If you have other IRA accounts with pre-tax contributions in them, you'll have to mind the pro rata (or aggregation) rule. This makes the backdoor Roth strategy ineffective. You can get around the problem if your work 401(k) allows rollovers from an IRA. Roll over your pre-tax IRA funds into the 401(k) and then use the backdoor Roth conversion.
Saving for retirement in a Roth IRA
If you meet the income requirements for contributions, there are two compelling reasons to use a Roth IRA for retirement savings.
- Tax diversification: Your withdrawals of contributions and earnings after the age of 59 1/2 are tax-free as long as you've had the account open for five years or more. Your 401(k) and traditional IRA withdrawals, on the other hand, are taxable. Tax-free withdrawals from a Roth IRA are most appealing if you expect to be in a higher tax bracket in retirement. In that case, it's not a bad idea to diversify your retirement income with a tax-free source.
- Estate planning: Roth IRAs are not subject to required minimum distributions (RMDs). If you don't need the money for expenses, you can leave it in the account to bequeath to your loved ones.
Other reasons to use a Roth IRA
One of the biggest advantages of a Roth IRA over other retirement savings accounts is the ability to access contributions at any time. Thus a Roth IRA can be a good vehicle to save for preretirement goals if you otherwise wouldn't contribute to an IRA.
Assuming you're eligible for Roth IRA contributions, let's say you deposit $9,000 over three years. You invest those contributions in low-cost mutual funds, and your balance grows to about $13,000 in six years. At that point, you decide to buy a car. You can withdraw up to $9,000 from the account without explanation and without penalties. You can't touch the $4,000 in earnings unless you want to pay income taxes plus a 10% penalty.
There's also a way to access your Roth IRA earnings early without paying penalties or taxes. You can withdraw up to $10,000 in earnings (plus any amount of contributions) if you use the money for a home purchase. These are the requirements:
- It's been at least five years since your first Roth IRA contribution.
- You and your spouse haven't owned a primary home in the past two years.
- You use the funds within 120 days of withdrawal.
The $10,000 earnings withdrawal exception is a lifetime cap, so you can't repeat this move in the future.
If you use the backdoor Roth strategy, you can access conversions after five years. You can use conversions to gain access to your traditional pre-tax retirement accounts early without paying a penalty if you strategically convert funds five years before you'll need them. You'll still owe taxes on the funds at the time of conversion.
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