There are a number of reasons why a Roth IRA is a smart way to invest for retirement. For most investors, tax benefits rank #1 in their reasoning for investing in a Roth IRA.
Roth IRA contributions are made after tax, so potential earnings in a Roth IRA grow tax free as long as the owner abides by the Internal Revenue Service (I.R.S.) rules. Withdrawals are federally tax free once you reach age 59½ and have held the Roth IRA for at least five years.1
Unfortunately, some people make too much money to contribute to a Roth IRA. In 2021, joint filers with modified adjusted gross incomes (MAGI) of $208,000 or more and single filers with MAGI of $140,000 are not eligible for a ROTH IRA.2
This is where the “Backdoor” Roth IRA strategy comes in to play.3
This strategy allows taxpayers to create a Roth IRA indirectly by first contributing to a traditional IRA. The contributions to this new IRA my not be deductible depending upon the owner's adjusted gross income. With the help of a financial professional, some or all of the traditional IRA funds are then converted to a Roth IRA account. Any tax liability due will be paid in the year of the conversion.4
We mention the importance of using a financial professional to assist with the Roth conversion as any amount converted does become taxable income. The investor will want to consider that the additional income could potentially raise them to a higher tax bracket. Keep in mind this article is for informational purposes only. Tax rules are constantly changing, and there is no guarantee that the tax treatment of Roth and Traditional IRA's will remain the same.
For more about Roth IRA's take a look at this recent episode of 5 Minute Finances.
Benefits of Roth IRA and the "Back-door" strategy.
- The potential for tax-free retirement income, not to mention tax-exempt growth for the account.
- It allows the investor to pay taxes on the income now at a potentially lower tax rate rather than in the future when tax rates may be higher.
- There are no mandatory annual withdrawals (RMD's) from Roth IRA's while the original owner lives.
Any Roth IRA conversion is a taxable event, and these conversions cannot be undone. That given, think about the basic rules for Traditional IRA's. Generally, distributions from traditional IRA's must begin once you reach age 72. These RMD's are taxed as ordinary income.4,5 Because there is no such requirement with a Roth IRA, the investor will retain control of when to begin withdrawals which allows for greater potential growth in the account.
After the account owners death, under the 2019 SECURE Act, most non-spouse beneficiaries of a Roth IRA are required to have the funds distributed to them by the end of the 10th calendar year following the year of the original owner’s death.5
If you are a retirement saver who has not been able to invest in a Roth IRA the "Back-door" Strategy may be a good addition to your financial plan.
1 - Investopedia, January 24, 2020
3 - RetirementPlans.Vanguard.com, May 11, 2020
4 - Fool.com, July 25, 2019
5 - IRS.gov, February 24, 2020