Ask the CFP®: What is a Backdoor Roth IRA?

Welcome to this month’s Ask the CFP® segment. Today, we are going to discuss a financial strategy that could have a positive impact on your retirement planning: the Backdoor Roth IRA.

Now, you might be wondering, what exactly is a Backdoor Roth IRA? Let me break it down for you…

If your income exceeds the limits for direct Roth contributions, but you still want to contribute to a Roth IRA to enjoy its tax benefits, that’s where the Backdoor Roth IRA comes into play.

Here’s how it works:

First, you make a non-deductible contribution to a Traditional IRA. Since your income surpasses the threshold for direct Roth IRA contributions, this serves as a workaround. 

Keep in mind that this is limited to the maximum IRS contribution allowance, which in 2024 would be $7,000, plus another $1,000 catch up if you are older than 50.

Step two: After making the contribution, you convert the funds from the Traditional IRA to a Roth IRA. Yes, that’s a taxable event, but here’s the kicker: if you’ve only contributed non-deductible funds to your Traditional IRAs, the tax implications are typically minimal. Don’t forget that if you do have more than one IRA, some complexity is added to this strategy because the IRA Aggregation Rule says all of your IRA accounts need to be considered as if they were one IRA.

Here are a few key points to keep in mind:

  • The initial contribution to the Traditional IRA is non-deductible, but any earnings  on those contributions will be subject to taxes upon conversion. However, if you’ve only held the Traditional IRA for a short time, depending on the amount of earnings, the tax impact could be minimal.
  • Unlike direct Roth IRA contributions, there are no income limits for Roth IRA conversions. This makes the Backdoor Roth IRA strategy attractive for some high-income earners.

But remember, before you decide to use the Backdoor Roth IRA strategy, it’s important to consult with a financial advisor or tax professional who can provide personalized advice based on your financial situation and goals to avoid costly tax mistakes.

In summary, the Backdoor Roth IRA strategy can offer high-income individuals an opportunity to enjoy the benefits of a Roth IRA, including tax-free growth and withdrawals in retirement.

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