A Step-by-Step Guide to Executing a Backdoor Roth IRA Conversion

The Backdoor Roth IRA is a financial strategy that allows high-income earners to take advantage of the tax benefits of a Roth IRA, even if they exceed the income limits for direct contributions. The limits for direct Roth contributions are income levels of more than $153,000 for single tax filers and $228,000 for those married filing jointly. This strategy involves converting a Traditional IRA (or a portion of it) into a Roth IRA, effectively bypassing the income limits.

The first step is to open both a Traditional IRA and a Roth IRA. Ensure that these accounts are established. Next, contribute to your Traditional IRA with AFTER-TAX dollars. You can contribute up to $6,500 or $7,500 if you are 50 or older in 2023. As soon as your funds settle in the Traditional IRA, initiate a Roth Conversion. Contact your financial institution to start the process. Typically, you will do this by filling out forms or completing the process online. Additionally, you will need to file a Tax form 8606 to alert the IRS that your contributions are after-tax. That’s it. You have now executed the Backdoor Roth IRA conversion. However, there are a couple of tax-related items to be aware of.

First, any growth on this after-tax money will be taxed as income in the year you perform the conversion. This is why we recommend making the maximum contribution all at once and immediately converting it before there is any growth. This way, you can enjoy tax-free growth.

The other catch is the IRS Pro-Rata rule. The IRS requires all Roth conversion amounts to be pro-rata from both pre-tax and after-tax money sources. For example, if you have a $5,000 pre-tax IRA from a rollover and you deposit $5,000 after-tax, your balance is $10,000 with 50% taxable and 50% after-tax. If you convert $5,000 to Roth, the conversion will be pro-rata: $2,500 pre-tax and $2,500 after-tax, and you will receive a tax bill with $2,500 in income for the year you execute the conversion. The workaround for this is to keep all pre-tax money in your employer plan. Not only does this allow you to perform the Backdoor Roth, but it also allows you to access your pre-tax money penalty-free at 55.

In conclusion, the Backdoor Roth IRA can be an excellent tool for high-income earners to manage taxes in retirement. If you need more assistance on how to do this, reach out to your Francis LLC Financial Planner.

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