The door to a Roth IRA gets slammed in your face if you make too much money. Well, sometimes, when you can't get in the front door, the backdoor is wide open!
While using a tax-free Roth IRA to save for retirement is a smart move, you can’t contribute if your income is too high. Laura answers a listener question about how to have one using a backdoor strategy, and rules for doing a Roth IRA rollover.
Money Girl is hosted by Laura Adams. A transcript is available at Simplecast.
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A Money Girl listener named Nuno F. says, "I follow your podcast, but with so many episodes, it's getting hard to find specific topics. I was wondering if you've ever addressed how a "back door" Roth IRA works and the consequences of rolling over a 401(k) into a Roth IRA? If not, I was wondering if you could cover those topics on a future podcast."
Thank you, Nuno! I have podcasted about those crucial topics before, but I would love to review them today.
So, if you're like Nuno and want to know more about IRA rollovers and what a back door Roth is like, stay with me! I'll make them easy to understand even if you don't have a Roth IRA or earn too much to qualify for one.
Hey, friends! I'm Laura Adams, and I'm glad you downloaded the show. If you're new here, I'm an award-winning personal finance author and have hosted Money Girl since 2008. I also work with select brands as an on-camera PR spokesperson, consumer advocate, voice-over talent, and multimedia creator.
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Today's episode is number 741, called Tips for Roth IRA Rollovers and Back Door Accounts. Let's dig in!
RELATED: 9 Retirement Account Rules Everyone Should Know
If you're a regular Money Girl listener, you've heard me discuss the fantastic tax benefits of a Roth IRA. However, the door to a Roth IRA gets slammed in your face if you make too much money. Well, sometimes, when you can't get in the front door, the backdoor is wide open!
So, I'll answer Nuno's question by reviewing who can have a Roth IRA and discuss a backdoor Roth or conversion strategy, which allows high earners to fund a Roth IRA without breaking the rules. Then we'll cover what to know about doing a Roth IRA rollover.
First, let's review what a Roth IRA is. It's a retirement account for individuals where the tax benefit comes in retirement. Instead of getting an upfront tax deduction (like you do with deductible contributions to a traditional IRA), you can withdraw Roth IRA contributions and earnings entirely tax-free if you've owned the account for at least five years and are over age 59.5.
You can make IRA contributions if you have earned income, no matter your age. For example, for 2022, the maximum contribution is $6,000 or $7,000 if you're over 50.
As I mentioned, not everyone qualifies for a Roth IRA. For 2022, when a single taxpayer has modified adjusted gross income (MAGI) of at least $144,000, they can no longer contribute. Married couples filing a joint tax return can't participate when their household MAGI is $214,000 or above.
If your income exceeds the annual limit, you can keep an existing Roth IRA, but you can't make new contributions. Note that if you have a Roth at work, such as a Roth 401(k) or 403(b), it doesn't have income limits to qualify. Unlike a Roth IRA, you can max out a workplace account yearly, no matter how much you earn.
Now that you know high earners typically can't contribute to a Roth IRA, I want to explain how to fund one legally anyway! Yes, the backdoor method allows high-earners to sneak in the back door.
If your income exceeds the allowable Roth IRA threshold, here's the ideal way to make a backdoor contribution. First, you make a nondeductible, taxable contribution to a traditional IRA. A regular IRA has no income limit—a Roth IRA is the only retirement account with income limits.
Interestingly, once you have a nondeductible traditional IRA balance, the IRS allows you to convert it to a Roth IRA, which is the "backdoor" concept. It's also known as a Roth conversion.
So, a backdoor Roth is a legitimate way to move after-tax money from a traditional IRA into a Roth IRA, even if you earn too much to qualify for one in the first place!
You must file IRS Form 8606, Nondeductible IRAs. However, you won't owe taxes, except on investment growth in the account earned between the time of your traditional IRA contribution and the Roth conversion. If it was a short period, your earnings and resulting tax should be small.
Backdoor Roths are popular because you can withdraw your contributions and earnings entirely tax-free in retirement. That could translate into massive tax savings!
Though sneaking into a backdoor Roth IRA sounds excellent, it doesn't always work as planned. Here's why: The IRS requires you to lump all your IRAs together when you make a distribution and doesn't allow you to cherry-pick one account to convert. So, if you already have pre-tax money in a traditional IRA, the tax must be prorated over all your IRAs.
For example, let's say you have $5,000 in a nondeductible traditional IRA that you want to convert into a Roth IRA, and you also have $15,000 in a traditional deductible IRA. Since you have a total of $20,000 in IRAs, the $5,000 nondeductible portion is 25% ($5,000 / $20,000 = 0.25 or 25%) and the taxable portion is 75% ($15,000 / $20,000 = 0.75 or 75%).
You must pay the same ratio of tax on the conversion. In other words, 75% of $5,000, or $3,750, would be subject to tax. However, if you don't have any pre-tax IRA funds, you could convert the $5,000 from a nondeductible IRA into a Roth IRA with no tax due.
Yes, this gets complicated. Remember that if you have a substantial amount of pre-tax funds in a traditional IRA, doing a backdoor Roth IRA doesn't help you avoid additional tax. Unfortunately, you can't convert only nondeductible funds and forget your pre-tax amounts.
So, unless you don't have any money in a regular, pre-tax traditional IRA, you'll likely owe tax. You'll have to weigh that upfront tax liability against the future benefits of getting tax-free withdrawals from a Roth IRA.
There is a workaround solution for a backdoor Roth IRA if you have a retirement plan at work, such as a 401(k). If your plan allows, you could roll over your pre-tax traditional IRA funds into your workplace account. That would leave you with just after-tax, traditional IRA funds to convert to a Roth IRA.
Or, if you're self-employed, you could set up a solo 401(k) that allows roll-ins and move your pre-tax IRA money into it.
Note that once you create a backdoor Roth IRA, you still won't qualify to make new contributions to the account in years your income exceeds the limit. However, your converted funds would grow tax-free, and that could save a bundle in taxes.
Additionally, unlike other retirement accounts, a Roth IRA doesn't have required minimum distributions (RMDs). That means you can keep them indefinitely and easily pass them on to your heirs.
So, doing a backdoor Roth IRA can be worthwhile if you can afford to pay a potentially significant tax bill on your converted balance. But don't forget that your converted funds count as income for tax purposes, which could move you into a higher tax bracket for the year. So be sure to speak to a tax or financial advisor about the pros and cons of a backdoor Roth.
In addition to a backdoor Roth, Nuno asked about the consequences of rolling over a 401(k). First, be aware that you can't do a workplace rollover until you're no longer employed because you leave the company, get terminated, or retire.
After you leave your job, you can roll over funds into like accounts with no tax consequences. For example, you can move a Roth 401(k) into a Roth IRA or a traditional 401(k) into a traditional IRA with no problem.
However, you can't roll over traditional, pre-tax funds into an after-tax Roth account unless you're willing to pay tax on the total amount, which could be a significant liability.
If you need to tap your traditional 401(k) while you’re still employed, you typically must qualify for an eligible financial hardship or borrow funds and repay them with interest over a set period. You can use a 401(k) Loan Calculator to determine how much a loan would cost and your monthly payments.
I hope that helps, Nuno, and thanks again for the great questions!
Before we go, I want to invite you to connect with me on Twitter @lauraadams or Instagram @lauradadams. And LauraDAdams.com is my personal site where you can use my contact page and learn more about my work, books, and money courses.
That's all for now. I'll talk to you next week. Until then, here's to living a richer life.