Do you want to fund your Roth IRA, but can’t?
If you’re like many high-income earners, you don’t contribute to a Roth. You think you make too much money, disqualifying your ability to do so.
Believe it or not, there’s a way. And it’s legal, too!
Every year that you have earned income, you can put money into an IRA. Funds that can get transferred to a Roth using the backdoor Roth IRA conversion!
Most people save for retirement and grow their nest egg using 401Ks and IRAs. Accounts the IRS designates as having special tax benefits.
One of the best retirement vehicles available is the Roth IRA. The contributions get made using post-tax earnings where they grow and get withdrawn tax-free!
Paying taxes on your money upfront locks you into today’s low rates. Removing all uncertainty of what your future tax liability may be.
Today, there is a growing concern about the US and its financial wellbeing. With each passing day, the National Debt grows larger and one day soon we may have to start repaying it. Whenever this time comes, leaders will get forced to reduce spending or increase taxes. And if the past is any sign of the future, cutting expenses is least likely to happen!
Roth IRAs offer greater flexibility than other retirement accounts, too. Unlike Traditional IRAs and 401Ks, they don’t have Required Minimum Distributions (RMDs). You’re not forced to withdraw money regardless of whether you need it or not.
But, Roth IRAs do allow you to withdraw your contributions tax and penalty-free. Money that can help bridge the gap between early and standard retirement age!
The IRS designates if you’re eligible to contribute to a Roth IRA based on your income. As your earnings increase and pass limits, the amount you can deposit begins getting phased out. A process that continues until you can’t put money into one at all!
A backdoor Roth IRA conversion solves the income issue for high wage earners. It provides a way to get around these income restrictions. Legally allowing you to get money into a Roth!
Each year, the IRS gives you until Tax Day (April 15th) to fund your IRA. In tax years 2020 and 2021, you can deposit up to $6,000. Or $7,000 if you’re over the age of 50.
High-income earners can’t contribute directly to a Roth. But, they can use the backdoor Roth IRA conversion to deposit funds in a roundabout way.
The first step is getting money into a Traditional IRA. An account that everyone with earned income is eligible for. If you don’t have one, consider opening one with Vanguard or Fidelity. Both of which offer a wide variety of investment options with low total expense ratios.
A backdoor Roth IRA conversion is easier if you don’t have any money in Traditional IRAs. But if you do, you can still make the deposit. You’ll just want to review the Backdoor Roth IRA Conversion Pro-Rata Rule and determine if you’ll owe any taxes.
After making the deposit, leave it in the cash portion of the account. If the funds get put into the market and you realize a gain; then you’ll owe taxes on the profits. For simplicity, don’t invest your contribution.
Now you have money sitting in a Traditional IRA. The next step is to convert it.
There are 3 ways you can transfer funds from a Traditional to a Roth IRA. They are:
For most people, the transfer options work best. They remove the risk of human error, ensuring you don’t lose the check and pay needless fees or penalties. (Like financial automation)
Contact your IRA providers to find out their preferred method for completing the backdoor Roth IRA conversion. They’ll walk you through the process and may let you do everything online. Otherwise, there will be forms you’ll have to submit.
Contributions to Roth IRAs get made using post-tax income. If you’ve previously paid taxes on these funds, then you won’t pay them again.
But in some instances, Traditional IRA contributions are tax-deductible. If you’ve taken these discounts in the past, then you’ll have to pay taxes when you do a backdoor Roth IRA conversion.
Review your current income and tax brackets to determine the amount you’ll owe. Then, set aside enough money to cover the bill come tax time.
The IRS keeps track of Roth IRA conversions, too. Any time you do one you’ll need to fill out IRS Form 8606 and include it with your tax returns.
The IRS designates the amount that you can contribute to a Roth IRA each year. But, not the amount that you can convert.
If you have money in a Traditional IRA, you can convert it to a Roth at any time. But before you do, you’ll need to consider the tax liability.
Often, funds in Traditional IRAs were made pre-tax. Meaning the conversion to a Roth creates a taxable event. Along with any profits you realize, too.
First, consult with a CPA and determine your tax bill. Then, make sure you have enough money outside your IRAs to pay the bill in full. Allowing the power of compounding to continue uninterrupted!
Using money inside your IRA to pay taxes defeats the whole purpose of a Roth. Your goal is to get money into this account, not to convert it and end up with a lesser amount with which to grow!
You don’t have to convert your entire Traditional IRA to a Roth at once, either. Instead, consider converting a portion of it. A good rule of thumb is to transfer an amount that doesn’t move you up into the next tax bracket, allowing you to keep more of your money!
Also, once you start making money inside a Roth, the gains need to stay inside it for at least 5 years. Otherwise, you may pay taxes and penalties on the early withdrawals if they’re not for a qualifying reason.
There are many ways to save for retirement. Each one has its pros and cons. The secret is using the ones that allow you to build wealth in the most efficient way possible.
For example, imagine you have $6,000 sitting in a HYSA to invest. You could put this money into a brokerage account where it will get taxed every time you realize a gain. In a Traditional IRA, you’ll have tax-free growth, but remain uncertain about your future liability. However, if you did a backdoor Roth IRA conversion you’ll pay taxes now, eliminating tomorrow’s risk. Allowing your money to grow and get withdrawn tax-free!
The IRS realizes that Roth IRAs are powerful wealth creation tools. They set limits in an attempt to regulate who can contribute to one. But, a backdoor Roth IRA conversion removes these restrictions, making them available for all!
Will you do a backdoor Roth IRA conversion this year? Comment below.
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