Decoding the Legalese: How AI can Help Explain the Benefits of a Backdoor Roth IRA in Layman’s Terms
- May 17, 2024
- Posted by: legaleseblogger
- Category: Related News
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## Current Financial Status and Retirement Plans
I am currently making approximately $120,000 as my base salary and I am on track to retire early at the age of 55 with the help of my employer’s 401k plan. My goal is to have a comfortable retirement income that matches my current salary, by living off the interest generated from my investments.
## Importance of Understanding Backdoor Roth IRA
Despite numerous discussions about the benefits of a backdoor Roth IRA, I still struggle to grasp its concept and why it is considered a valuable investment option. I am unsure of how it works and how it can contribute to my overall financial strategy for retirement.
### How AI Legalese Decoder Can Help
AI Legalese Decoder could provide me with a clear and simplified explanation of the mechanics behind a backdoor Roth IRA. By breaking down complex legal language and financial jargon into easily understandable terms, AI Legalese Decoder can empower me to make informed decisions about incorporating this investment strategy into my retirement planning. With its assistance, I can better comprehend the advantages of a backdoor Roth IRA and potentially optimize my financial portfolio for a secure retirement.
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It’s just a mechanism to allow you to put more of your money into a tax advantaged retirement account if you make too much money to contribute to an ira.
Beyond that’s it’s not really much different than an IRA or 401k.
It’s not even a type of account, it’s just a technique for moving money that sidesteps some of the irs limits.
If you make 120k a year then you just want a Roth IRA. No need to backdoor at that salary.
Depending on your income, you cannot contribute to a Roth IRA due to your income. You also cannot deduct a Trad IRA contribution.
So the choice is between a nondeductible Trad IRA whose earnings are always taxable upon withdrawal, and a Roth IRA whose earnings are (conditionally) tax free upon withdrawal.
So in your case your income is not high enough to necessitate a Backdoor Roth IRA.
Workplace retirement plans – like 401ks – have annual contribution limits of $23,000 per year. People like to max those out because they have attractive tax savings. Those tax savings come in two flavors; the traditional (default) flavor let’s you avoid paying income taxes on any money you contribute today, in exchange for paying taxes on withdrawals later. The Roth flavor is the opposite; you pay normal income taxes on the money you contribute today, but won’t have to pay anything when you withdraw it later. Which flavor is a better deal depends on how much those taxes are today vs in the future. That is, if your taxes are lower now, you should want to pay them now. Vs if they’ll be lower later, you’d want to defer paying them until later.
But what if you want to save more than $23,000 per year? You can also open an IRA – an individual retirement account – on your own, with a contribution limit of $7,000 per year. It’s just like your workplace 401k, with the same Traditional and Roth flavors. The rub, though, is that there are income limits on who can get the tax savings. If you earn to much, the government doesn’t want to give you the extra tax savings.
If you earn to much, and contribute to a traditional IRA, you won’t get the tax deduction for it when you file your taxes. And you straight up cannot contribute to a Roth IRA.
But there is a loophole that let’s you get money into a Roth IRA. The loophole is the so called “back door”. It is a way to avoid the income limit and still get money into the Roth IRA that would otherwise be ineligible. People do this so that they can avoid paying taxes on it in the future when they withdraw it.
TLDR: do you want to save more than $27,000 per year with tax advantages, but make too much to contribute directly to a Roth IRA? Then you should consider a backdoor Roth IRA contribution.
Why would you not want to take advantage of tax-free growth?
At a high enough income, you can afford to save lots of money (up to you whether you are a spender or a saver, as a personality type).
When you save money, you have some limits that constrain how much you can put into certain kinds of accounts.
If you are “full” on your 401k and your HSA bucket, then you have the option of using backdoor mechanism to access the Roth IRA bucket (that would otherwise be inaccessible to you, without the backdoor, due to income limits).
Let’s say hypothetically you have $7000 worth of unspent post-tax income lying around, at the end of your personal budget year. Let’s assume you choose to invest it, instead of spending it. Your only options are either: in a taxable brokerage account, or in a backdoor Roth IRA. If you put it into the taxable brokerage, you are willingly choosing to pay capital gains taxes on it later on. If you choose the Roth IRA, then you never have to pay capital gains taxes on it.
Given that choice, why would you willingly give more tax money to the government than you need to? And of course, you repeat this choice every budget year, so it really adds up quite a lot over decades.
(Of course I am oversimplifying, esp. some of the liquidity aspects of this choice, such as only being able to do penalty-free early withdrawal of Roth contributions but not gains, vs being able to withdraw brokerage money whenever you want… Honestly that degree of extra liquidity, is not worth the cost premium of paying 15-20% extra in taxes)
>Everyone keeps talking about a backdoor Roth IRA but I just don’t understand it? Why is it a good investment?
do you understand what’s the purpose of IRAs first of all?
since you already have a 401k plan at work:
Traditional IRA offers you no tax benefit since you make more than ~$80k/year, so contribution to Roth IRA becomes your only logical choice
then, once you make more than ~$150k/year (you’re not there yet) you’re flat out forbidden to contribute to Roth IRA either, so you do the backdoor way
that’s why
I thought I’d be right on the limit so I did a backdoor but when it came to tax time, it was calculating my rollover as a full withdrawal of $6500 when that’s how much I funded for the year. Was messed up.
An IRA let’s you save for retirement outside of a 401(k), you typically get a wider access to funds and no account fees.
If you are fine with your 401(k) and don’t max it out you don’t need an IRA.
Just like a 401(k), IRAs can be Traditional or Roth. However, high earners who have a 401(k) can’t deduct Traditional IRAs and make too much to qualify for Roth IRAs, but a backdoor is a process where you use tax loopholes to convert Traditional to Roth.
However, you are not above the Roth IRA income limit (unless your bonuses are >$20k), so you don’t even need to do a backdoor.
You have no rmd with a Roth and pay no taxes when withdrawing the money
Roth IRA:
* Unlimited investment options
* Can withdraw *contributions* before age 59.5 without penalty (but not gains)
* $7k contribution limit
Roth 401(k)
* Limited to plan’s investment options
* $23k contribution limit
It doesn’t have to be either-or, you can do both. With $120k income and aspirations to retire early, you probably *should* be doing both. You should definitely fully fund a Roth IRA before considering investing in a taxable brokerage.
Tax-free gains, that’s why. And more flexibility to combine taxable and tax-free withdrawals in retirement.
Pay tax now vs pay tax later. 401k = pay tax later when you don’t have as much income. Roth = pay tax now when you make more money (and have an external income stream).
If you do it, make sure it’s done right because you are looking at a 33% tax rate on it if it is done incorrectly
you know normally if you make too much money, you can’t directly contribute to a Roth IRA because there are income limits. But with a backdoor Roth IRA, you can sidestep those limits.
If you are currently making the 401k and think that is sufficient for when, where, and how you want to retire, fine. Just use the 401k. Even if you want to go over the regular limit, you can mega backdoor Roth within sone 401k plans to save more.
However, if you are maxed out and have spare cash, it’s never a bad idea to frontload savings. You never know when you might need to back off in the future. Having children (daycare), job loss, major home expense, etc.
Put some money in a Fidelity HSA for healthcare costs including Medicare premiums. And it’s tax deductible. You don’t pay taxes as long as you use it for medical expenses. Check it out.