As you may already know, a Roth IRA is arguably the best retirement plan you can save with. What you may not know is that not everyone can directly contribute to one. If you earn too much money (based on limits the IRS sets), you can’t technically utilize it. However, there is a strategy, known as the Backdoor Roth IRA, that allows you to reap the benefits of the plan. In the following, we’ll talk about what it is and how everyone can take advantage.
Roth IRA – What and Why?
First, let’s explain what a Roth IRA is and why you should have one. A Roth is a tax-advantage retirement plan. Unlike a traditional IRA, there is no immediate tax-break. This is because Roths are funded with after-tax money. Traditional plans are funded with pre-tax money, so taxes aren’t generally due on those contributions until you start withdrawing from the plan. The biggest lure of the Roth IRA is that all qualified distributions from the plan are tax-free. This is the number one reason you need a Roth. Pay taxes now on the amount you put into it and withdrawals, including earnings and profits, are never taxed during retirement.
Another reason to fund a Roth is there are no required minimum distributions. Most other retirement plans require you to start taking distributions, whether you want to or not. There are no such rules in place for a Roth. You never have to withdraw the money and can allow to grow unhindered. You can then pass it along to your beneficiary, where it has a chance to grow some more. Note that the SECURE Act has changed the rules on both RMDs and Inherited IRAs.
Lastly, a Roth is a great way to diversify yourself. No one knows the future, especially in regards to taxes. Up, down, who knows? Contributing to both a traditional plan (such as a workplace 401(k)) and a Roth IRA let’s you hedge. Having money in accounts with different tax treatment is a great idea for everyone.
What is a Backdoor Roth IRA?
As we mentioned earlier, not everyone can contribute to a Roth IRA. If you are single and earn more than $139,000 or married filing jointly and earn more than $206,000, you cannot contribute directly to a Roth. This is where the Backdoor Roth IRA comes in. As of 2010, there are no limitations in rolling over traditional funds into a Roth IRA. If you have accumulated one million dollars in your traditional IRA, you can convert any or all of it to a Roth IRA. Of course, taxes will be due on any amount converted.
Tax considerations are an important part of any retirement strategy. This is especially true when converting to a Roth. Since you have to pay taxes on anything you convert, it might be best to do your conversion over a period of years. This all depends on your personal preference. You can take a large tax hit one year or spread it over several years. Of course, you should talk with a qualified financial planner to see what best fits your goals.
Taxes are one disadvantage of a Backdoor Roth IRA conversion. Another one is the availability of your funds. When you directly contribute to a Roth IRA, those contributions can be withdrawn tax- and penalty-free at any time. Since a Backdoor Roth IRA is a conversion, those funds must remain in the account for at least five years before you can withdraw them penalty-free.
Should You Consider a Backdoor Roth IRA?
Absolutely, yes! If you are earning enough money that you must use a Backdoor Roth IRA, then it makes sense to do it. You probably have enough funds to pay the taxes. Further, you may not need your retirement funds during your lifetime. What better way to help out your heirs, then to leave a nice retirement plan to them?
Again, talk to a financial planner before deciding anything. Backdoor Roth IRAs may not work for everyone. Bear in mind the tax implications of the conversion, as well as your age and the age you wish to retire. Lastly, look into the SECURE Act and other future legislation to see if the benefits of the Roth are worth it.
You may also consider the Self-Directed Roth IRA as an option as well. By self-directing your account, you can invest in alternative assets, such as real estate and precious metals, in addition to the usual financial investments.
The Backdoor Roth IRA is a powerful tool for high earners, just ask Mitt Romney! The inability to directly fund a Roth is usually a nice problem to have! That doesn’t mean you shouldn’t have one. Feel free to contact one of our IRA Experts @ 800.472.1043 to learn more about the Backdoor Roth IRA!