Last Updated on April 17, 2024 by Ben
The Backdoor Roth IRA is an outstanding way for people who cannot contribute directly to a Roth IRA because their income exceeds the limits but still wants to take advantage of the tax-advantaged growth and diversification that a Roth offers.
This blog post will discuss how Backdoor Roth IRAs work when they’re appropriate and what the potential drawbacks might be, as well as some helpful tips on how you can get started today!
The Backdoor Roth IRA
A backdoor Roth IRA is not an official type of retirement account, but it is a way to fund a Roth IRA when someone’s income is too high. It can be hard to do, but you should talk to your tax advisor about contributions if you want to do it. Brokerages that offer both traditional IRAs and Roth IRAs help you when you want to make a conversion. When you do this, the money from your traditional IRA becomes a Roth IRA.
This is not a way to avoid paying taxes. When you convert money from your traditional IRA to a Roth IRA, you will need to pay the tax on all of the money in that year. But as with any Roth IRA, you will not owe any more taxes when you withdraw that money after retirement.
A backdoor Roth IRA is a good way to save. You can get money from your job or the government and put it into a traditional IRA. Then you can convert it to a Roth IRA, which means that you do not have to pay taxes on that money when you make withdrawals in retirement.
When you retire, you will have a higher tax rate. This might work for your plan if you predict that your tax rate will be lower now when you are working.
You can deposit money in a Roth IRA account. When you withdraw the money, you will not have to pay taxes on it. With a traditional IRA or 401(k), you will get an immediate tax advantage when you make deposits because, when you withdraw the money, you will not have to pay income taxes on it. When you lay hold of money out of an account, you also have to pay taxes on what was earned and the money that was there at the start of your investment.
If you want to contribute directly to a Roth IRA, your income must be under a certain amount. This is called your modified, altered gross income (MAGI). Some people cannot open a Roth IRA account. If you make more than a certain amount, you cannot open the account or pay money into it.
How Does it Differ from a Traditional IRA
Traditional IRAs and Roth IRAs are different. Traditional IRAs give you a deduction now, but you pay taxes later. Roth IRAs mean that you pay the taxes now, but then later, it is free for withdrawals.
The main difference is when you pay taxes on the money you put into a retirement plan. With a traditional IRA, you pay the taxes at the end – that is, when you withdraw the money in retirement. But in some cases, you will not have to pay taxes on the front end when you put money in an account.
With a Roth IRA, you pay the taxes upfront. But when you take your money out, there are no taxes. And in both traditional and Roth IRAs, your money grows tax-free while it is in the account. There are other differences. If someone earns money, they can contribute to a traditional IRA. But if someone does not earn money, they cannot contribute to that same IRA. Some people can’t take advantage of an IRA. Roth IRAs are more flexible if you need to withdraw some of the money early.
With a Roth IRA, you can keep the money in for as long as you want. You don’t have to start withdrawing it when you turn 70½. With a traditional IRA, by contrast, you must start withdrawing the money when your age is 70½.
Is the Fidelity Backdoor Roth IRA Right for You?
A backdoor Roth IRA is a type of account that you can use if you have a high income. If you are interested, talk with someone who has done it before. The backdoor Roth IRA is a retirement account that you can put money into even if you don’t earn a lot.
There are limits to how much you can put into a Roth IRA. But there is a way around these limits. The backdoor Roth IRA is when you put money in a regular IRA and then transfer it to a Roth IRA.
When you have traditional IRAs with pre-tax and post-tax dollars, Roth IRAs converted from traditional IRAs, and when it is time to take a distribution, you will be subject to the pro-rata rules.
Rules from the IRS are complicated, so you need to read them carefully. If you make a mistake, you may have to pay more taxes and penalties for not paying enough. We will talk about back door Roth IRAs and the pro-rata rule. This will help you make good decisions when it is time to distribute your money. When you have a Roth IRA, it’s important to know how it works. This is a brief introduction about what a Roth IRA is and how they work. We’ll show you step-by-step instructions on setting one up at Fidelity.
Considerations Before Opening a Backdoor Roth IRA
An IRA is a good way to save money for retirement. If you have a 401K, it can be helpful. This type of account lets you take out your money without paying taxes on it when you retire. That is good if you are in a higher income tax bracket because then the taxes will not hurt as much.
Not everyone can contribute to a Roth IRA, but you can. The Internal Revenue Service will ask about your income and if you are married or single. If your income is under $124,000 as a single person or $196,000 as a married couple filing jointly, then you can contribute the maximum to your Roth IRA in 2020. If you are unmarried and your MAGI is less than $125,000, or if you are married and your MAGI is less than $198,000, then you can make the maximum contribution.
There is a way to save money by investing in an IRA, but it may not be for everyone. Depending on your salary, you might be able to invest and get the tax benefits of a Roth IRA.
You can only make a reduced contribution to your Roth IRA if your MAGI is less than $139,000 for a single filer or less than $206,000 for a married couple filing jointly in 2020. Those amounts increase to $140,000 and $208,000 for 2021.
If you want to do this, make sure that you do the math. It is important to list out the pros and cons of doing this. You will want to be careful when deciding if you are going to convert your entire traditional IRA balance into a Roth IRA.
If you have a traditional IRA and desire to convert it to a Roth IRA, you can. But the new law (the Tax Cuts and Jobs Act of 2017) does not allow people to convert back again.
Roth IRA Basics
Contributions and Withdrawals
Roth IRAs are a type of IRA. Investors can pay money into Roth IRAs, but it is not tax-deductible like with traditional IRAs. The difference is that Roth IRA earnings are tax-free while in the account, but not when the investor takes them out.
In 2021, you can put $6,000 into a Roth or traditional IRA. And if you are 50 years old or older, you can add an extra $1,000 and have a total of $7,000 in your IRA. You can withdraw your contributions if you want to without paying any taxes or penalties.
If you have a Roth IRA, the money in it is tax-free after five years. If you withdraw money from your account when you are under age 59 1/2, you will pay the penalty. But if you hold for at least five years and start after age 59 1/2, there is no penalty.
Unlike traditional IRAs, Roth IRAs don’t have a minimum time when you must take money out. You can decide how you want to withdraw the money. That is a good thing.
Enter the Backdoor Roth
The backdoor Roth IRA is easy to do. It starts with a non-deductible contribution to an IRA. As we mentioned earlier, there are no income limits for non-deductible IRAs. Just stick to the contribution limits, and you will be OK.
For easier accounting, it is good to keep your IRA (where you paid taxes) separate from other IRAs.
Once you have an IRA, the next step is to convert your traditional IRA to a Roth IRA. The only problem with this is that you might think that because you’ve already paid taxes on the nondeductible contributions, then you won’t pay taxes when you convert.
Not so fast.
Suppose you have different types of IRAs. If this is the case, then any money that you take out will be subject to a percentage. For example, if you withdraw money from your traditional IRA and Roth IRA (money converted from traditional IRAs), then some of it will be taxed because it was pre-tax money.
The Pro-Rata Calculation Formula
Many IRAs are considered one IRA. This includes traditional IRAs, SEP IRAS, and Simple IRAs. So the IRS looks at all of them when figuring out how much tax you owe.
The Roth IRA and inherited IRA do not count. Non-IRA employer plan balances get prohibited as well. Here is how to compute the pro-rata rule:
Total after-tax amounts in all applicable IRAs (those listed above) / Total balance of all applicable IRAs = % of the tax-free distribution.
Watch Out for this Rollover Trap
When you calculate the pro-rata rate, it is important to use the IRA balance at the end of the year. If you convert an IRA in February and then roll over a company retirement plan to an IRA later in the year, that balance is added to your total for the year. Doing this could mean that a higher percentage of the conversion amount or the non-taxable IRA balance will be taxed.
Exceptions to the Pro-Rata Rule
Qualified Charitable Distributions
Qualified charitable contributions (QCDs) mean that you can transfer up to $100,000 to a qualified charity and not report the money as income.
An ancillary benefit of this is to lessen the pre-tax amounts in the whole IRA bucket to calculate the pro-rata percentage. This only works if you have both pre and post-tax money in IRAs.
Qualified HSA Distributions
People are able to transfer money from their IRA funds to help pay for health-related things. The IRS allows this so people can do a qualified HSA funding dispensation or QHFD. The QHFD has a limit of one convey per year. The maximum contribution is the contribution limit for the HSA (less any contribution already made for the year). You can only use pre-tax funds, not after-tax money.
Rollover to Employer-Sponsored Retirement Plans
When people have a retirement plan with a company, they might want to move it over to an IRA. This is called a rollover transaction. When people have an IRA, they can do the opposite and put money in their company’s retirement plan. If you have a lot of money in your IRA, some of it may be pre-tax. If this is the case, you can deposit the pre-tax money into your employer’s retirement plan. Ask if they accept rollovers from IRAs. They only take pre-tax money. This will reduce the number of IRAs counted for the pro-rata rule and may help reduce your taxable income.
Taxes
When you pay taxes, the money that you don’t already owe is gone. When you lay money in a traditional IRA, it has not been taxed yet. When you convert that to a Roth IRA, the money is taxed as soon as it goes into your new account. When you put money into a traditional IRA, you will have to pay taxes on it when you take it out later. But the Roth IRA is different. You don’t have to recompense taxes on the money inside of the Roth IRA at all.
Most of the money you convert to a Roth IRA will likely be counted as income. And because of that, you might end up in a higher tax bracket. But don’t worry! There is something called the pro-rata rule, which means that you are only taxed on the part of the money.
The Roth is unalike from the traditional IRA. The Roth has converted funds, not contributions. That means that if you are under the age of 59½, you will have to wait five years to access your money without penalty. With a regular Roth IRA, you can take out money whenever you want. With these special ones, it is different. You can’t take them out when they are not in the Roth IRA.
How To Set Up a Backdoor Roth IRA With Fidelity
Open a Traditional IRA with Fidelity
Go to the website https://www.fidelity.com/retirement-ira/, and then follow their step-by-step guide to set up your account.
Link a Bank Account
This may be the first time you use Fidelity, so you need to link a new bank account to it in order to make a one-time deposit.
- Go to their website.
- When you want to transfer money into your traditional IRA, you can use a wire or an electronic funds transfer. Wire transfers are faster, but banks might charge fees. Electronic funds transfers are less expensive and also finish quickly.
- Select a Traditional IRA account that you have created. Then link your bank account to it.
- Fill out the fields that Fidelity needs.
Fund Your Traditional IRA
After you are done setting up your bank account, you can now put money in your Traditional IRA.
- Go to their website.
- Select which account to move money from. If you just connected a new bank account in Step 2, you’ll likely want to choose that bank account. If you’re a subsist Fidelity customer, it’s also possible to choose another investment account like an individual Fidelity brokerage account that contains cash.
- Next, choose your Traditional IRA as the account the money should be transferred. As I mentioned before, you will notice that the approximate delivery time of the cash deposit is 1-3 business days.
- For “Frequency,” choose “Just once.”
- Enter a “Date” you wish to move money from your bank into your account.
- For “Amount,” you may give up to $6,000. If you’re 50 or mature, you can give up to $7,000. Note: These restrictions are valid as of 2021.
Cash Settlement
Wait 1-3 days for the money to settle when you are converting your IRA from a Traditional IRA to a Roth IRA. You can also wait if you want the conversion to happen at a later time. Personally, I prefer this way because it is cleaner and I don’t have to invest my money in the meantime.
Open a Roth IRA
Similar to Step 1, but unlocked a Roth IRA instead. Don’t put any money in it right now. They are doing the “Backdoor IRA Conversion,” so there is not enough money yet in this account.
Go to their website. Follow their step-by-step guide to opening a Roth IRA account.
Backdoor IRA Conversion
To finish this guide, you need to convert your Traditional IRA to a Roth IRA account. This will take time. The more days it takes for your money to settle, the longer it will take. So try this step every day after waiting one business day since your original deposit (step 3).
- Go to their website.
- Select your Traditional IRA to move money from.
- Select your Roth IRA from the dropdown and continue.
Summary
A Roth IRA is a great way to save for retirement, but your income limits what you can contribute. If you make too much money and are looking for an alternative solution, the Backdoor Roth Conversion might be the answer. With it, you don’t have to pay taxes on your money until retirement.
This Backdoor Roth IRA strategy is an excellent way for people who make too much money to save up for their future without paying any penalties when they take out their savings; this allows them to potentially retire with a higher nest egg and more options!