Backdoor Roth IRA: How It Works & Whom It Benefits

In the intricate world of retirement saving strategies, the backdoor Roth IRA stands out as a maneuver that could be beneficial to high-income earners as well as those that are married and filing separately in order to keep their monthly payments low on the student loan IDR plans.

The backdoor Roth IRA is an investment tool that may not be as straightforward as the traditional Roth IRA, but it is a very powerful tool.

This article is intended to provide a comprehensive understanding of the backdoor Roth IRA, examining its process, benefits, and the type of investors who may find it most suitable.

What Is A Backdoor Roth IRA?

A Backdoor Roth IRA refers to a method to create a Roth IRA by contributing to a traditional IRA and then converting it into a Roth IRA.

This backdoor method is perfectly legal and is especially beneficial for those who want to take advantage of the tax-free growth and tax-free withdrawals in retirement offered by the Roth IRA, despite their income bracket.

Below I dive deeper into the process but before I do, you need to know if you should use one or not.

Who Should Use A Backdoor Roth IRA?

There are two specific situations where you could massively benefit from using a backdoor Roth IRA which I detail below

Those on an IDR Student Loan Repayment Plan

When you are married and using an Income-Driven Repayment plan to repay your student loans, filing separately can save you a ton of money in regard to your monthly student loan payment.

In fact its not uncommon for FitBUX Members to see their payments drop by $500 to $1,500 a month by filing separately.

However, when you file separately, you can no longer contribute to a Roth IRA. Therefore, in order to take advantage of the benefits of a Roth IRA, you must contribute to one via the backdoor Roth IRA method.

Your Income Is Too High To Contribute To A Roth IRA

If you find yourself earning an income that is above the limit set by the IRS for contributing to a Roth IRA, the backdoor method may be your ticket to still take advantage of the Roth IRA’s benefits.

In the next section, we’ll delve into the step-by-step process of establishing a backdoor Roth IRA and why high earners can take advantage of it.

How To Do A Backdoor Roth IRA

From a high level, a backdoor Roth IRA is done by contributing to a Traditional IRA first, then doing a Roth conversion. A Roth Conversion simply means moving the money from a Traditional IRA to a Roth IRA.

Below I go through the detailed process so you can make sure you do it right.

Note: If you are a FitBUX Member we can do this for you via our Hybrid Robo-Advisor.

Step 1

Open a Traditional IRA and make your contribution.

There is no income limitations on a Traditional IRA which is why high earners can contribute to one.

Step 2 – The Key That You Don’t Want to Forget

Most of the time, when you contribute to a Traditional IRA you do so on a pre-tax basis. If you do that, then when you convert it via a backdoor Roth IRA you must pay taxes on the contributions AND the gains.

This can become a headache for you during tax season.

Instead, when you file your taxes you can specify on your tax return that the contributions were done on an after-tax basis. Therefore, you have to pay tax on the money today but its far easier to deal with in the future.

Thus, we recommend you choose after-tax contributions.

One more item to point out. You do not elect this with the company you are investing with. For example, if you have an investment account with FitBUX, there is nothing to do with the actual account for tax purposes.

Instead, you specify the after-tax contribution on your tax return.

Step 3

Open a Roth IRA.

Step 4 – Backdoor Roth IRA Conversion

Convert the Traditional IRA to a Roth IRA.

You’ll want to do this as soon as you can after you contribute to the Traditional IRA. The reason being is if the account value goes up, you’ll have to pay taxes on the gains when it is converted.

Ideally you’d want to convert it ASAP. Realistically this isn’t possible because people don’t remember to do it all the time… let’s face it we are all busy.

Therefore, most people do it periodically. For example, FitBUX does it on a quarterly basis for their Members.

What is the Benefit Of A Backdoor Roth IRA?

There are three primary benefits of a backdoor Roth IRA

Benefit 1

The primary benefit of a backdoor Roth IRA lies in its tax advantages. Unlike a traditional IRA, where withdrawals in retirement are taxed, a Roth IRA allows for tax-free withdrawals.

This means that as your investment grows over the years, you won’t have to worry about losing a portion of your retirement savings to taxes.

Benefit 2

For those on an IDR plan, a Roth IRA is awesome because you can withdraw contributions for the tax bomb without penalty.

Additionally, a backdoor Roth IRA is a powerful tool for high-income earners who are normally excluded from contributing to a Roth IRA due to income limitations. By contributing to a traditional IRA and then converting it to a Roth IRA, high-earners can bypass these limits and take advantage of the Roth IRA’s tax-free withdrawals in retirement.

Benefit 3

Moreover, Roth IRAs do not have required minimum distributions (RMDs) unlike traditional IRAs. This allows the account holder more control over their retirement funds, making it an excellent estate planning tool.

The Pro-Rata Rule

One area you need to be careful of is the Pro-Rata rule.  If you have a traditional IRA that was funded with pre-tax monies, then the IRS will consider part of the conversion from those monies.  It doesn’t matter if it is from a traditional IRA.

We typically see this when an individual has rolled over an employer retirement account to a traditional IRA.  

For example, if you have $50,000 in a 401k then roll it over to a traditional IRA, that is done with pre-tax money.

Then if you make an after-tax contribution of $7,000 to a traditional IRA this year to a brand new IRA, when you convert it to a Roth IRA, the IRS is going to consider part of the $7,000 being pre-tax money from the $50,000 roll over IRA.

Here is more information on the formula for calculating the pro-rata amounts. 

FAQ

Is a Backdoor Roth Still Allowed?

Yes, as of the time of this writing, the backdoor Roth IRA is still allowed.

What are the drawbacks of a backdoor Roth IRA?

One downside is having to take multiple steps and make sure you do it right. That is why so many FitBUX Members do it through their FitBUX account. FitBUX has coaches to guide you through it plus technology to make it easy.

Another potential drawback is if you need to withdraw funds from the Roth IRA within five years of the conversion, you may be subject to penalties.

Do You Pay Taxes On A Backdoor Roth IRA

Only if you make the contribution to the Traditional IRA on a pre-tax basis. Also, you will pay taxes on the gains in the account at the time of the conversion.

Conclusion

In conclusion, a backdoor Roth IRA is a strategic method for high-income earners & married couples filing taxes separately to leverage the benefits of a Roth IRA, including tax-free withdrawals during retirement.

It involves contributing to a Traditional IRA first and then converting it to a Roth IRA.

This approach is particularly beneficial for those with an IDR student loan repayment plan or those whose income is too high to contribute to a Roth IRA. However, the process can be complex and requires careful attention to tax rules.

That’s where FitBUX comes in. With our Hybrid Robo-Advisor, we make the process simple and stress-free.

We also offer periodic conversions on a quarterly basis, ensuring your money is working as hard as you are.

So, why wait? Join FitBUX today and harness the power of a backdoor Roth IRA to secure your financial future.