Backdoor Roth IRAs

By Nick Clay
Arched Doorway to Starburst Sun
*Note- this is an updated blog entry with a corrected link to the “Traditional or Roth IRA?” article.

Want to contribute to a Roth IRA but your income is too high? There’s another way. Enter the Backdoor Roth IRA Conversion.

Since the inception of the Roth IRA, it has been a favorite investment vehicle for investors saving for retirement. You can read about the benefits of Roth IRAs, as well of what makes them different than Traditional IRAs in a previous blog here (Traditional or Roth IRA?). However, some investors have income over the amount to contribute to a Roth IRA. Currently the Roth IRA is not available to married couples earning $193,000 or more, and singles earning $131,000 or more.

In 2010, Congress made a change to the rules and allowed anyone to convert their IRA into a Roth IRA, so even high income earners can convert to a Roth IRA, but they still cannot contribute to the Roth IRA. So how can a high income earner contribute to a Roth IRA? By using the Backdoor Roth IRA Conversion strategy.

While this strategy is relatively easy in theory, we recommend working with a qualified tax and financial professional when thinking about converting. Below we have outlined the necessary steps in order to take advantage of this strategy:

  1. Establish an IRA account
  2. Make a nondeductible contribution to the IRA account
  3. As soon as possible, convert the IRA to a Roth IRA, because as we discussed earlier anyone can do this

The sooner you convert after making your nondeductible contribution the better. The idea is to have little to no “gain” in the account before converting, because upon converting you will have to pay tax on any investment earnings and gains. If the IRA hasn’t had a chance to earn any money, then there will be no tax due upon the conversion.

It’s that easy, BUT…. this is ideal for people who do not already have an IRA account. For someone who already has an IRA account, and decides to convert a contribution to a Roth IRA, ALL of their earnings and untaxed contributions are taxed – even on the IRAs that aren’t being converted.

In order to avoid any unwanted consequences, remember to consult with your financial professionals before making any decision regarding your financial future.

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