A Roth IRA is an individual retirement account that may provide investors with a tax-free income once they reach retirement. With a Roth IRA, investors save after-tax dollars, and their money grows tax-free. Roth IRAs also provide additional flexibility for withdrawals—once the account has been open for five years, contributions can be withdrawn at any time, for any reason.
But there’s a catch: Investors can only contribute to a Roth IRA if their income falls below a specific limit. If your contribution is for 2022, that maximum is $129,000 for a single person or $204,000 for a married couple filing jointly (based on modified adjusted gross income). Though, if you make slightly more than that, you may qualify to contribute a reduced amount.
Related: What Is a Roth IRA?
Want to contribute to a Roth IRA, but have an income that exceeds the limits? Good news: There’s another option. It’s called a backdoor Roth IRA.
What is a Backdoor Roth IRA?
If you aren’t eligible to contribute to a Roth IRA outright because you make too much, you can do so through what’s called a “backdoor Roth.” This process involves converting funds in a Traditional IRA into a Roth IRA.
The government allows you to do this as long as investors pay income taxes on any contributions deducted on taxes (and any profits made) when the investor converted the account. Unlike a standard Roth IRA, there is no income limit for doing the conversion, nor is there a ceiling to how much can be converted.
Related: Traditional Roth vs. Roth IRA: How to Choose the Right Plan
Is a Backdoor Roth Worth Doing?
It depends. Use SoFi’s IRA Contribution Calculator to make an informed decision.
High earners who don’t qualify to contribute under current Roth IRA rules may opt for this route. As with a typical Roth IRA, a backdoor Roth may be a good option when an investor expects their taxes to be lower today than in retirement. Investors who hope to avoid required minimum distributions (RMDs) when they reach age 72 might also consider doing a backdoor Roth.
But if someone is eligible to contribute to a Roth IRA, it may not make sense to bother with a backdoor conversion.
Another thing: A conversion can also move people into a higher tax bracket, so investors may consider waiting to do a conversion when their income is lower than usual.
Related: How Much Can You Put in an IRA This Year?
If an investor already has traditional IRAs, it may create a situation where the tax consequences outweigh the benefits. Say an investor has money deducted in any IRA account, including SEP or SIMPLE IRAs, the government will assume a Roth conversion represents a portion of all the balances. For example, if they contributed $5,000 to an IRA that didn’t deduct and another $5,000 to an account that did deduct. If they converted $5,000 to a Roth IRA, the government would consider $2,500 of the conversion taxable.
If an investor plans to use the converted funds within five years, a backdoor Roth may not be the best place to park their cash. That’s because withdrawals before five years are subject to income tax and a 10% penalty.
Related: Roth IRA 5-Year Rule Explained
How to Open a Backdoor Roth IRA
If an investor has no other Traditional IRAs, here’s how to make a backdoor Roth IRA happen with SoFi:
• Open both a Traditional IRA and a Roth IRA with SoFi Invest®.
• Make a non-deductible contribution to the Traditional IRA by the tax deadline (April 18, 2022 for tax year 2021). The maximum allowable yearly contribution is $6,000 (or $7,000 if you’re 50 or older).
• SoFi will send you a form to transfer the money into your Roth IRA. Sign and return it.
• If you choose an automated investing account, once the funds are in your Roth IRA, SoFi will invest them in the portfolio you’ve chosen.
Related: 3 Easy Steps to Starting A Retirement Fund
If you have any questions or want some help as you go through the process, schedule a complimentary appointment with one of our licensed financial advisors. SoFi Invest is all about empowering you and your financial future, and we’re here to help.
The Takeaway
A backdoor Roth IRA may be worth considering if tax-free income during retirement is part of an investor’s financial plan, and they make too much to contribute directly to a Roth. Roth IRAs are a good option for younger investors at low tax rates and people with a high disposable income looking to reduce tax bills on capital gains in retirement.
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