What is a Backdoor IRA?

Estimated reading time: 3 minutes(Last Updated On: April 13, 2021)

Roth IRAs are fantastic ways to grow your retirement tax-free and access contribution funds at any time. However, not everyone can contribute to one. The contribution limits on a Roth IRA vary based on income and marital status. The most someone can contribute to a Roth IRA is $6,000 per year (as of 2021). This limit starts to taper off the higher in income you go, and eventually reaches $0 when you earn too much to qualify for Roth contributions. As of right now, however, there is a loophole of sorts to these limits with what is called a “backdoor IRA”.

What is a Backdoor IRA?

If you earn too much to contribute to a Roth IRA, you can still contribute to a Traditional IRA, and then roll over the funds into a Roth IRA. There are no age limits or income limits on a rollover. Keep in mind, however, that recent changes to IRA laws bar anyone from recharacterizing their rollover back to a Traditional IRA once the transaction is complete. Rollovers are final, so proceed with caution.

Remember, Roth IRA contributions are made post-tax, so rolled over funds from a Traditional IRA that were made pre-tax will be subject to taxation that year. If your investments lose money, and with no option to recharacterize, you may not have enough funds to pay the taxes owed and be on the hook for the deficit.

What are the Benefits of a Backdoor IRA?

Now that congress has restructured the tax brackets, you may qualify for a lower tax bracket than you were previously. If so, this is a great time to roll over your funds into a Roth IRA, so you pay the lower taxes now. Congress can change tax brackets again in the future, so it’s wise to take advantage of the lower taxes if you can swing it.

Distributions upon retirement for a Traditional IRA are taxed at the tax bracket you qualify for at the time. If you believe you will be at a higher tax bracket at the time you need to take distributions from your Traditional IRA, then you may consider making a rollover to a Roth IRA. Roth IRAs don’t require any minimum distributions at a certain age, so you can keep growing your funds as long as you need. Roth IRAs also allow for distributions on contributed money at any age penalty-free. Having investments in a variety of accounts, including Roth IRAs, allows more flexibility in retirement and helps diversify your portfolio.

How to Do a Backdoor IRA Conversion

There are two methods for completing a backdoor IRA.

Method One: Convert your entire Traditional IRA into a Roth IRA.

Method Two: Sell shares from your Traditional IRA and transfer those funds into a Roth IRA.

Remember, this strategy is only beneficial if the taxes you will save outweigh the costs of the transfer, including any fees associated. Always consult your financial advisor before moving funds from a Traditional IRA into a Roth IRA.

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