Contrivance of the Roth IRA
- Darcy Bergen
- Apr 12, 2023
- 3 min read
Contributing to a traditional IRA with after-tax dollars and immediately converting the money into a Roth IRA is known as a "backdoor Roth conversion." It's a smart move for future tax diversification and avoiding RMDs from your 401(k) or IRA.
But there are a few catches you should be aware of before you try this tactic. The IRS's IRA aggregation rule and pro-rata rule are the first things you need to know.
Some investors may find that a backdoor Roth conversion helps them avoid the strict income requirements for contributing to a Roth IRA. There may be tax consequences to this method, so it could be a better fit for some.
When you make after-tax contributions to a traditional IRA and then decide you want to convert those funds to a Roth IRA, this is known as a "backdoor Roth conversion." Due to the pro-rata rule, which mandates that all IRA distributions be split evenly between pre-tax and post-tax IRA contribution dollars, the conversion will result in taxable income.
Seek the advice of a qualified financial advisor before attempting a "backdoor" Roth conversion. They can advise you on whether or not the additional tax burden is justified in light of your unique circumstances.
Both partial and complete conversions are possible with a backdoor Roth IRA. Both the traditional IRA and the Roth IRA can be converted in whole or in part. A partial conversion entails transferring only a portion of the IRA value, while a complete transformation communicates the entire IRA balance.
The tax advantages of a Roth IRA can be taken advantage of through a backdoor Roth IRA conversion. However, it is recommended that you first speak with a tax expert.
Backdoor Roth conversions can be problematic due to IRS restrictions around IRAs. The amount of money you owe taxes on might be drastically altered by the aggregation and pro rata laws.
Your IRA payouts must be made up of a split between after-tax and pre-tax cash, as mandated by the Internal Revenue Service. A high amount of taxes may be required as a result of a backdoor Roth conversion if there is a mix of after-tax and pre-tax funds in the IRA.
Although they aren't prohibitively expensive, taxes are a common source of anxiety. The end result is likely to be better than if you had left your traditional IRAs alone and paid income tax on them in retirement, even if you end up paying a considerable amount of taxes.
If your salary is too high to qualify you for a Roth IRA, a backdoor Roth conversion may be an option for you. However, if you have a sizable sum of money in a traditional IRA and you want to convert it, this technique might get expensive fast.
Know the tax consequences of a backdoor Roth conversion before you do one. Consult a financial planner to see if it makes sense for your situation.
High-income workers often use the "backdoor Roth" technique to avoid the income thresholds that prevent them from contributing to a Roth IRA. A bill to eliminate the loophole has been introduced in Congress, but its future passage is still being determined.
The pro-rata rule, which establishes what percentage of your conversion is recorded as coming from nondeductible IRA contributions and other pre-tax IRA assets, is a considerable risk connected with a backdoor Roth conversion. This means that the IRS may seek a portion of the converted amount if you have substantial quantities of both traditional IRA assets and nondeductible IRA money.
The primary danger of a backdoor Roth conversion is that it could be deemed an illegal donation by the Internal Revenue Service. This is due to the fact that the method goes against the step transaction theory, which states that many acts can be combined into a single taxable event.
In particular, doing multiple backdoor Roth conversions quickly in a row could be seen as breaking this criterion. It's like driving 57 mph in a 55 mph zone; you won't get caught very often, but if you do, it could be challenging to prove your innocence in court.
The possibility always exists, too, that the IRS will one day decide to shut down this "backdoor Roth" loophole. This is intended to be accomplished via a section of President Biden's $1.7 trillion omnibus legislation, The Build Back Better Act, but its passage has yet to be stalled by West Virginia Senator Joe Manchin. If this happens, the year 2022 may see the complete elimination of backdoor Roth conversions.
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