(Charlene Rhinehart, CPA)
If you feel like you’ve missed out on capturing tax-free income in retirement through a Roth IRA (individual retirement account), there is another opportunity for you to jump. It’s called a backdoor Roth IRA, and it may be the perfect solution for you to get your hands on the benefits of a Roth if you have high incomes.
Here’s a breakdown of how it all works and why you should consider a backdoor Roth IRA to accelerate your wealth goals.
Roth IRA Advantages You Don’t Want to Miss
Roth IRA they are a special brand of retirement accounts that come with tax-free benefits during retirement. You fund the account with after-tax dollars, invest in assets that grow tax-free, and make 100% tax-free withdrawals after you qualify. Imagine building a $1 million Roth IRA and not having to pay any taxes when you withdraw your money in retirement.
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However, there is only one thing that can stand in the way of your tax-free treasure. The Roth IRA comes with strict income limits that make it difficult for people with high incomes to obtain these benefits. The more money you earn, the less likely you are to make direct contributions to a Roth IRA.
Backdoor Roth IRA to the rescue
When your income exceeds the threshold, you will not be permanently excluded from the Roth IRA club. You may be able to legally sneak your money into the account through the Backdoor Roth IRA.
Is that how it works. If you have a traditional IRA or 401(k), you can transfer those funds to a Roth IRA. This can be helpful if you’re trying to protect your retirement balances from heavy taxes in retirement.
Let’s say you have $50,000 in your 401(k). You can do a direct transfer or ask about the 60-day rule. You will pay tax on your conversion from a Traditional 401(k) to a Roth IRA when you make the switch, but you’ll lock in tax-free earnings and income later on. If you think you’ll be in a higher tax bracket later, this may be a smart move for you.
Avoid contribution limits
Another benefit of making a conversion is that it is not subject to the annual rate Roth IRA contribution limits.
For 2022, you can contribute up to $6,000 to a Roth IRA depending on your income and filing status. If you’re over 50, you can contribute up to $7,000 to your IRA.
You can waive the contribution limit rules when you make a backdoor Roth IRA. Income limits will also be a thing of the past.
The conversion allows you to quickly increase your Roth IRA balance. Suppose you have $100,000 in your 401(k). You can pay taxes on the money now and roll it over to a Roth IRA. After the conversion, you’ll have more money available to invest in a broader list of assets in your Roth IRA.
The type of Roth IRA you choose can make a big difference in your wealth potential. You can shop for a Roth IRA at a traditional brokerage firm. This will open the doors for you to invest in the assets offered by the brokerage house, such as individual actions or exchange traded funds.
Understand how taxes work before you make a move
The main difference between traditional retirement accounts and Roth IRAs is when taxes are paid. For example, a traditional IRA generally allows you to take a tax deduction in advance and pay your tax bill in retirement. However, if you convert your traditional IRA to a Roth IRA and you’ve already taken a tax deduction, you’ll have to pay income taxes for the year.
There are ways to avoid a hefty tax bill, but it can be tricky if you contribute to other traditional IRA assets like a SEP IRA. You should seek the help of a professional to determine if a backdoor Roth IRA is the best strategy for you before making a move.
This Backdoor Strategy May Expire Soon
A backdoor Roth IRA can be a good way for high-income households to get around the income limit and build wealth tax-free. However, if a backdoor Roth IRA is something you want to pursue, you may need to act fast. Last years build back better The plan sparked talk of banning Roth conversions through the Roth IRA backdoor, so you never know when this opportunity will expire.
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