The IRS provides individuals with two main ways to save money for retirement. One of these, the Roth IRA, consists of after-tax contributions to a retirement account. And while this is a standard tool used by many individuals for retirement savings with tax-free growth, there are restrictions and limitations to a Roth account.
But even if, on the surface, it doesn’t seem like you qualify for Roth contributions, you can get around these restrictions by using a backdoor Roth IRA. Not only will this allow you to contribute to an IRA, but it’s completely legal and sanctioned by the IRS.
Backdoor Roth IRA Explained
A backdoor Roth IRA is the method of contributing funds to a Roth IRA account for individuals who are otherwise restricted from doing so. The IRS limits Roth IRA contributions based on income, with high-income earners ineligible from making such contributions.
However, by making pre-tax contributions to a Traditional IRA and then rolling those funds over into a Roth IRA, anyone can contribute to a Roth IRA, regardless of income restrictions.
Why Choose a Roth IRA?
Profits from the sale of cryptocurrency can bring a hefty, unexpected tax bill. That’s why more and more investors are choosing to shelter their cryptocurrency investments in an IRA. For some investors using a Roth IRA would provide even more tax-related benefits than a Traditional IRA.
However, with single filer taxpayers with incomes above $161,000 and married filers earning more than $240,000, they cannot make contributions to a Roth IRA. Luckily, you can still contribute to one using a backdoor Roth IRA strategy if you fall into this category.
Here’s why this may be a smart move for you: will your tax bracket in retirement be higher than your current tax bracket?
For example, imagine you are currently in the 22% tax bracket today but expect that you might be in the 32% tax bracket in retirement. If you contribute to a Traditional IRA today, you will actually pay more in taxes when it comes time to withdraw in retirement. But, if you contribute to a Roth IRA and pay taxes on contributions at your current 22% rate today, you will be paying less than if you were to pay taxes at a 32% tax bracket in retirement.
The main advantage of the Roth IRA is that there are absolutely zero taxes when you withdraw it during retirement. If your Roth IRA investment triples or quadruples over the course of multiple decades, you can be left with a significant amount of money that you will never owe taxes on.
Here’s an extreme example– Peter Theil, a co-founder of PayPal, paid income taxes on then invested $2,000 in PayPal stock within his Roth IRA in 1999. Today in 2021, that initial investment has grown to over $5 billion. When Theil withdraws this money, he will never owe taxes on it– zip, zero, nada. If he invested the $2,000 in a Traditional IRA instead, he would have to pay a 37% tax bill or $1.85 billion (assuming he withdrew all $5 billion at once).
The differences between Traditional and Roth IRAs
- Contributions made on a pre-tax basis (no taxes paid on contributions)
- Individuals can deduct contributions in a given year from that year’s income
- Taxes paid on all contributions at the time of withdrawal
- The IRS enforces Required Minimum Distributions (RMDs) with a penalty for any missed RMDs
- No income-based contribution limit
- Contributions made on an after-tax basis (taxes paid on all contributions)
- Tax-free withdrawals in retirement
- No RMDs during your lifetime
- Income-based contribution limits
Setting Up a Backdoor Roth IRA
There are three ways to set up a backdoor Roth IRA:
- Convert an existing Traditional IRA to a Roth IRA directly: Take funds from your existing Traditional IRA and convert it to a Roth. Pay taxes on any contributions as well as any earnings made in the account before the conversion. For example, you have an existing Traditional IRA account that is 10 years old. When you roll it over to a Roth IRA, you will have to pay taxes on the entire balance– including all contributions and earnings you’ve made in the 10 year period.
- Contribute new funds to a Traditional IRA and roll funds into a Roth: The rollover is completed immediately after opening and funding a Traditional IRA account. This way, there are no earnings on the account and therefore no taxes to be paid. Remember, you will still need to pay taxes on your contributions. Rolling a Traditional IRA to a Roth IRA immediately after funding minimizes any taxes on earnings within the account. This is the preferred backdoor Roth strategy for investors, with many contributing the maximum limit and rolling it over the same day on a yearly basis.
- Make a new after-tax contribution to a 401k and roll it into a Roth account: Only applicable if your employer allows for after-tax contributions to their 401k plan. Use after-tax contributions to fund a Roth account using a rollover. And since these are after-tax contributions, you won’t have to worry about the tax implications of the rollover.
As previously mentioned, one of the most significant differences between a Roth and a Traditional IRA is taxes on contributions. While contributions to a Roth IRA are made after-tax, Traditional IRA contributions are made pre-tax. This means you don’t pay taxes on the income you contribute to a Traditional IRA, but you will have to once you convert it into a Roth. So, make sure to consider this fact when converting a Traditional IRA to a Roth.
Additionally, in accordance with the Roth IRA 5-year rule, you must wait 5 years after your first contribution to withdraw from your account tax-free. Otherwise, the withdrawal will be considered an unqualified distribution by the IRS, and you will incur both a 10% penalty plus taxes on any earnings withdrawn.
Can I Convert a Roth to a Traditional IRA?
Not anymore. While the backdoor Roth IRA allows investors to convert from a Traditional IRA to a Roth, investors have historically used another method to convert a Roth IRA back into a Traditional IRA. This method, known as Recharacterization, was once used by investors, but thanks to the 2017 Tax Cuts and Jobs Act, Recharacterization is no longer allowed.
As digital assets become more popular investment options for retirement accounts, it can be challenging to know whether to use a Traditional IRA or a Roth IRA to fund your digital asset purchases. Specialists at BitIRA are here to help you learn the benefits of either account and how you can use your new self-directed Roth or Traditional IRA (SDIRA) to invest in cryptocurrencies and enjoy the long-term benefits of a tax-advantaged retirement account.