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What Is a Back-Door Roth IRA?

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What Is a Back-Door Roth IRA?

Question-And-Answer

Nick M.-

The main characteristic of the Roth IRA account is that it offers tax-free growth on your investments. Unlike the Traditional IRA, contributions to a Roth IRA are not tax deductible, however, the investment earnings and capital appreciation can grow in this account tax-free until retirement. Withdrawals from the Roth IRA will not be taxed like it would be with the Traditional IRA account which is taxed at the current tax rate.

One of the main problems with a Roth IRA account is that there are certain income limitation restrictions for people whose MAGI exceeds the limits of $137,000 for single and $203,000 for married couples. Nevertheless, there is a workaround to this situation called “back door Roth” which basically consists in making a direct contribution to a Traditional IRA to then convert it to the Roth IRA.

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It is very important to know that you cannot have any money in an IRA account that is tax deferred before making the conversion. If you do, you will be subject to the pro-rata rule therefore you will end up having to pay taxes when making the conversion. To prevent this from happening, it is recommended to figure out the total ratio of IRA funds that are deductible IRA contributions and earning to the total assets in all of your IRAs.

Then the process of creating a backdoor Roth IRA is rather simple. First open a traditional non-deductible IRA account and fund it. Secondly make the conversion as soon as possible after funding and there is a reason why. Ideally, after contributing money into the Traditional IRA with the sole purpose of doing a Backdoor Roth, you may want to make the conversion immediately. If you don’t, you may run the risk that the account receives earnings which you would have to pay taxes once you make the conversion. Even worse, if you leave the account unattended, you might run into the situation where the earnings accumulate to a certain point where the conversion will cause an “excess in contributions” for which an adjustment will need to be made.

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