Roth IRA Loophole: The Backdoor IRA Hack

If you’re looking to beef up your retirement savings, then you’ll want to check out this Roth IRA loophole right now.

Roth IRAs have been around since the introduction of the Taxpayer Relief act in 1997, and are considered to be a smart tool for retirement if used correctly.

In fact, according to recent studies, Roth IRAs are the second most popular type of IRA, owned by 19% of all US households. And in this article, I’m going to show you a smart investment strategy to super-fund your retirement by using a legit IRS loophole.

Are you Eligible to Contribute to a Roth IRA?

There are several key guidelines that determine whether you’re even eligible to contribute to a Roth IRA.

Some of these guidelines include:

• You can’t contribute more than your annual salary
• You must have earned income (like a job) to contribute
• If you’re under 50, you can contribute a maximum of $6000 per year
• If you’re over 50, you can contribute a maximum of $7000 per year
• If you earn too much money in a given year, then you can’t contribute

Under 2021 rules, you won’t be eligible to contribute to a Roth IRA if you earn more than:

• $140,000 for individual tax filers
• $208,000 for married tax filers

However, there are several ways to legally get around income thresholds on Roth IRAs, especially if you’re beginning to earn some serious money.

The Backdoor IRA Hack

The IRS won’t allow you to make contributions directly to a Roth IRA if you earn too much money …

… But, if you’re financially savvy, you’ll soon find out that there is a legal way to get around the IRS rules.

It’s called the backdoor Roth IRA.

The backdoor Roth IRA option gives you several advantages, including:

• Tax-free distributions
• Tax-free withdrawals during retirement
• No required minimum distributions (when you’re age 72)

Backdoor Roth IRA Defined:

A backdoor Roth IRA is a legal way to add money to your Roth IRA, even if you earn too much money. This is when you first make a contribution to a traditional IRA (which does not have income limits) and then immediately convert your traditional IRA contribution to a Roth IRA.

Backdoor Roth IRAs are a legal way to help you avoid:

• Roth IRA annual income limits
• Roth IRA contribution limits*

*A Roth IRA (and a traditional IRA) only allow you to contribute $6000 annually if you’re under 50 and $7000 annually if you’re 50 or older. With a backdoor Roth conversion, you could convert more than the annual maximum contribution — if you already have funds in a traditional IRA account and wish to convert a portion or all of those funds to a Roth IRA.

Pro Tip: Keep in mind that you can only make 1 Roth IRA conversion a year.

To master this IRS loophole, you’ll need to first open both a traditional IRA and a Roth IRA if you haven’t already.

This is how you make a backdoor Roth IRA:

• Open a Roth IRA
• Open a traditional IRA
• Make your annual contribution to the traditional IRA
• Immediately roll the funds from the traditional IRA to a Roth IRA account

The backdoor Roth IRA is a legal way to max out your Roth IRA, even if you earn too much money.

Pro Tip: While it’s not required to immediately convert your traditional IRA contribution to a Roth IRA, it’s going to be in your best interest for accounting purposes. You’ll have to pay taxes on any earnings between the time you contributed to the traditional IRA and the time to rolled your traditional IRA contribution to a Roth IRA.

Because the accounting and the paperwork can be a headache, it’s best to make an immediate rollover (same-day, if possible) to avoid any future tax issues.

Remember that:

• You’ll have to pay income taxes on the converted or “rolled over” funds
• You’re required to wait five years to access any converted funds without penalty

You’ll also want to keep the pro-rata rules in mind. The pro-rata rule takes into account all of your existing traditional IRA money and determines what percentage of your Roth conversion will be taxable.

Since I’m no accountant, I would suggest you research the pro-rata rules and check with your tax expert as well.

Is a Backdoor Roth IRA Right for You?

The backdoor Roth IRA loophole might not be for everyone — and that’s OK.

A backdoor Roth IRA could be a good strategy for you if:

• You can’t make contributions to a Roth IRA because youre earning too much money
• You expect to be in a higher income tax bracket during retirement and don’t want to pay taxes on Roth IRA withdrawals in the future
• You want to take advantage of the historically low-income tax rates today by paying taxes on conversions now

On the other hand, a backdoor Roth IRA may not be for you if:

• You can’t afford to pay the taxes on the conversion
• You need access to the conversion within the next five years
• The conversions may push you into a higher income tax bracket

Remember that although a backdoor Roth IRA might be a good idea, you should confirm the numbers with your accountant first to determine whether this loophole makes sense for you.

Closing Thoughts

If used correctly, Roth IRAs could be an excellent retirement planning tool for not just yourself but also for your family.

Of course, since I am neither a financial advisor nor someone who knows your financial situation personally, it would be best for you to have these retirement planning discussions with someone who knows your current situation. So before you jump head-first into a new strategy, I strongly recommend you to speak to your financial advisor or accountant.

Remember that to enjoy the Roth IRA tax benefits in the future, you’ll first have to follow the rules imposed by the IRS.

Your bank accounts will thank me later.

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About the author: Fiona, a.k.a The Millennial Money Woman, is a personal finance blogger and a dog lover! She graduated college debt-free by working 50-plus hour weeks (on top of her regular class and study work) and earned a Master of Science degree in Personal Financial Planning. She bought her first house at 23, co-founded a local non-profit charity, and is now helping others take control of their financial lives to achieve financial freedom early in life!

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