The backdoor Roth IRA is an indirect loophole that allows high-income earners to contribute to the Roth IRA. Although, the government-sanctioned contribution to the Roth IRA through a backdoor, if you are qualified for the advantage, you should take the chance. Backdoor Roth IRA contribution allows you to save more than tens of thousands of dollars on taxes for some years before retirement. Hence, it allows account holders to maximize retirement savings.
A backdoor Roth IRA can be operated by first making contributions to the traditional Roth IRA and then indirectly convert this into a Roth IRA. Once the requirements are met and the account is successfully converted, you don't have to pay tax on your earnings or have earnings that put you beyond the contributions limit. Basically, Roth IRA is very good because it operates a tax-free distribution and they don't have RMDs.
Why You Should Have A Backdoor Roth IRA.
Although both traditional IRA and Roth operates tax-free contributions, Roth has more advantages over the traditional IRA. The first significant advantage is that they don't operate with RMDs (required minimum distributions). You can leave your money to keep growing for you for as long as you like. This is very good if you already have another retirement plan like the 401(k) and want to use your Roth IRA as an inheritance or a bequest.
Also, the lack of RMDs also helps simplify an aspect of your record-keeping, future financial decision-making, and tax preparation. Roth distributions are not taxable in comparison to other accounts. In fact, in some accounts, the future tax rates are higher than the current tax rate, operating a Roth IRA allows you to pay tax on your retirement account contributions and not on retirement distributions as applicable with other retirement plans like 401(k) and the traditional IRA.
Note that converting your traditional IRA into a Roth IRA does not mean that you turn one into the other, it simply means that you move your money from the former account into the latter.
How To Operate A Backdoor Roth IRA
Open and contribute to a traditional IRA
In 2020, the maximum amount you can contribute to your traditional IRA is $6000 or a lesser amount of your income earned. For couples, if one out of the two is working while the other is not, the spouse who is working can contribute an additional $6000 on behalf of his or her husband or wife.
Individuals who are 50 years and above can pay an additional $1000 on the stipulated $6000. This implies that the married couple can contribute up to $14,000 into their traditional IRA account.
Next, convert your traditional IRA into a Roth account
Leaving your money in your traditional IRA could lead to paying tax when you have earnings.
Note: to operate a Roth account, you would have to abide by the Internal Revenue Service rules and regulations on your account. The tips to obeying the rule are simplified below:
If you are already making a tax-deductible contribution in your traditional IRA account, make sure you follow the prorate rule in order to operate the Roth account. The easiest way to avoid this rule is not to have any money in your traditional IRA account.
Do not make any withdrawals from your Roth account for at least five years. The only exception to this rule is if you are 59½ and beyond. If not you would have to pay the 10% penalty fee.
Do a trustee to trustee transfer in converting your traditional IRA into a Roth IRA.
When you allow your backdoor contributions to fall back into your hand, you might face an additional tax bill.
When you file for your tax return, fill out IRS Form 8606, Nondeductible IRAs.