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Should You Do a Backdoor Roth IRA Conversion?

Updated: Nov 29, 2023

🏦 What is a Backdoor Roth IRA Conversion?


The process of rolling over money from a Traditional IRA to a Roth IRA. There is no limit on the rollover amount and no income restrictions on who can complete the conversion, but the funds are TAXED at the time of the conversion. The contributions can be withdrawn penalty-free after 5 years.


🤔 Who should consider it?

  • High-income earners who cannot typically contribute to a Roth IRA

  • Someone in an abnormally low tax bracket (due to job loss, sabbatical, business losses, etc.)

  • Someone looking to early retire who will need access to their retirement funds earlier than the typical retirement age.


👉 What is the process?

  1. (Optional) Roll over an old 401k account to a Traditional IRA

  2. Open a Roth IRA account

  3. Roll some amount of money from a Traditional IRA account to the Roth IRA account

  4. Invest the Roth IRA money into funds/stocks/bonds of your choosing

  5. (If needed) Make an estimated tax payment before the end of the year to cover the conversion


💰 What are the benefits?

  • Can potentially pay a lower tax rate on retirement savings

  • The Roth IRA now grows tax-free forever

  • Earlier access to retirement contributions

  • No Required Minimum Distributions (RMDs) in retirement

Example:

Ella leaves her current job and takes a year-long sabbatical to travel and work on some side projects. Her income during this year is unusually low compared to her usual tax bracket.


Because Ella has left her job, she rolls her previous 401k into a Traditional IRA. This is all pre-tax money, so she has never paid any taxes on the contributions or the growth. Ella’s income is normally too high to contribute directly to a Roth IRA.


Since she has no income this year, Ella decides to complete a Backdoor Roth IRA Conversion – she opens a Roth IRA and rolls $24,850 from her Traditional IRA into this Roth IRA. Income taxes are now due on the $24,850, but since that is the only income Ella has this year, after the standard deduction of $13,850, Ella only owes 10% tax on the remaining $11,000, for a tax bill of $1100, and a total net tax rate of 4.4% on that $24,850.


🎉 So Ella was able to deposit that money in her 401k tax free, move it to a Roth IRA at only a 4.4% tax rate, and now it will continue to grow forever tax free. She can also withdraw that $24,850 contribution in 5 years without penalty! 🎉



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