What is a backdoor Roth IRA?
You won’t find the terminology “backdoor Roth IRA” in any IRS publication, because it’s not an official product. In fact, it might sound like something shady in a back-alley or something, but I can assure you it’s perfectly legal.
So, what is it? It’s essentially a strategy to get into a Roth IRA even if you don’t qualify for one.
In this article, I’ll help you answer:
- What is a Roth IRA?
- What are the Roth IRA benefits?
- What is a backdoor Roth IRA and who would benefit from one?
- And are there other tax-exempt assets that might work even better than a backdoor Roth IRA?
And if you prefer to see a video version of this topic, please watch the video below:
By the way, if you’re nearing retirement, be sure to also check out my video on ‘The ONE big retirement mistake people make and how you can avoid it to retire happy and stress-free’.
What is a Roth IRA?
Many are familiar with a traditional IRA or a 401K, a retirement arrangement with the government where you’re allowed to put money away on a pre-tax basis.
So before any taxes, you can trim that money off the top of your income.
For example, let’s say you make $100,000 a year and you put $6,000 into a traditional IRA or 401K. Instead of reporting $100,000 of income, you only have to report $94,000 of income, which means you’re paying tax on less income.
That’s a traditional IRA.
And then it grows (tax deferred), you get interest on your interest for many years until you pull it out and THEN you pay tax on the back-end.
A lot of people think you get a tax break for putting it into a traditional retirement plan, but you don’t.
It’s really a tax deferment, you’re just waiting to pay taxes until later.
But what is a Roth IRA then?
It’s an IRA where you’re putting money in and you don’t get an upfront break, so there’s no tax reduction. It’s not lowering your income, you’re putting that money in after you’ve already paid tax.
Why would you want to do that?
Well, you still get the tax deferral, but the key benefit of a Roth IRA is that when you pull money out on the back-end in retirement, the money you’ve put in plus all of the growth is completely tax-free.
So let’s say you pay $6,000 and it grows to $20,000 over years, you could pull the whole $20,000 out in retirement without paying any taxes at all.
That’s one of the major benefits to doing a Roth IRA. It’s tax-free money on the back end.
What makes a Roth IRA attractive?
If we think about right now, the government is spending trillions of dollars on COVID, bailing out companies and creating all these stimulus checks.
All that money has to come from somewhere. Where is it gonna come from?
A lot of people are concerned that the government’s going to raise taxes later to be able to pay for the spending today.
So if you think taxes are going to get worse later, a Roth IRA might be a great vehicle for you to use.
Also if you’re very good at saving, chances are you’re not going to be in a lower tax bracket in retirement, because you’re going to have a good amount of income.
You’re going to be able to maintain your standard of living throughout retirement, which means your tax bracket isn’t going to get any lower later on.
It’s going to stay at least the same, or maybe get worse, but wouldn’t it be nice to be able to pull money out in retirement tax-free?
One last reason why it’s really great to put at least some money into a tax advantage program like Roth is because it’s going to be tax-diversified.
Tax-diversification means not having all of your money in the same tax bucket.
As you know, if you ever need access to lump some cash, like in a situation where you’re sick and need to draw out $40,000 to pay for healthcare expenses, or your spouse ends up needing to go into a nursing facility, that’s going to cost your family $60,000 to $70,000 a year.
You’re going to have to pull out money rapidly from your retirement accounts.
If you have it all with tax-deferred money, pulling that large sum of money out all at once in one year could very likely raise your tax status, put you into a higher tax bracket and cause your social security to be taxable, all kinds of tax issues.
Whereas, if you had a Roth IRA, you would have a place to go to pull a lump sum of money out that wouldn’t wreak havoc on your tax bill that year.
What is a backdoor Roth IRA and who benefits from one?
After all I’ve said, you might be reading this thinking, “Wow Tony, that sounds like a great idea! I’m going to go out and open a Roth IRA tomorrow!”
Well, not everybody qualifies for a Roth IRA. You might find out that you might not be allowed to.
Why would that happen?
If you’re single and you make over $125,000 a year, or if you’re married and make over $198,000 a year as a couple, the Roth IRA gets phased out.
What does that mean?
Well the government says, “Hey, you make too much money to get this wonderful tax break, we’re not going to let you play along and participate.”
At those levels they say you can do a small one, but if you make a little bit more than that, they just phase it out all together and say that no, you can’t do one at all.
So the backdoor Roth IRA is a solution for anyone who really wants to put money into a Roth IRA but finds out they’re not allowed to do so.
So, how does a backdoor Roth IRA work?
You can open a traditional IRA and then convert it over to a Roth, because there’s no limit on how much money you can convert to a Roth IRA.
That’s why we call it a backdoor Roth IRA.
Are there taxes when going from a traditional to Roth IRA?
Yes, but remember, this was supposed to be after tax money anyway. The big problem was that you didn’t qualify, and now you’re doing a workaround.
The government said you couldn’t do it, but if you take these two steps, now you can.
It’s a great opportunity for people who thought they wouldn’t qualify for a Roth and now find out that they do.
Are there other tax-exempt assets that might work even better?
Yes, there is. If you don’t qualify for a traditional IRA and don’t want to take these complicated government steps, you can use a LIRP plan.
I have a video called ‘What is a LIRP and is it a good investment?’ that goes through in more detail how this all works.
Now if you’re getting anywhere near retirement and you’re not sure if you’ve got everything just right then I have a video talking about the one big retirement mistake a lot of people make that if you can avoid it will help you retire happy and stress-free. Click here to check out the video.
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