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What is a Backdoor Roth IRA?

Have you ever heard about the “hack” – called the “backdoor Roth” – that’s allowing smart investors a way to fund a Roth IRA beyond the normal contribution limits?

Today I’ll share with you what I know about the backdoor Roth and convey it’s potential benefits.

How Does a Backdoor Roth IRA Work?

  • The focal point of this financial shift is converting a traditional IRA into a Roth IRA.
  • When you make contributions directly to a Roth, you can be restricted due to income levels.  When you convert a traditional plan, you avoid all of this.
  • There is currently no limit to the amount you can convert.

Explaining the Thought Process

Anyone in financial planning will tell you that a Roth IRA is a very smart way to save up for your retirement.  And as they should, the money grows tax free since it’s after-tax money that you are investing.  Growth to the account, as well as future withdrawals, are all free of taxation.

The issue with this retirement plan is that when you earn over a certain amount (deemed by the government / IRS) you are prohibited from starting a Roth IRA.  (Legally, at least.)

This backdoor way of funding a Roth IRA is amazing for the people who desire a tax-free income when they retire.

The Process is painless, and simple:

  1. Start a Traditional IRA.
  2. Convert it to a Roth.

Why Does this Type of IRA Conversion Work So Well?

As things stand right now, anyone can perform this very simple conversion.  It does NOT have anything to do with income levels.  Even better, let’s say you have a very large amount of money in an existing Traditional IRA and you want to roll it over into a Roth IRA.  You can do this – totally legally.

Most people (myself included) started other sorts of IRA accounts in order to be able to contribute more money into it than a Roth would allow.  So for people like me (I’m Self Employed) this is a perfect vehicle to grow money tax-free.

The reason this works is because it’s not a Scott-Free way of avoiding taxation.  The money you put into your Traditional IRA has already been taxed.  (Assuming you are a law-abiding, tax-paying person, of course.)

Disclaimer:  This is where I’m going to tell you to contact your Financial Advisor and CPA to make sure you are kosher.  There may be unique situations that will imply that your income will go up because of this contribution.  I’m not a Financial Advisor, I’m a Wealth Hacker, and my situation may be different from yours.

You can do this backdoor Roth IRA in a couple of ways.

  1.  Make your contributions to an existing IRA (Traditional.)  From there, you can sell your shares and move the money into a Roth IRA.
  2.  Convert an entire Traditional IRA to a Roth IRA.

In either scenario, whomever you have the account(s) with should be able to assist with these transactions.

The Benefits of the Backdoor IRA

Of course, you are paying your taxes in advance of these contributions, let’s be very clear about that.  Why this IRA really helps you is because:

  • The Roth IRA limits are typically very low and you may not be able to contribute if you pass the earnings barrier.
  • The Roth IRA contribution limits are (currently for 2018) $5,500 if you are under 50, and $6,500 if you are over 50.

With a conversion, limits are not applied.

The Taxation Explained in Summary

Again, this is not a tax loophole, so don’t go spreading any rumors.  In my case, I’ve already paid taxes on the money contributed to the Traditional IRA I rolled over, so for me, my funds will be growing tax-free for the next 20+ years.  Of course, I moved this into a custodian so I could manage my own investments, but that’s another topic.

Remember, if you convert a Traditional IRA that gave you a tax deduction, you’ll definitely assume taxation on the converted amount.

Contact your Financial Advisor or CPA – this may be a nice strategy for you depending on your investing history, goals, and corporate or personal set-up.

To learn more about some of the topics covered here, it’s wise to read the following pages:

Tim Schmidt

A Florida-based Entrepreneur, Author, and Life Hacker, Tim Schmidt decided to take control of his retirement portfolio several years ago by setting up a self-directed IRA. This website shares his thoughts and opinions on retirement, investing, and managing credit. You can follow his career and travels on his Official Website as well as on his Instagram page.