IRAs can be great supplemental income in retirement. They operate similarly to brokerage accounts in that you can purchase any stock traded on the major stock exchanges, yet they come with tax breaks that make them worth utilizing.
Contributions to a traditional IRA are possibly tax-deductible, which lowers your income and tax bill. Roth IRA contributions aren't tax deductible, but you can take tax-free withdrawals in retirement. In 2022, the maximum contributions allowed to an IRA, both traditional and Roth combined, is $6,000 ($7,000 if you're 50 or older).
The main drawback of a Roth IRA is that it has income limits for full contribution eligibility:
|Filing Status||Income at Which No Roth Contribution Is Allowed|
|Single||$144,000 or more|
|Married, filing jointly||$214,000 or more|
|Married, filing separately||$10,000 or more|
Have no fear, though, because where there's a will, there's a way. Even if you're over the income limit to contribute to a Roth IRA, you can still manage to have an account using a backdoor Roth IRA. Here's how.
It's all about the conversion
Creating a backdoor Roth IRA requires two main steps:
- Contribute to a traditional IRA account: Traditional IRAs don't have an income limit, so anyone is eligible to contribute to one. If you already have a traditional IRA, all you have to do is contribute to it. If you don't currently have one, you can easily open an account and contribute your desired amount.
- Convert your traditional IRA to a Roth IRA: Once you've contributed to your traditional IRA, reach out to your IRA plan provider and let them know you want to convert funds to a Roth IRA. This process may look different for different IRA plan providers, so it's important to check with your plan administrator. Most of the time, you can do it online. If you don't currently have a Roth IRA, you'll open one during the conversion.
Once you've made the conversion, you still have one more thing to possibly worry about: taxes.
Don't forget about Uncle Sam
The main appeal of a traditional IRA is that contributions can be tax-deductible. Whether you're able to deduct your contributions depends on your filing status, income, and if you're covered by a retirement plan at work. Conversely, a Roth IRA is meant strictly for after-tax money. So, if you deduct your traditional IRA contributions and then convert them to a backdoor Roth IRA, you'll likely be subject to income taxes.
For example, if you contributed $6,000 to a traditional IRA, deducted it, and then converted the money to a Roth IRA, you'd owe income taxes on the $6,000 and any money it earned between the time of contribution and conversion.
Conversions to a Roth IRA also have different withdrawal rules for the funds you contribute. With a traditional Roth IRA, you can withdraw any contributions, but not earnings, at any time without facing penalties. Funds converted to a Roth IRA must be kept there at least five years (if you're younger than 59 1/2 years old) to be withdrawn penalty-free.
The pro-rata rule
Being able to contribute to a traditional IRA, take a deduction, and then convert it to a Roth and take tax-free withdrawals would be too good to be true.
When you create a backdoor Roth IRA, the IRS will calculate the exact amount of your tax bill pro-rata (meaning proportionally). First, it will look at the sum of your traditional IRAs. Since it's possible to have multiple traditional IRA accounts, the IRS will look at the sum of all your accounts, and not just the one you may be using to convert to a Roth IRA.
Then, the IRS will examine how much of your traditional IRA is pre-tax (meaning you took a deduction) versus after-tax contributions. Whatever percentage of your account(s) that's pre-tax is the same percentage of money converted to a Roth IRA that you'll owe taxes on.
For instance, if 75% of the money in your traditional IRA is pre-tax, 75% of the money converted to a Roth IRA will be taxable, and there's no way to only convert after-tax money. If you converted $100,000, you'd owe income taxes on $75,000.