A backdoor Roth IRA conversion can be tempting if you are considering retiring early and are currently over the income limits for a Roth IRA contribution. In case you are unfamiliar, a backdoor Roth IRA conversion is where you contribute money to a traditional IRA and then convert that money into a Roth IRA. This is a useful transaction for those who earn too much income to contribute to a Roth IRA as Traditional IRAs have no income limits. It’s also a perfectly legal transaction. However, when doing a backdoor conversion, keep in mind that the taxman will get his due and that this is not a way to avoid paying taxes on IRA contributions. The money you convert will most likely count as income and you will have to pay taxes on the money in your Traditional IRA that hasn’t already been taxed. It’s also important to understand how the IRS looks at your retirement funds. If you have more than one IRA, the IRS looks at the total of your IRAs and not just the IRA you make the conversion from. This can really pose a problem if you have more than one IRA with a large balance and may make you walk away from doing a backdoor Roth IRA conversion if the taxes are too high. Income limits are another important thing to understand when doing a backdoor Roth IRA conversion. Doing one backdoor conversion doesn’t mean you can start making regular contributions to the newly created Roth IRA. Rather, you will need to do a backdoor conversion every year that you are over Roth IRA income limits, which can potentially be for many years, especially if you are a high-income earner early in your career. That’s a lot of backdoor conversions and that can leave you open to the possibility of making more mistakes. A mistake on a backdoor Roth IRA conversion can be costly depending on the amount you convert and it can be as much as 6% of the conversion if you do so over the income limits. Since backdoor Roth IRA conversions are not particularly common and require a lot of thought, you should seek out the advice of a certified financial planner before doing one.
Did you know that even if you have too much income to make a deductible contribution to a traditional IRA, you can still make a nondeductible contribution? There are two main reasons why you would do this: to obtain tax deferral for investments or to make a backdoor contribution to a Roth IRA. Remember, there is nothing in the tax laws that places income limits on eligibility to make nondeductible contributions to a traditional IRA or to convert a traditional IRA to a Roth IRA. It should be noted however, that your nondeductible contribution cannot exceed $5,500 (or $6,500 if age 50 or older). Also, there is a downside if you are doing a nondeductible contributions for the purpose of obtaining tax deferral for investments, which is that distributions will be taxed at ordinary rates and, most importantly, you will need make sure you keep accurate records. Nondeductible contributions are tax-free when distributed and you must be able to separate them from any taxable distributions you may have. This can be an easy way to trip up and thus you must be very careful that you keep track of your distributions and whether they are deductible or nondeductible. If you are considering making a nondeductible contribution, you should talk with a financial planning expert to make sure that its the right decision for you as well as to make sure it is done correctly.