Welcome, Future Early Retirees.

Roth IRAs are my favorite tax advantage account. Why? Because you pay ZERO taxes when you withdraw your earnings in retirement. Most people only know about the standard contribution limit of a yearly basis ($7,000 as of 2024) but what if I told there was a way to contribute even more than just that contribution limit? This is what is known as the backdoor IRA.

In today’s newsletter:

• Share Money Bags 💰

• Understanding the backdoor IRA

• Things I found interesting

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Understanding the backdoor IRA

What is a Roth IRA?

A Roth IRA (Individual Retirement Account) is a special type of retirement account where you contribute after-tax dollars. This means you've already paid income tax on the money you put in, but in return, you get significant benefits:

• Tax-Free Growth: All the earnings on your investments within the Roth IRA grow tax-free.

• Tax-Free Withdrawals: If you follow certain rules (like waiting until you're 59½ and the account has been open for at least 5 years), you can withdraw your contributions and earnings without owing any federal tax.

• No Required Minimum Distributions (RMDs): Unlike traditional IRAs, you're not required to start taking withdrawals at age 73, allowing your money to potentially grow for longer.

However, one catch is the income limit; for 2024, if your Modified Adjusted Gross Income (MAGI) exceeds $161,000 for single filers or $240,000 for joint filers, you can't directly contribute to a Roth IRA.

The Backdoor Roth IRA Strategy

Here's where the backdoor Roth IRA comes into play, offering high-income earners a way to still enjoy the benefits of a Roth IRA:

• Open a Traditional IRA: First, you need to have or open a Traditional IRA. This is crucial because the strategy involves converting pre-tax contributions to after-tax Roth contributions.

• Make a Non-Deductible Contribution: Contribute money to your Traditional IRA on an after-tax basis. For 2024, you can contribute up to $7,000 ($8,000 if you're 50 or older). Remember, this contribution is not tax-deductible since you're doing this for the backdoor strategy.

• Convert to a Roth IRA: Immediately after contributing to your Traditional IRA, convert those funds to a Roth IRA. This step should be done as soon as possible to avoid any earnings in the Traditional IRA, which could complicate your tax situation.

• File Form 8606: When you file your taxes, you'll need to complete IRS Form 8606 to report the non-deductible contribution to your Traditional IRA and the subsequent conversion to a Roth IRA. This form helps ensure that you're not taxed on the conversion of after-tax dollars.

Important Considerations

• Pro-Rata Rule: If you have other traditional IRA funds with pre-tax contributions, the conversion might not be entirely tax-free due to the pro-rata rule. This rule averages out your pre-tax and post-tax contributions across all your IRAs, potentially making part of your conversion taxable. To avoid this, you might consider rolling pre-tax IRA funds into an employer's plan like a 401(k) before doing the conversion.

• Tax Implications: If you've already benefited from a tax deduction on traditional IRA contributions, converting to a Roth IRA will incur taxes on the converted amount unless it's all after-tax money.

• Record Keeping: Keep meticulous records of your IRA contributions and conversions, especially if you plan to do this annually, as these records are essential for tax purposes.

Implementation Tips

• Consult a Professional: Given the complexities, speaking with a financial advisor or tax professional can ensure you're doing everything correctly, particularly if your financial situation is complex.

• Timing: It's advisable to perform the conversion within the same year to manage tax implications effectively.

• Annual Strategy: You can use this strategy every year, but remember the annual contribution limits apply to the sum of all IRA contributions, not just to the backdoor Roth.

In summary, the backdoor Roth IRA strategy can be an excellent tool for high-income earners to gain the tax advantages of a Roth IRA. By understanding and implementing these steps carefully, you can set yourself up for tax-free growth in retirement.

Thank you for reading!

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