Roth IRA income limits to contribute are $144,000 for single filers and $214,000 for married filing jointly filers for 2022. Backdoor Roth IRAs allow individuals with earnings above these thresholds to contribute to a Roth IRA. This article explains how a backdoor Roth IRA works, the possible tax effects, the five-year rule, and advice on determining whether a backdoor Roth is for you.
How does a Backdoor roth ira work?
You can create a new traditional IRA with after-tax funds (money that has been taxed) and convert the account into a Roth IRA or convert an existing traditional IRA. However, be aware of possible tax effects.
What are the possible tax effects?
When converting, if your account has only pre-tax money, your ordinary tax rate applies. But if your account has pre-tax and after-tax money, the pre-tax and after-tax funds ratio determines the tax on your conversion (the pro-rata rule). If you have more than one IRA, the IRS treats all accounts as one entity (SEP and SIMPLE IRAs are included. Spousal and inherited IRAs are not).
Example:
Suppose you have traditional IRAs that consist of 80% pre-tax and 20% after-tax money combined. You want to convert $10,000 to a Roth IRA. In this case, $8,000 of the $10,000 is taxable (80% * $10,000).
IMPORTANT: The pro-rata rule states that you cannot choose to convert pre-tax money to avoid taxes. Also, the pro-rata rule applies to the year-end total IRA balance, not the balance at the time of conversion.
The Five-year rule
To withdraw tax-free, you must wait five years and be at least 59.5. If you are under 59.5 and withdraw during the five-year period, a 10% penalty applies. The five-year period starts on January 1 in the calendar year you made the contribution.
Exceptions to the 10% penalty:
You use up to $10,000 of the withdrawal if it is for a purchase of a first new home, higher education expenses, or birth or adoption expenses.
is a backdoor roth ira good for me?
It may benefit you, especially if you are a high earner. Unlike traditional IRAs, Roth IRA distributions are not taxable, and Roth accounts do not have required minimum distributions, allowing you to pass on the funds to heirs.
However, a backdoor Roth might not be for you if you need the converted funds in less than five years or if you will incur a high tax bill from the conversion.
Overall, a backdoor Roth IRA may be worthwhile if it will save you taxpayer dollars at retirement. A tax advisor can help determine if a backdoor Roth IRA will be advantageous.
