Backdoor Roth IRA
It is lovely to chat with you all again!
With the arrival of the New Year and the promise of a new start that it brings, I hope that the coming months will bring health, happiness, and new opportunities to all of you.
In today’s post, we will talk about Roth IRAs and how they can prove to be useful as smart investment options for young people just starting out. We will be going into detail on how they can serve as powerful tools to save for retirement, how to set them up, their disadvantages, alongside techniques that you can employ to invest in them.
I hope this article will help you lay the groundwork for a more financially healthy future later into your retirement years.
A Brief Recap
Last week, we left off our discussion on the difference between the various retirement funds that exist today (Think: 401K, and Roth IRA). It was a valuable session on how to set up retirement accounts within these different systems and most importantly, how to go about investing in them for the future. We went into the nitty-gritty details about how factors like your income bracket and marital status determine the limitations on your account type and what accounts you can open, together with the advantages of how the money that you redeem later in life is tax-free.
Lastly, when discussing the eligibility for a Roth IRA and the upper-cap of $129,000 in gross income that is required for single filers (or up to $204,000 for joint filings), we briefly touched upon the concept of a ‘Backdoor Roth IRA’ for those who do not quite make the cut as they earn more than the upper-ceiling required for the Roth IRA.
You may have several questions on what this backdoor involves, especially with regards to its legality and returns as an investment, which is why we at Stocks4Docs have prepared this handy podcast episode with all the information that you need to get a head start on your retirement plans.
How It Works
Let’s get started with the basics. This method is entirely legal, and we would never endorse any approach or financial advice that stands outside the bounds of the law. It is more along the lines of a widely employed tax loophole across the country.
In order to get a functioning Backdoor Roth IRA account, you would first need to start a regular or traditional IRA account as it does not have any income limitations and arduous eligibility requirements, while still being able to be opened from any brokerage of your choice.
The setup for a traditional account, as the name implies, is rather simple with only the most basic of details needed such as connecting to a checking account as proof of valid income, and relevant details such as your social security number and your full name. The next step is to open a Roth IRA account within the same company and then transfer money from your traditional IRA account into your Roth IRA account.
The applicable limit here, given that you are less than the age of 50, is $6,000 per annum. When retracted later, this money will count as ‘tax-deducted’ funds, meaning that it is money that you have already had paid your income taxes on. This makes IRAs quite handy to process once a year, similar to doing a bank transfer between your two accounts. The reason this works is that it counts as a conversion rather than a direct deposit into your Roth IRA. While direct deposits may have applicable income limits and upper-ceilings as we discussed earlier, these are simply not applicable for conversions.
The Pitfalls You May Encounter
There are also a couple of caveats that come with this process, and they are worth going over at this point.
The first one is that you cannot have funds in both your two different types of IRA accounts. For example, if you have money transferred to your Roth IRA, you cannot simultaneously keep funds in your traditional IRA. As such, the way I personally go about it is to only transfer money into my IRAs as soon as I’m ready to transfer the entire amount into my Roth IRA once a year. This also includes the two to three days it takes for the money transfer transaction to actually take place.
The reason you don’t want to have money at once in both types of IRA accounts is that it further complicates your tax returns, leading you to be charged penalties in the instance that you have money kept in both of your IRA accounts. Aside from the legal technicalities, it is also in part a loss on your end as the cash that you stave away in your traditional IRA account would accrue interest and make you lose your hard-earned money to further tax complications in the long run.
Due to the aforementioned taxation-related issues, ensure that you make all of these transactions within the same financial calendar year and do not leave money in your traditional IRA account.
Conclusion and Investment Options
The investment-related choices that you can make almost entirely depend on the brokerage firm with which you open your IRA accounts. My personal experience includes the one I had with Fidelity, as that is the company that I use, but most brokerages give you a myriad of investment options to go about spending your money.
Normally, you will be defaulting on your target-date fund when accounting for risk allocation. Taking your personal retirement age into account, going about distributions like 60% stocks to 40% bonds ratio, both domestic and international, will help ensure that your money will grow by the time you are retired.
I am personally an advocate for taking control of your finances. I hold the firm belief that someone in their 30s can easily convert most of their savings into stocks, whether they are mutual funds or even individual stocks. This, of course, only works when you follow our principles on investing in the right stocks and value investing. While guidelines like ‘your age subtracted from hundred, as a percentile invested in bonds’ are handy, they can also relatively hinder your growth possibilities.
Roth IRAs are attractive investment plans for a stress-free retirement future, especially if you opt for those plans that generate the highest interest income and short-term capital gains. Investments that are deemed somewhat ‘risky’ are those that appreciate significantly over time, are also ideal options for Roth IRAs.
Looking for more great content about investing, personal finance, and more? Keep tuning into the Stocks4Docs Podcast.