If you feel like you've missed out on your chance to capture tax-free income in retirement through a Roth IRA (individual retirement account), there's another opportunity for you to jump on. It's called the backdoor Roth IRA, and it may be the perfect solution for you to get your hands on the benefits of a Roth if you're a high earner.
Here's a breakdown of how it all works and why you should consider a backdoor Roth IRA to accelerate your wealth goals.
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Roth IRA perks you don't want to miss
Roth IRAs are a special brand of retirement accounts that come with tax-free benefits during retirement. You fund the account with after-tax dollars, invest in assets that grow tax-free, and make withdrawals 100% tax-free after you've met the requirements. Imagine building a million-dollar Roth IRA and not having to pay any taxes when you withdraw your money during retirement.
There's only one thing that may be standing in the way of your tax-free treasure, though. The Roth IRA comes with strict income limits that make it hard for high earners to capture these benefits. The more money you make, the less chances you have to make direct contributions to a Roth IRA.
Backdoor Roth IRA to the rescue
When your income exceeds the threshold, you won't be permanently banned from the Roth IRA club. You may be able to legally sneak your money into the account through the backdoor Roth IRA.
Here's how it works. If you have a traditional IRA or 401(k), you can move those funds to a Roth IRA. This can come in handy if you're trying to shelter your retirement balances from hefty taxes during retirement.
Let's say you have $50,000 in your 401(k). You can do a direct rollover or ask about the 60-day rule. You'll pay taxes on your conversion from a traditional 401(k) to a Roth IRA when you make the switch, but you'll lock in tax-free gains and income later. If you think you'll be in a higher tax bracket later, this may be a smart move for you to make.
Bypass contribution limits
Another benefit of doing a conversion is that you aren't subject to the annual Roth IRA contribution limits.
For 2022, you can contribute up to $6,000 to a Roth IRA based on your income and filing status. If you're over 50, you can contribute up to $7,000 to your IRA.
You can throw away the contribution limit rules when you do a backdoor Roth IRA. The income limits will also be a thing of the past.
The conversion allows you to quickly pump up your Roth IRA balance. Suppose you have $100,000 in your 401(k). You can pay taxes on the money now and roll it over to a Roth IRA. After the conversion, you will have more money at your disposal to invest in a more expansive list of assets in your Roth IRA.
The type of Roth IRA you choose can make a big difference in your wealth potential. You can look into a Roth IRA at a traditional brokerage firm. This will open doors for you to invest in assets that the brokerage firm offers, such as individual stocks or exchange-traded funds.
You can also check out a self-directed Roth IRA. This will give you access to more exotic assets, such as cryptocurrency and real estate. This is the trick to turning your Roth IRA into a wealth machine.
Understand how taxes work before you make a move
The main difference between traditional retirement accounts and Roth IRAs are when taxes are paid. For example, a traditional IRA typically allows you to take an up-front tax deduction and pay your tax bill during retirement. However, if you convert your traditional IRA to a Roth IRA and you already received a tax deduction, you'll have to pay income taxes for the year.
There are ways around a hefty tax bill, but it can be tricky if you contribute to other traditional IRA assets like a SEP IRA. You should seek the help of a professional to determine if a backdoor Roth IRA is the best strategy for you before making a move.
This backdoor strategy may expire soon
A backdoor Roth IRA can be a nice way for high-income households to get around the income limit and build up tax-free wealth. However, if a backdoor Roth IRA is something you want to pursue, you may need to act fast. Last year's Build Back Better plan stirred up conversations about banning Roth conversions through the backdoor Roth IRA, so you never know when this opportunity will expire.
