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Avoid These Backdoor Roth IRA Pitfalls – Forbes Advisor

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Editorial Note: The Forbes Advisor may earn a sales commission earned from affiliate links on this site, but this does not affect the opinions and ratings of our editors.

While the prospect of non-taxable retirement income is tempting, Roth’s individual retirement accounts (IRAs) are not without their reductions and can lead to unexpected costs, especially if you use a behind-the-scenes strategy.

With a Roth IRA backdoor, you avoid set income limits Roth IRAwith the first giving of non-deductible contributions a traditional IRA (which anyone can do as long as they have earned income) and then turn your traditional IRA into a Roth.

If you are otherwise excluded from the Roth IRA because your income is in the high six digits, this practical back door can allow you to reap Roth’s tax benefits. But these conversions can become inconvenient and expensive. Here’s what you need to pay attention to when performing a backdoor Roth IRA conversion.

Backdoor Roth IRA Trap # 1: An Unexpected Tax Account

The attractiveness of a Roth IRA backdoor is the potential to complete the transaction and avoid any additional taxes you would face in retirement if you put the money in a traditional IRA. But if you don’t consider all of your existing IRAs, you may get an unexpected tax bill.

Two facts to keep in mind: Non-deductible contributions are given with money already taxed. And when you turn a traditional IRA into a Roth IRA, you owe Uncle Sam a bill for money that hasn’t been taxed yet. Practically speaking, you can avoid this until you invest the money when you put it in your IRA and then quickly turn it into a Roth.

Here’s the big catch, though: If you have money before taxing on any other traditional IRA account, your backdoor Roth conversion will trigger a tax account, courtesy of the IRS’s proportional rule.

Pro-Rata Rule and Backdoor Roth Conversion

For tax purposes, the IRS considers all of your (seemingly separate) IRAs into one large account. The proportionality rule comes down to the percentage of your total combined IRA balances that have yet to be taxed. Whatever the percentage, it determines the percentage of your backdoor Roth IRA conversion that will be taxed.

For example, let’s say you have $ 94,000 in existing traditional dollars-financed IRAs before taxes. And now you contribute $ 6,000 to a new traditional IRA with dollars after tax, and then turn that $ 6,000 into Roth right away through a backdoor Roth IRA strategy.

As for the IRS, you now have $ 100,000 in traditional IRAs, and the $ 6,000 you pay in dollars after tax represents 6% of your total. This means that only $ 360 of your background conversion of $ 6,000 is tax-free (6% of $ 6,000). You owe the other $ 5,640 in income tax.

Backdoor Roth IRA Trap # 2: A five-year rule

One of great benefits of Roth IRAs is that you can withdraw your contributions from the account at any time, for any reason, without imposing penalties or taxes. There is only one limitation of this feature: You must wait five years after making your first contribution to avoid penalties when withdrawing funds from your account.

The five-year clock starts ticking on January 1 of the year in which you made your first contribution. If you withdraw funds before the expiration of five years, you may have to withdraw taxes and a 10% penalty on withdrawal.

With this rule, there are extra creases when converting to the background. Each of your converted Roth IRAs has their own five-year watch on them. And since no money has been taxed before, all money, not just earnings, is subject to tax plus a 10% penalty if you withdraw money before the expiration of five years.

“If you think there’s a chance you’ll need the money five years ago, you might want to reconsider the move,” he says. says Brian Robinson, Certified Financial Planner (CFP) Phoenix.

Backdoor Roth IRA Trap # 3: Unwanted Expenses

If you are 60 or older, it is vital to understand that other parts of your financial life, namely Social Security and Medicare benefits, could be affected if you technically generate income by converting a Roth IRA.

  • Taxation of social security benefits. If you are already receiving Social security benefits, they may be partially taxed based on your income. If your backdoor Roth IRA increases your income, you may notice that your Social Security benefits are partially taxable or most of your benefits could become taxable.
  • Higher Medicare premiums for Part B. Almost everyone enrolled in Medicare pays a monthly premium for Medicare Part B, which covers doctor visits, tests, and outpatient treatment. The monthly premium is based on your MAGI tax return from two years ago. In 2021, individuals who reported income below $ 88,000 upon return in 2019 and married couples below $ 176,000 pay the lowest possible monthly premium from Part B of $ 148.50. Above these thresholds, premiums for Part B are higher. There are also income-based premiums for Medicare Part D that cover prescription drugs.

Trap # 4: You expect your retirement tax rate to be lower

If you are in a high state income tax class today and expect your retirement income to be much lower, turning Roth into a background that includes taxes may not make sense. But Robinson warns that, even if you expect to have less revenue, it is worth considering that the federal government could at some point raise tax rates from its current historically low levels to help address the federal deficit.

A final word on Backdoor Roth IRAs: Talk to a professional first

If you don’t have money in traditional IRA accounts, back-back Roth is a smart way to create retirement savings that will be tax-free in retirement. And it can still make sense if you already have savings in traditional IRAs.

Either way, talk to a trusted one tax expert or financial advisor who first understands all the moving parts. Backdoor Roth IRAs affect your taxable income, and an expert can help you navigate the potential pitfalls of this useful strategy.

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