high-income earners in the U.S. can use to reduce tax liability. Investors can use this tax loophole to contribute to a self-directed IRA and avoid paying taxes on profits, dividends, and other earnings from their investments.
Put simply, if you earn more than $144,000 a year ($214,000 if married) then you can save on taxes by transferring assets from a regular retirement account to a tax-advantaged Roth IRA. That's basically what a backdoor Roth IRA is, but it's a bit more complex than it may seem.
A backdoor IRA is completely legal and involves moving your money and other assets from a tax-deferred retirement account to a Roth IRA account. A traditional IRA is a tax-deferred retirement account, which means you must pay taxes on your contributions later. The main difference with Roth IRAs is that your contributions are taxed upfront, which is a great way to not pay tax on earnings your retirement contributions made.
You can transfer up to $6,000 annually from retirement accounts like 401K or IRA to a Roth IRA, which essentially converts those assets into tax-advantaged Roth assets. This enables high-income earners to circumvent Roth IRA income limits and, by doing this every year, build up a tax-advantaged asset portfolio. This works even better if you're over 50 years old because your annual backdoor Roth IRA conversions limit goes up from $6,000 to $7,000.
Performing a backdoor Roth IRA conversion involves more than just transferring assets between retirement accounts. There are certain stipulations to backdoor Roth IRA conversions, so here's what you'll need to know before you send your assets from your traditional IRA to a Roth IRA.
The main thing to note about backdoor Roth IRAs is that you can only fully realize their tax benefits if you don't hold any assets in another retirement account. In other words, you want to make sure all your other IRA accounts are empty before you do a backdoor Roth IRA conversion to eliminate tax liability on all your retirement contributions.
This means all your retirement contributions must be in your Roth IRA by the end of the tax year to properly pull off a backdoor Roth IRA strategy. Traditional IRA contributions are taxed for any amount of time they're not in a Roth IRA, so it's best to do a backdoor Roth IRA conversion as soon as you make your retirement contribution.
Another reason to convert your retirement contributions from your traditional IRA to your Roth IRA as soon as possible is that all your earnings in a traditional IRA are taxed. That means you'll owe taxes on capital gains and interest earned in your traditional IRA account. So, if you're going to do a backdoor Roth IRA conversion, do it the moment your retirement contribution arrives in your account to avoid other tax consequences.
You'll want to file the proper forms with the IRS to inform the authorities that you've made after-tax contributions to a Roth IRA and that those are your only retirement contributions. There is no official guidance on how to properly do a backdoor Roth IRA, but one form that is compulsory to submit is IRS Form 8606. Filling out the correct forms is the best way to ensure that you won't owe taxes on assets contributed to your Roth IRA.
For those earning a high enough income, backdoor Roth IRAs are a super useful way to bypass the income limits of Roth IRAs and maximize a tax-free investment portfolio. Even individuals earning less than $144,000 can benefit from contributing to a Roth account. Rather than contributing to a traditional IRA and paying more taxes, long-term investors of any income can save on taxes by holding their assets in Roth IRAs.
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