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High-Income Earners: It's Possible to Achieve Tax-Free Income in Retirement

Updated: Nov 10, 2021

Part 3

The “Mega” in mega backdoor Roth IRA

You can convert as much as you want anytime you want from a Traditional IRA, SEP IRA, Solo 401(k), and 401(k) (if the plan allows) because the IRS does not have restrictions or limitations on conversions.

I highly recommend you discuss this strategy with your tax advisor because the conversion strategy with an existing Traditional IRA to a Backdoor Roth IRA has pro-rata rules that must be considered. Also, converting too much and spilling over into the next tax bracket could make the conversion to the Backdoor Roth IRA strategy costly.

How to create a Backdoor IRA:

  1. Put money in a Traditional IRA account. You may already have an account, or you may need to open one and fund it.

  2. Open a Roth IRA account. You cannot convert until the Roth IRA is open.

  3. Convert your contribution to a Roth IRA. Complete the conversion paperwork provided by the IRA custodian.

  4. Prepare to pay taxes. Only post-tax dollars should go into the Roth IRA. If you plan to use a previous Traditional IRA that you deducted your Traditional IRA contributions in previous tax years and then you decide to convert your Traditional IRA to a Backdoor Roth IRA, you’ll need to give the tax deduction back. When it comes time to file your tax return, be prepared to pay income tax on the money you converted to the Backdoor Roth IRA.

  5. Prepare to pay taxes on the gains in your previous Traditional IRA. If the money in a previous Traditional IRA has investment gains, you will also owe taxes on those gains at tax time. See the pro-rata rules below.

Keep these rules in mind to avoid tax penalties:

  1. Types of transfers. The conversion must be completed by using one of the following options: 1) a rollover, where you receive the money from you Traditional IRA and deposit it into the Roth IRA within 60 days, 2) a trustee-to-trustee transfer, where two different IRA custodians move money from the Traditional IRA directly to your Roth IRA, or 3) a same trustee transfer, where your money goes from the Traditional IRA to the Roth IRA at the same financial institution.

  2. The pro-rata rule. The IRS requires rollovers from Traditional IRAs to Roth IRAs to be done pro-rata. When determining your tax bill on a conversion from a Traditional IRA to a Roth IRA, the IRS is going to look at your Traditional IRA accounts combined. If your Traditional IRAs combined consist of 50% pre-tax money and 50% after-tax money, that ratio determines what percentage of the money you convert to a Roth IRA is taxable. No matter how much money you convert or which IRA account you pull the money from, 50% of the amount you convert to the Roth IRA will be taxable. You cannot choose to convert only after-tax money; the IRS does not allow it. The IRS also applies the pro-rata rule to your total Traditional IRA balance at the year-end, not at the time of conversion.

If you are high-income earner that knows that your taxable income now and in the future is going to be a target of the IRS, make the moves to remove future taxation on your hard-earned money by getting it converted into a Roth IRA now. Once you do, you will thank me because after the conversion every dollar you make in the Roth IRA is tax-free for life. Those are two words you thought you would never hear!

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