If you make too much to be eligible to contribute to a Roth IRA, Money Girl explains how to create a backdoor Roth - and whether doing so is a smart move for your situation, and your financial needs.
Tax Pitfalls of a Backdoor Roth IRA
But there’s still a tricky tax pitfall to be aware of with a backdoor Roth. What most people don’t realize is that the tax on a Roth conversion is based on all of your IRA accounts.
You have to pay tax based on the ratio of your after-tax IRA assets to your pre-tax IRA assets. For example, if your nondeductible (taxable) contribution equals 25% of all your retirement accounts, then only 25% of your Roth conversion would be tax-free. If this sounds confusing, it’s because it is!
Just remember that if you have other IRA funds that haven’t been taxed yet—such as a traditional IRA, SIMPLE IRA, or a traditional 401k rollover from a previous employer—you could still end up with a tax bill when you create a backdoor Roth IRA.
A backdoor Roth is the perfect move if you don’t have any other IRAs, but it gets a little complicated if you do. So always seek advice first from your IRA custodian or a tax professional.
There are some tax solutions, such as doing a series of small Roth conversions over time, or doing a reverse rollover to move your traditional IRA assets into a Solo 401k (if you’re self-employed), or into a retirement plan at work, if available.
Should You Create a Backdoor Roth IRA?
So who should consider creating a backdoor Roth? In general, I recommend maxing out a retirement plan at work before contributing to an IRA.
Many workplace retirement plans also offer a Roth option, which, unlike a Roth IRA, has no income limit. Workplace plans have higher contribution limits than IRAs: $18,000, or $24,000 if you’re over age 50, for 2015. Plus, they might also offer additional employer matching funds.
All these perks make them the optimal savings vehicle for retirement, if available. But if you don’t have access to a workplace plan or consistently max one out, a backdoor Roth IRA is something to consider. As I previously mentioned, though, if you already have traditional IRA funds, creating a backdoor Roth won’t be completely tax free.
So proceed with caution, and make sure to seek advice so you fully understand the pros and cons of a backdoor Roth for your situation.
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