Alternate Ways to Fund a Roth IRA
Saving for retirement with a Roth IRA is a smart move, especially if you expect your tax rate in retirement to be higher than your current tax rate. That’s because with a Roth IRA, you pay current taxes on contributions and your withdrawals from qualified earnings are tax-free.
Unfortunately, many individuals are prevented from directly contributing to a Roth IRA because their income is too high. Many believe that a Traditional IRA funded with pre-tax dollars is their only option. However, there’s another option to contribute to a Roth. The “Backdoor” Roth IRA strategy can be a viable alternative to save and invest for retirement.
How it works
Using this strategy, you can make a contribution to a Traditional IRA and convert the funds to move them to a Roth IRA.
After the conversion, withdrawals from earnings are tax freeD if you’ve owned the Roth IRA for 5 years or longer and are over 59 ½. You can also remove your original contributions, which are tax free at any age. If your Roth IRA has been open for 5 years or longer but you are under 59 ½, you can remove earnings tax free if the withdrawal is due to disability, first time home purchase or if you’re a beneficiary that’s inherited the Roth IRAD.
This strategy offers these advantages:
- Roth IRA income limits don’t apply to conversions
- Conversions aren’t considered contributions, so the annual Roth contribution limits don’t apply
- There’s no limit on the number of times you can convert funds from a Traditional IRA to a Roth IRA
- Annual maximums for tax-qualified IRA contributions are still applicable, however, there is no dollar maximum for how much you can convert in a year
Here’s an example
The conversion begins with the distribution of all or a portion of your funds in existing Traditional IRAs into a Roth IRA. Within your Traditional IRA you may have pre-tax dollars as a result of rollovers from a retirement plan or tax-deductible contributions or earnings. However, your Traditional IRA could also include after-tax dollars if you’ve made any nondeductible contributions. The tax liability on a conversion will be based on the percentage of your overall balance that hasn’t been taxed yet. This example is based on converting funds from a single Traditional IRA:
John has $200,000 in his Traditional IRA, including $20,000 (10%) in after-tax money. He wants to convert
$40,000 into a Roth IRA using the backdoor strategy. According to federal guidelines, $4,000 ($40,000 x 10%) will be converted tax-free, and John will owe current taxes on the remaining $36,000. Once John qualifies, he could withdraw future earnings tax-free.
The IRS aggregation rule requires that all IRAs must be aggregated when calculating the tax consequences of a distribution from any of them. To determine if a tax-free conversion can occur, please consult your tax advisor.
The backdoor conversion strategy may fit well with your financial plan. As you think through your options, it’s important to:
- Know the difference. Are your Traditional IRA retirement funds before-tax or after-tax dollars? Only after-tax money moves tax-free. Current income taxes must be paid on any pre-tax money converted to a Roth IRA.
- Realize you can’t undo it. No recharacterizations are available. Once you execute a conversion from a Traditional IRA to a Roth IRA, you’re not allowed to undo the transaction.
- Understand the five-year rule. A conversion must remain intact for at least five years before a tax-free withdrawal can be made from the Roth IRA. The five-year period begins at conversion.
- Pass the age rule to withdraw funds. To withdraw Roth IRA funds tax-free, you must be over 59½ years old.
- Avoid penalties. You could be subject to a 10% early distribution penalty if you withdraw money from the Roth IRA before meeting the age and five-year rules.
A few financial insights for your life
Withdrawals are not subject to federal taxes, and may not be subject to state taxes based on current state laws.
IRS Publication 590. Always consult with your tax advisor for tax advice.
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