Backdoor Roth
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I have been investing in Roth IRA. Currenty the contribution limit is $7,000/year.
I haven’t been paying attention much, but there are income limits for traditional and Roth IRA. For traditional, married couples filing jointly cannot deduct contributions if their modified adjusted gross income (MAGI) is above $136,000. For Roth, married couples filing jointly cannot contribute if their MAGI is above $240,000.
Because I recently got a raise by changing employer, I can no longer contribute to Roth. However, there is a legal loophole called backdoor Roth. All you need is to contribute to a traditional IRA (which is not tax deductible due to the income limit but this is irrelevant) and then do a Roth conversion. This way, anybody can contribute to Roth regardless of their income. So from next year on, I can simply contribute $7,000 of cash to my traditional IRA account, do a Roth conversion, and invest the funds in whatever way I like.
However, for this year there is a problem because I have already contributed to Roth before I knew I would exceed the income limit. I did a bit of research and found this article. Reading it, I did the following.
- First, I recharacterized this year’s Roth contributions to traditional.
- Then, I contributed cash to traditional to hit the annual contribution limit.
- Finally, I converted all funds from traditional to Roth.
The idea is that, by recharacterizing my existing Roth contributions to traditional, it’s as if I contributed to traditional in the first place. To save my mental resource, I added sufficient cash to hit the $7,000 annual contribution limit right away so that I can forget about it for this year. Because the existing contributions to Roth had capital gains, by recharacterizing to traditional, I will have to pay capital gains taxes. This TurboTax article explains how to handle taxes.
It’s fun to learn something new about money tips, but I spent a few hours of my time doing so. Since the income limit for Roth is not binding due to the backdoor Roth loophole, it would make more sense for the government to simply eliminate the income limit for Roth altogether. And if there is no income limit for Roth, there should be no limit for traditional either. Our lives will be much simpler that way.