What is Backdoor Roth IRA
Want to make a Roth IRA contribution but think you can’t because you make too much money? Don’t count yourself out too quickly! A TWO-STEP, also known as a “Backdoor” Roth IRA contribution might work for you. To learn how, watch this short video https://youtu.be/nkJzWUPp9ag or continue reading…
But, first! Some IRA basics. IRA stands for Individual Retirement Account. You must have earned income to contribute to an IRA. There are generally two types of IRAs:
1. Roth IRA - Income limits apply. If you make too much money, you may not contribute to a Roth IRA. Also, when money goes in = NO tax deduction, but growth is tax-free, and when money comes out, assuming you follow all the rules, it is NOT taxable.
2. Traditional IRA – anyone can contribute to a traditional IRA (if you have earned income). However, some contributions are “eligible” for a tax deduction, others are “not eligible.”
If eligible, when money goes in = tax deduction, growth is tax-deferred, when money comes out = taxable.
If not eligible, when money goes in = no deduction, growth is tax-deferred, when money comes out = part taxable, part non-taxable. These are technically referred to as “nondeductible” contributions.
Nondeductible contributions create “basis” in the traditional IRA. Simply put “basis” is your tax basis that you have already paid income-tax on, so you don’t have to pay tax on it again when it comes out. It’s important to be sure appropriate reporting to the IRS is done. Making a nondeductible contribution to a traditional IRA is step-one.
Example: if Jill, who has no IRAs already, makes a nondeductible contribution of $6,000 to her IRA, the balance of the IRA is $6,000, so it is 100% basis.
Now the fun begins! The CONVERSION. Anyone can do a Roth conversion. A conversion moves money from a traditional IRA to a Roth IRA. The catch is, when you do a conversion, you must pay income-tax on any taxable conversions.
Let’s go back to our example of Jill who made the $6,000 contribution to her one-and-only traditional IRA. The balance of that IRA was $6,000 and therefore was 100% basis. If she converts that $6,000 to a Roth IRA, there will be no income-tax due because the conversion is 100% basis, or money she already paid income-tax on. Thus, the conversion is step-two. By taking both steps, Jill has effectively made a Roth IRA contribution, albeit a two-step Roth IRA contribution, also known as a “backdoor Roth contribution”
It is important to note, this video is for educational purpose only! Also, if Jill already had a traditional IRA with money in it, the rules become significantly more complicated. There are several rules, income thresholds, and other considerations when making IRA contributions and doing conversions. So please consult with a tax and or a CERTIFIED FINANCIAL PLANNING ™ professional. We can help!
