What is a Back-Door Roth IRA? A Back-Door Roth IRA is a way for high income earners to contribute to a Traditional IRA (without deduction) and then move it over to a Roth IRA so the money can grow tax free. Normally, high-income earners cannot contribute to a Roth IRA; however, this practice allows high income earners to still get into the Roth IRA game. This article will cover all the details of a Back-Door Roth: the basics of a traditional and Roth IRA, why high-income earners use this method, and how to actually implement this investment strategy. Traditional IRA vs Roth IRA – Brief Overview Key Tax Difference: With a Roth IRA your investments grow tax free, but taxes are paid before money is invested. With a Traditional IRA, contributions can be deducted from taxes on the front-end. The money grows tax free but upon withdrawal taxes are paid on the gains. Income Limits. There are no income limits for Traditional IRAs, however there are income limits for tax deductible contributions. There are also income limits for Roth IRAs. Individuals earning more than $139,000 a year cannot contribute to a Roth IRA. Married couples must have less than $206,000 a year combined to contribute to a Roth IRA. Age Limits – Contributions. The SECURE Act of 2019 removed the age limit at which an individual can contribute to a traditional IRA. Prior to 1/1/20, an individual could not contribute after age 70 ½. This Act now allows anyone that is working and/or has earned income to contribute to a Traditional IRA regardless of age. Contributions. For both a Traditional IRA and a Roth IRA contributions can be made up to the lesser of 100% of earned income or $6,000 in 2020. Once the “catch-up” is reached at age 50, additional contributions of an extra $1,000 can be made. Required Minimum Distributions. With a Roth IRA there are no required minimum distributions. Meaning money grow and grow because taxes have already been paid on the money. However, with a Traditional IRA there are required minimum distribution laws that must be followed. Why High-Income Earners need a Roth IRA For years, high income earners have wondered how they can get the tax-free benefits of a Roth IRA. Understandably, they want their money to grow tax free just like everyone else. Some people will argue that they – “high income earners” – are making so much money they should not get a tax-free option like everyone else. What could be argued back is that high income earners are still paying tax on that money (at a higher rate than most people). It is not like they are exclusively getting the benefits, or they are not paying tax – they are actually paying more. However, it does not seem right to take away American privileges just because some are working hard and earn a better living. Now begs the question, why would someone pay higher taxes today, in hopes of no taxes down the road? That is a good question and one which there are three answers too: Diversity. This Back-Door Roth IRA strategy provides a little more diversity. 401ks, Traditional IRAs, pensions, etc. all will require the taxpayer to pay taxes when they receive the money at some point in the future. If the government is charging 90% tax, it does not matter how much money is being brought in, it will be taxed to death. Protection. It’s an insurance policy on the future of America’s taxes. This method provides protection against the future state of the United States’ financial system. If the US is bankrupt and taxing has gotten out of control – a consolation is knowing there is a pot of money set aside that will be not taxed. If there is a possibility someone’s income or taxes will be higher later in life, they may want to try to get money into a Roth IRA. My hopes for everyone reading this is that their income is higher later in life and one of the best planning methods for reducing future “tax exposure” is through the Roth IRA. How the Back-Door Roth Works Someone is now sold on these points and wants to start investing through the Back-Door Roth strategy, but realized they need to have some diversification and protection over their future taxes. How possible is it that this can easily be a several million-dollar tax-free nest egg? How is it set up? Great questions – let us walk through the steps together on what it will take to setup this tax-free account. Three Steps to a Tax-Free Retirement Account The first step is open a Traditional & Roth IRA account. To implement a Back-Door Roth, the account holder must already have Traditional and Roth accounts. Both accounts can be opened at Schwab or another investment firm and mostly likely, it should take less than an hour to set these up. However, these accounts do need to be at the same investment shop. While it could be possible to have the accounts at different brokerage firms, the paperwork nightmare would probably not be worth it. The second step is to contribute funds into the Traditional IRA Account. This can be done by writing a check at the local branch, making a transfer into the account, or whatever ways the brokerage allows. The key is that there must be a deposit made to the traditional IRA account before it can get to the Roth account. This is a key requirement in the Back-Door Roth process.As a high-income earner, there will not be a tax deduction for this deposit. Which is fine. Money can be left in the Traditional IRA for however long – even though there will not be deduction, it can stay in the account. However, there is not really a point to leaving it in the Traditional IRA unless there will be a deduction, or it is planned to move over to the Roth.It is also suggested not to put that money into any investments until it gets over to the Roth IRA. The normal transaction time at Schwab takes about 15 minutes to handle and it’s all online. The third step is getting the money into the Roth. Inside the Transfers/Payments section of the brokerage account it will be accessible to select a funds transfer from your Traditional to your Roth. This will qualify under the Back-Door Roth IRA process. This probably seems too simple and almost like it should not qualify to be a loophole, but it is. Since everything is documented by the brokerage firm and no deduction was taken (because of the “high income earner” status) money can be moved over to the Roth with no tax consequences. What is also nice is that most online software systems will keep track of the contributions made through the years. When tax season comes around, it will be easy to look back and see the contributions made each year to provide to CPAs. This article has shown why High-Income Earners need and should utilize a Back-Door Roth IRA and how to set one up. Do not wait to set one up, because the years missed growing tax-free money will never come back! For more information about IRA’s visit our Financial Basics page.