Because Roth IRA’s have income limits, this means that those who make a certain level of annual income are prohibited from contributing directly (herein referred to as “regularly”) to a Roth IRA.
Backdoor Roth IRA Strategy
However, there is a common method so called the “Backdoor Roth IRA” strategy for high-earners (annual pre-tax income above $146k for Single tax filers or $230k for Married filers) to still be able to get funds into a Roth IRA via a conversion. Search this Backdoor Roth IRA term in your browser of choice and hundreds of articles will appear on the mechanics of doing so.
Roth IRA Contributions vs Roth IRA Conversions
Assuming the Backdoor Roth IRA strategy is optimized (meaning nearly 100% of your conversion amount from the Traditional IRA to the Roth IRA is not taxable), there is still 1 major difference between the Backdoor Roth IRA Strategy compared to a Regular Roth IRA Contribution. The key difference is a Regular Roth IRA is a contribution while the Backdoor Roth strategy leverages a conversion. And the rules for contributions differ from those of conversions as it pertains to penalty-free access to the principal.
Principal Amount - Defined
Another term for principal is your “Basis”, or the amount you originally put in yourself. For example, if you put in $7,000 to a Roth IRA, the amount grew by $500 up to $7,500, the principal amount in this example is the $7,000 (what you put in). The earnings of $500 in this example are subject to different rules that are beyond the scope of this post.
The Key Difference Explained
The principal/basis amount put in via Regular Roth IRA contributions are ALWAYS available to be withdrawn, both tax and penalty free. Free and clear. Anytime.
But the principal/basis on conversions are subject to a 5-year waiting period if you are not at least Age 59.5 to dodge an early 10% withdrawal penalty! Given the Backdoor Roth IRA strategy has to leverage a conversion to get money into the Roth IRA, a 10% hurdle rate in the form of an early withdrawal penalty awaits you if you pull out the principal/basis amount within 5-tax years from the time of the conversion!
What about my Roth 401k dollars with my previous employer? Could I roll those to a Roth IRA and tap those?
Because there are no income limits as it pertains to contributing to a Roth 401k, they would at a minimum assume similar ‘character’ as the Regular Roth IRA rules explained above if Roth 401k funds were rolled over to a Roth IRA. This again assumes the Roth 401k account holder was under Age 59.5 and had the Roth 401k for less than 5 years before rolling it to the Roth IRA.
Strategic Retirement Accumulation Strategy
Getting retirement dollars into Roth can play an integral role in planning for a tax-efficient retirement. But know the rules before you play the game! If you are wanting to start building your financial house on the rock so you can weather the storms of future changes in tax rates and laws, economic cycles, and begin to truly optimize your comprehensive financial plan from a fiduciary financial advisor, please check out our website, services, transparent pricing, or book a complimentary 45-minute Discovery Call!
About the Author
Zack Gutches, CFP®, CPA is a fiduciary Christian Financial Advisor who provides integrated financial planning, tax preparation, and investment management services for Christian professionals and families in Denver's Central Park, Montview, and Lowry neighborhoods as well as nationwide virtually.
