Reaching retirement is exciting, but having enough to maximize your quality of life during retirement is key. If you've maximized your 401k contributions, you may be wondering what are your next best options for retirement savings? The IRS income and contribution limits hinder the options available to some high earning individuals or families, which is why a backdoor Roth IRA may be one of your only options.
What is a backdoor Roth IRA? Below we’re breaking down what you need to know about this retirement savings strategy.
A Reminder About Traditional IRAs vs. Roth IRAs
The money you contribute to your Roth IRA is after-tax dollars, meaning you will have already paid income tax on it before putting it into your account. In turn, that money continues to grow tax-free. Because you already paid taxes on that income before contributing it to your Roth IRA account, you do not have to pay taxes on it when you withdraw money in retirement. This, essentially, creates tax-free withdrawals in retirement.
If you choose to place your money in a traditional IRA account, you are using pre-tax dollars. This means the money has not been taxed, which can be an effective strategy in lowering your present taxable income. In return, the money in your traditional IRA account grows tax-deferred. Once you reach retirement and begin making withdrawals, you will be responsible for paying taxes on the withdrawals.
With both traditional and Roth IRA Accounts, there are restrictions and annual maximum contribution limits that may be adjusted annually by the IRS. Before contributing to your account, you’ll want to check these limits or ask your financial advisor to clarify.
Backdoor Roth IRA Explained
Roth IRA accounts have income limits. In 2021, you are ineligible to contribute to a Roth IRA account if you earn:1
- $140,000 or more as a single filer
- $208,000 or more as a joint filer
If you are a high earner with an income above the IRS’s income limit for Roth IRA accounts, you still have the option to create a backdoor Roth IRA. Just as it sounds, this option allows high earners to bypass the income limits and still utilize the tax advantages of a Roth IRA account.
Here’s how to create a backdoor Roth IRA account in a nutshell:
- Open and contribute to a traditional IRA.
- Convert your traditional IRA to a Roth IRA account (your account administrator will provide the necessary paperwork and instructions to do this).
- Once tax season rolls around, properly notify the IRS of non-deductible contributions (file form 8606).
- Make sure that the 1099-R is coded correctly (tax free, rollover).
Who Does a Backdoor Roth IRA Work Best For?
Backdoor Roth IRAs are complicated strategies with lots of steps, and they aren’t ideal for everyone. This strategy is typically most useful for those who max out their regular contribution limits and/or earn too much to be eligible for a Roth IRA. In addition, these people will have a substantial amount of savings leftover that they’re ready to dump into the after-tax bucket of their retirement plan.
If this doesn’t sound like you, you may be better off utilizing a traditional or Roth IRA account and your 401(k) account to save for retirement.
It’s not a simple process, but if you think a backdoor Roth IRA may be the right option for you, have a conversation with a financial planner or tax professional to get started. They can help cover the finer details of this process and answer any questions about your potential tax liability if you choose to use this strategy.