Use Backdoor Roth IRAs to Reduce Taxes

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Having a Roth retirement account enables your money to grow tax-free. You also will not be required to take required minimum distributions (RMDs) when you reach 73 and do not need to pay taxes on the money when you make a withdrawal. Contributing through a backdoor Roth individual retirement account (IRA) enables you to reduce taxes and skip the requirement for taking RMDs.

Contributions to a traditional IRA are tax-deductible. Because you get a tax break with your contributions, you will pay taxes when you withdraw money at your regular income tax rate.

You can save money on taxes if you put your money into a Roth IRA. You can also roll over money in a 401(k) into a Roth IRA. It can be done by making a rollover into the new Roth account. Even if you make too much money for Roth contributions, you can use the backdoor Roth IRA method to bypass the limitation legally.

Tax-Free Withdrawals From Roth Accounts

Getting a tax-free withdrawal from your Roth account has two requirements. You must be at least 59½, and the account must have been open for at least five years. When withdrawals are made that do not meet these requirements, you will need to pay taxes on the amount withdrawn, and there will be a 10 percent penalty.

Income Limits on Contributions

People who are married and filing jointly and earn more than $143,000 in 2024, the Fool says they cannot contribute to a traditional IRA and get a tax deduction. Singles cannot contribute more than $77,000. If an employer’s retirement plan covers your spouse, a married couple filing jointly cannot make any contributions once their combined income exceeds $240,000.

When a high-earner makes an after-tax contribution to a regular IRA and does not get a tax deduction and then uses the backdoor Roth conversion, Investopedia says that the money will not be taxed a second time. If you claim a tax deduction, you will owe taxes when you make a conversion.

If you are self-employed or own a small business, or if your employer offers them, you can still contribute to a SIMPLE (savings incentive match plan for employees) IRA or a SEP-IRA (simplified employee pension). These IRAs do not have any income limits.

The Backdoor Roth Option

You can still contribute to a regular IRA even if you earn more than the income limit. When you do, you will not get a deduction for it.

It can be beneficial because you can use the money in the IRA to convert it later to a Roth IRA. Even though you can no longer make direct contributions because of income limits, this method is still available.

The Pro Rata Rule for Conversions

Vanguard states that some IRAs require the application of a pro-rata rule when making a conversion. When present, this rule will vary, but it may state that a conversion consists of 90 percent pre-tax money and 10 percent after-tax money. Taxes will be required on any earnings.

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According to Fidelity, the Internal Revenue Service (IRS) considers all your IRAs as a single account—if you have more than one. It is how the pro-rata rule may apply to your accounts. Before making a conversion, you should consult a tax advisor to understand how many taxes will be involved. You may also owe state and local taxes.

Since you will need to pay taxes on any conversion of pre-tax money, the taxes owed on a larger money transfer could be sizeable. You will need to pay taxes at your regular income level. Generally, money put into an IRA is pre-tax. You can also use the back door method to put money into a Roth 401(k), but all contributions to this account are after-tax.

Another Five-Year Rule

Even though the five-year rule was mentioned already, a second five-year rule applies to backdoor Roth conversions. Forbes mentions that each time you make a backdoor Roth conversion, you will need to wait five years before you can withdraw it without a penalty. The rule applies to each conversion you make.

Contribution Limits for Roth IRAs

The IRS says the 2024 contribution limit to an IRA is $7,000. People 50 and older are allowed to contribute an extra $1,000.

A big advantage of making a backdoor Roth IRA conversion is that the money is treated differently than when you contribute to a traditional IRA. Investopedia says that the IRS does not consider a backdoor conversion a contribution. It enables you to roll over as much as you want to a Roth account, and there are no income limits or contribution limits on rollovers.

When you properly do the backdoor Roth conversion, you will owe taxes on the amount you roll over. No taxes will need to be paid on money already taxed. Your account administrator must automatically send the money directly to the new account. If you cash it out and do not redeposit it within 60 days, you will pay taxes on all of it. Once in the account, you will not owe taxes on the growth.

You can make a backdoor Roth IRA conversion the day after depositing it. It is not necessary to wait. If you wait, you will also owe taxes on any growth the money receives. For more details, talk to your account manager to be sure you make no mistakes.

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