Backdoor Roth IRAs: Everything you need to know

What is a Roth IRA? What is a backdoor Roth IRA?

A Roth IRA is a type of retirement account that you fund with your post-tax income. When you open this type of account and make your contributions, withdrawals that you subsequently make will be tax-free as long as they comply with the governing regulations.

A backdoor Roth IRA conversion is completed by converting a traditional IRA to a Roth IRA. It is a way for you to open a Roth IRA even if your modified adjusted gross income exceeds the maximum Roth IRA income limits. 

How is a backdoor IRA created? Who is it for?

You can create a backdoor IRA by opening a normal IRA and then contributing $6,000 to it. Next, you will roll the funds over to make a backdoor Roth IRA contribution without being penalized. Backdoor Roth IRA conversions are for people with high modified adjusted gross incomes that cannot otherwise qualify because of the Roth income limits.

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Some stats for backdoor IRAs

Among people who have retirement savings, 79% have 401(k) plans through their jobs. Of those who have IRAs, 39% have traditional accounts, and 36% have Roth accounts.

Older adults are likelier to create conversions. According to the Investment Company Institute, 5.4% of adults between the ages of 65 and 69 completed conversions as compared to 1.1% of those who were between the ages of 18 and 24. 

Rules for creating a backdoor conversion

Several rules apply to the creation of backdoor conversions. Under the 60-day rollover rule, you are able to take the funds directly from your traditional account, which occurs when a check from the administrator is made payable to you. Then, you must roll the funds over to your Roth IRA account within 60 days of the distribution date. If you fail to roll the funds that you have received over, your distribution will be taxable in the year that it is taken. No conversion will have occurred, and you will be assessed a 10% early distribution tax penalty. 

The one-rollover-per-year rule does not apply when you roll funds over from a traditional account to a Roth IRA. Conversions are unlimited.

You can only rollover funds from a Roth account to another Roth. You can only roll funds from one individual retirement account to another one within any 12 month period. The limit is applied by aggregating all of an individual’s accounts, including SEP, SIMPLE, traditional, and Roth IRAs. They are all effectively treated as a single account for purposes of the limit.

The easiest method to roll funds over from one account to another is through a trustee-to-trustee transfer. This occurs when you have the trustee of your original retirement account send the funds to the trustee at the new institution that holds your new retirement account instead of sending a check to you. Trustee-to-trustee transfers are unlimited.

A same-trustee transfer is another method of rolling money over from one individual retirement account to a new one. Under this method, the money remains in the original institution. The investor opens the new account and tells the trustee to move the money from the old account to the new one.

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Backdoor Roth IRA rules

When you complete the conversion to create a backdoor Roth IRA, you will pay income tax on the amount that is transferred. The taxable amount of the conversion is added to your income for the year. Your regular income tax rate will be applied to your total income. If the conversion is completed correctly, you will not be subject to a 10% early withdrawal penalty.

The Roth IRA income limits do not apply to conversions. Conversions are a method that taxpayers who exceed the Roth IRA income limits to make contributions. You make a non-deductible contribution to a traditional individual retirement account. Then, you immediately roll it over into the backdoor Roth IRA since income limits do not apply to conversions.

Once you complete a conversion, it cannot be undone. You are not allowed to re-characterize the account because of the Tax Cuts and Jobs Act of 2017. The Tax Act also lowered the income tax rates, which makes backdoor Roth IRA conversions even more appealing.

If you have started taking “substantially equal periodic payments” from your traditional retirement account, you can convert those amounts to your backdoor account as the payments arrive. The payments will be taxable, but the 10% early withdrawal penalty will not apply.

If you have started taking required minimum distributions from your traditional account or from your employer-sponsored plan, you will not be allowed to convert them to create a backdoor Roth IRA.

Under the pro-rata rule for conversions, the portion of your rollover contributions in a conversion must make up only a pro-rata share of the total amount that you roll over. 

Reasons you should create a backdoor Roth IRA

There are several reasons why you should consider creating a backdoor Roth IRA, including the following:

  • Investments grow tax-free
  • Ability to reduce your taxes in retirement
  • When your retirement income tax rate will be higher than it currently is
  • No required minimum distributions, which are mandated for traditional accounts after you reach age 70 1/2
  • The ability to take tax-free withdrawals in retirement as long as the account has been held for more than five years and you are over age 59 1/2 or are disabled
  • There are no income limits for conversions
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When is a backdoor Roth IRA is not the right fit? 

IRA backdoor conversions are not right for everyone. If it will subject you to a higher marginal tax bracket the year of the switch, and you cannot make the tax payments that the conversion will generate, you should not complete a conversion. If you deducted your contributions from your income in the past, you might have to pay taxes on those amounts during the year in which you complete the conversion.

The amount that is converted will be added to your annual adjusted gross income. This could cause you to move up a tax bracket and pay more taxes. Some people pay the taxes that are generated with a portion of the amounts that they convert. However, doing so will limit the tax-free growth of your investments. If you are under the age of 59 1/2, you may open yourself up to a 10% tax penalty on that money.

A conversion is also not a good choice if you anticipate needing the funds within the next five years. If you withdraw money within the first five years, you may have to pay income taxes together with a 10% early withdrawal penalty.

If you are over the age of 70 1/2, you must take your required minimum distribution before you can complete a conversion. It is always advisable to check with a tax accountant to make sure your strategy complies with the Roth IRA rules before you proceed.

When to convert

There are some good times to convert your account. When you are in a year in which you fall into a lower tax rate than you normally do, a conversion may be a good idea. For example, you might have changed jobs, have been unemployed, or have earned a lower salary. Under the Tax Act, the income tax rates will be lower through 2025, which means that it may be a good idea to complete a conversion now rather than waiting. 

When the market falls and causes your traditional retirement account balance to go down, it is also a good time to consider a conversion. Converting your account early in the tax year will allow you to wait to pay the taxes until April of the following year so that you will have more time to pay. You might also consider completing the conversion in stages to make the taxes more affordable.

Tax implications

It is important for you to understand the tax implications of IRA backdoor conversions. The money that comes out of your traditional retirement account will be subject to your regular income tax rate during the year in which the conversion happens. Any nondeductible contributions that you made to your traditional retirement account will not be taxable since they never had the benefit of tax deferral, however.

If the conversion is done properly, you will not be subject to a 10% early withdrawal penalty. If you have started taking “substantially equal periodic payments” from your traditional retirement account, you can convert those amounts as the payments arrive. The payments will be taxable, but the 10% early withdrawal penalty will not apply.

You are not allowed to convert RMD distributions. Under the pro-rata rule, your tax-exempt portions of the rollover contribution must only make up a pro-rata share of the total rollover amount. There are potentially other tax implications, so be sure to consult your personal tax advisors because M1 Finance does not provide tax advice.

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Benefits

Some of the benefits that you can enjoy when you convert IRA to Roths include the following:

  • Distributions will not be taxed when they are withdrawn
  • Contributions can be withdrawn tax-free at any time
  • No RMDs
  • Will have until the tax filing deadline for the following year to make a contribution
  • Multiple retirement accounts can help with tax diversification

Limitations

There are some limitations, including the following:

  • Contribution limits for high earners
  • Limits on the number of rollovers each year
  • Withdrawals are limited to your contributions

Make certain to list your beneficiaries to ensure that the tax advantages will be passed on after you die. 

Borrowing after you convert IRA to Roth

Under the Roth IRA rules, you are not allowed to use your retirement account to fund a loan to yourself, and your account balance cannot serve as collateral for a loan. These activities are both prohibited by the IRS. 

How to complete a conversion to create a backdoor Roth IRA

To complete a conversion so that you can create a backdoor Roth IRA, you can take the following steps. Start by depositing money into a traditional retirement account or open a new one. Convert the account using one of the three methods that we previously discussed, or open a new account.

Pay taxes on your contributions and earnings. Only post-tax dollars are allowed to go into the backdoor Roth IRA. If you previously deducted your traditional IRA contributions, you’ll need to give that tax deduction back. Those contributions and any gains will be added to your taxable income when you file your tax return for the year.

If the money in your traditional IRA is post-tax money, which means that you did not take a deduction on the money that you contributed, you may not owe tax when you convert IRA to Roth. Discuss this carefully with a financial advisor.

The Roth IRA contribution limits do not apply to amounts that you have converted, providing another advantage of creating a backdoor IRA. M1 Finance is a good firm for you to use for your conversion.

Why can you trust M1 Finance?

Smart investors choose M1 Finance for several reasons. When you choose M1, you can roll over all of your current retirement accounts for free, and the Roth IRA contribution limits will not apply to amounts that you convert.

Stop paying fees by moving to M1 today. You can start investing for free with our secure accounts. This allows you to keep more of your money since M1 does not charge any commissions or fees.

Open your new account today

At M1 Finance, you are able to select investments that match your risk level. You can build your own portfolio or choose one that has already been designed to meet your risk and needs from a menu of more than 80.

The investment platform at M1 Finance makes investing simple and straightforward. You are able to access your account at any time when you have access to WIFI. Your investments can grow faster since M1 does not charge fees for managing your account or commissions on the trades that you complete.

By using automatic features such as automated reinvestments and rebalancing, your portfolio will automatically remain aligned with your goals. Powerful technology helps to make the investment process simpler and effortless.

Call M1 Finance today at 312-600-2883. Get started today by filling out an application.



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