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What Is a Backdoor Roth IRA?

Editorial Note: The editorial content on this page is not provided or commissioned by any financial institution. Any opinions, analyses, reviews, statements or recommendations expressed in this article are those of the author’s alone, and may not have been reviewed, approved or otherwise endorsed by any of these entities prior to publication.

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Whether you’re a freelancer or a salaried employee looking to supplement a company-sponsored retirement plan like a 401(k), an individual retirement account (IRA) can be a powerful tool to help you reach your financial goals. These self-directed retirement funds are readily available through commercial brokerages and can make investing accessible regardless of your employment situation.

There are two types of IRAs: Roth and traditional. With traditional IRAs, contributions are tax-deductible, but the distributions you make later — including earned appreciation from compound interest — will be taxed. The opposite applies to Roth IRAs. Roth IRA contributions are taxed today, but they grow tax-free, which means you get to make the most of your gains in retirement. Furthermore, Roth IRAs are not subject to required minimum distributions (RMDs), which means you can let your contributions earn interest indefinitely.

However, all IRAs are subject to certain restrictions and limitations by the IRS. For instance, you can fund an IRA only up to the specified contribution limit ($6,000 in 2019), and Roths are available only to those who make less than a certain income threshold. For 2019, the income threshold is $203,000 for those who are married and filing jointly and $137,000 for single filers.So what’s a high earner who wants to benefit from the unique tax advantages of a Roth account to do?

Enter the Roth IRA conversion, also known as the “backdoor Roth.”

What is a backdoor Roth IRA?

A backdoor Roth is a basically a quasi loophole — but a totally legal one. The process is simple: You open a traditional, nondeductible IRA, make after-tax contributions and then transfer the assets to a Roth afterward.

This allows those who earn more than the income maximum set by the IRS to access the tax benefits of a Roth even though they’re ineligible to directly fund a Roth IRA.

It may sound sneaky, but a backdoor Roth IRA is totally legal. However, converting a traditional IRA to a Roth doesn’t mean you get to skip paying taxes entirely, and there are some important Roth conversion rules to consider before you take on this financial strategy.

Can you avoid taxes with a backdoor Roth IRA?

In short, no.

Whether you’re contributing to a traditional or a Roth IRA, you’re still responsible for taxes. The only question is when you’ll have to pay them. Remember that traditional IRA contributions are tax-deductible today but taxed when you make distributions. Roth contributions will count toward your taxes this year but can grow tax-free thereafter.

In order to take a backdoor Roth, however, you must fund a nondeductible traditional IRA in the first place. That means you’ll already pay taxes on your contributions. Then, when you convert that traditional IRA to a Roth, you’ll be responsible for the taxes on any gains, which will be allowed to grow tax-free thereafter (just like in any Roth account).

If your newly converted Roth IRA is the only one you have, your tax liability will be triggered just that once — at the time of the transfer. If you have several IRAs or if the IRA you’re converting has been funded with both post-tax and pretax dollars, then things get a little bit more complicated. Your total tax liability will be calculated according to something called the pro rata rule.

What is the pro rata rule?

The pro rata rule is also known as the IRA aggregation rule or the “cream-in-your-coffee rule.”

It might seem complex at first, but the idea is actually pretty simple: If you have both pretax and post-tax contributions in your IRA accounts, all those funds must figure in when calculating your tax liability. In other words, they can’t be separated out into categories, just like you can’t separate the cream from your coffee once you add it.

Instead, you’ll be required to pay income tax on a pro rata share of both. Once again, the question isn’t if you’re going to pay taxes; it’s when you will pay taxes.

For instance, let’s say you contribute the $6,000 maximum to a nondeductible, traditional IRA with the intention to take the backdoor Roth option. But you also have a rollover IRA with $94,000 in it, which you transferred from a 401(k) (so it was funded with pretax, deductible contributions). That means 94% of the total value of your IRA accounts would be subject to income tax at the time you make the Roth conversion. Here’s the math:

Total value of both accounts: $100,000
Pretax contribution: $94,000
After-tax contribution: $6,000
$6,000 ÷ $100,000 (expressed as percentage) = 6%
$6,000 (the amount converted) x 6% = $360 converted tax-free
$6,000 – $360 = $5,640 subject to income tax

However, once you pay the taxes on your contributions, you’re home free. You’ll be able to take tax-free distributions once you reach age 59 and a half as long as the account’s been open for at least five years.

Is a backdoor Roth IRA right for me?

Since the pro rata rule could complicate your conversion and trigger a heavy tax burden, Malik S. Lee, founder of Felton & Peel Wealth Management, said the backdoor Roth IRA is best for high earners who don’t yet have any IRA assets.

“Ideally, this is not really a strategy you want to do when you have a large number of IRAs already in place,” he said.

If you’re earning more than the listed limits, the backdoor Roth can help you diversify your retirement holdings or pass on nontaxable assets to your heirs. Since the taxes are already taken out, the Roth is especially useful for those who have a long time horizon in which money can grow.

Timing your backdoor Roth IRA conversion

Once you understand how to initiate a backdoor Roth IRA conversion — and what your tax liability will be when you do — there’s another important issue to consider: timing. You’ll need to pay your taxes when you make the conversion.

If you know you’re going for the backdoor option, Lee suggested you take action quickly, leaving the assets in cash so you can execute the transfer as soon as possible. “I don’t really see a benefit in waiting,” he said, explaining that he usually initiates the transfer “as soon as the check clears.”

After all, if you do invest the money while it’s still in a traditional IRA, you may end up paying taxes on those gains.

The bottom line

Although there’s no way to avoid taxes entirely, a backdoor Roth IRA is a good option for high earners who want to take advantage of the unique benefits of a Roth account. Not only will your distributions come tax-free when you reach retirement, but you’ll also be allowed to let the money grow indefinitely (as opposed to being subject to RMDs).

If a backdoor Roth doesn’t sound like the right path for your personal financial goals, there are lots of other options to help high-income savers fund their retirement. For example, you might ask your employer if it offers a Roth 401(k) option or open a SEP IRA, which features much higher contribution limits: up to $56,000 or 25% of your compensation for 2019.

Advertiser Disclosure: The products that appear on this site may be from companies from which MagnifyMoney receives compensation. This compensation may impact how and where products appear on this site (including, for example, the order in which they appear). MagnifyMoney does not include all financial institutions or all products offered available in the marketplace.

Jamie Cattanach
Jamie Cattanach |

Jamie Cattanach is a writer at MagnifyMoney. You can email Jamie here

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Investing

Should You Pay Off Debt or Save Your Money?

Editorial Note: The editorial content on this page is not provided or commissioned by any financial institution. Any opinions, analyses, reviews, statements or recommendations expressed in this article are those of the author’s alone, and may not have been reviewed, approved or otherwise endorsed by any of these entities prior to publication.

You have a regular source of income, you’re paying your bills on time and you have some extra dollars left over each month. What should you do with that extra cash?

If you don’t have debt (lucky you!), then the choice is simple — save or invest as much as possible. If you have debt, however, the choice can be a bit murkier: Should you pay off your debt first or save? Here are some things to consider when asking yourself that question.

Three times that saving your money might be smarter

1. If you don’t have an emergency savings fund

Just when you’re cruising along, life can throw some unexpected and expensive curves your way. A sudden job loss, medical bills or car repairs can pop up out of the blue, and if you don’t have the funds to pay for them, you can end up seriously in the red. To cover unexpected costs, some may resort to high-interest credit cards and loans. Those kinds of moves can dig you into a financial hole that can take years to pay your way out of.

Saving up a healthy emergency fund can protect you in instances like these. How much should you save? Experts generally suggest that you should save an amount equal to between three and six months of living expenses. Depending on your individual circumstances, however, you may need more than that. (Check out this article to figure out how much to save and where to keep it.)

2. Your employer offers matching retirement contributions

If you’re fortunate enough to work for a company that offers a retirement plan with matching contributions, then consider making that method of saving a priority.

For example, if your employer offers to match your contributions dollar-for-dollar up to 6% of your salary in a 401(k) plan, then contribute at least that much, if possible. The money can then grow in a tax-free or tax-deferred 401(k) until you withdraw it in retirement — all that compound interest can really add up over the years. If you don’t contribute up to that amount, you’re leaving free money on the table.

Note, however, that If you need to withdraw these funds early (before the age of 59 and a half and before the account is five years old) there will be penalties to pay. That makes this a better tool for long-term savings rather than for the short-term or as an emergency savings fund.

3. Your debt has a very low interest rate

Debt gets a bad rap — often for good reason — but in some cases, carrying your low-interest debt and investing or saving your funds instead may be more beneficial. For example, the current fixed interest rate for direct subsidized and unsubsidized student loans is 5.05%, and the average 30-year fixed mortgage rate is about 4.3%. The stock market, on the other hand, has gone up an average of 10% a year since 1926.

Beyond comparing interest rates, however, you also need to assess how much risk you’re willing to take and how much access to your savings that you’ll need. Of course, there are no guarantees that your investments will perform well, and paying down debt comes with zero risk. Savings accounts are a less risky saving option, but the average interest rate is often less than 1 or 2%. Other options, such as individual retirement accounts (IRAs), have restrictions on how the funds can be used outside of retirement.

Four times debt repayment may be more beneficial

1. You have high-interest debt

It’s hard to get ahead of high-interest debt, because compound interest is working against you. Credit card interest rates, for example, average between 15 and 20% — an amount which adds up quickly. If you make the minimum payment, you may not even be making a dent in the principal amount owed, and you can spend years just paying interest. Calculators like this one can help you figure out just how much interest you’ll pay and how long it will take to pay off.

If you have high-interest debt, make sure you explore all the options for paying it down, including consolidating your debt and researching balance transfer cards.

2. Your debt doesn’t offer any benefits

Though your debt is costing you in interest, you might find that some loans may offer useful perks. For example, federal student loans may offer tax benefits and even loan forgiveness programs for eligible borrowers. Similarly, there are tax write-offs for mortgages and in many cases, the money you invest in a home will pay off down the line when you sell your property.

On the other hand, the debt on the credit card you maxed out to pay for that trip to Cabo comes with no benefits — just a bunch of interest. High-interest debt with no benefits should be at the top of your pay-off priority list.

3. You want to raise your credit score

While there are many factors that go into determining your credit score, the amount of debt you carry is an important component. If you plan to buy a home or secure a loan in the near future, take a look at your debt-to-income ratio (DTI), which many lenders consider before approving you for a loan. If your DTI is high, you may want to consider paying off some debt before applying for that new loan, which may result in lower interest rates for you later.

4. Your debt stresses you out

Debt can take an emotional and physical toll on people, ranging from depression to insomnia and more. When it feels like a black cloud hanging over your head and it’s affecting your life in negative ways, it may be in your best interest to prioritize paying debt off first.

Should you pay off debt or save?

Of course, saving vs. paying off debt early doesn’t have to be an either/or situation — ideally, you can do both at the same time. If, however, a choice must be made between the two, there are many factors to consider. As with most financial moves, there are no cut-and-dry rules, and the best one for you will depend on your individual circumstances.

Advertiser Disclosure: The products that appear on this site may be from companies from which MagnifyMoney receives compensation. This compensation may impact how and where products appear on this site (including, for example, the order in which they appear). MagnifyMoney does not include all financial institutions or all products offered available in the marketplace.

Julie Ryan Evans
Julie Ryan Evans |

Julie Ryan Evans is a writer at MagnifyMoney. You can email Julie here

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Investing

How to Make Money in Stocks

Editorial Note: The editorial content on this page is not provided or commissioned by any financial institution. Any opinions, analyses, reviews, statements or recommendations expressed in this article are those of the author’s alone, and may not have been reviewed, approved or otherwise endorsed by any of these entities prior to publication.

Putting money in the market is well-worn financial advice for a reason: Investing in stocks is one of the best steps you can take toward building wealth.But how, exactly, is that wealth built? How is money earned by purchasing stock market holdings, and what can you do to maximize the gains you make from your own portfolio?

How to make money in stocks: 5 best practices

The way the stock market works — and works for you — is as simple as a high school economics class. It’s all about supply and demand, and the way those factors affect value.

Investors purchase market assets like stocks (shares of companies), which increase in value when the company does well. As the company in question makes financial progress, more investors want a piece of the action, and they’re willing to pay more for an individual share.

That means that the share you paid for has now increased in price, thanks to higher demand — which in turn means you can earn something when it comes time to sell it. (Of course, it’s also possible for stocks and other market holdings to decrease in value, which is why there’s no such thing as a risk-free investment.)

Along with the profit you can make by selling stocks, you can also earn shareholder dividends, or portions of the company’s earnings. Cash dividends are usually paid on a quarterly basis, but you might also earn dividends in the form of additional shares of stock.

Micro-mechanics of how stocks earn money aside, you likely won’t see serious growth without heeding some basic market principles and best practices. Here’s how to ensure your portfolio will do as much work for you as possible.

1. Take advantage of time

Although it’s possible to make money on the stock market in the short term, the real earning potential comes from the compound interest you earn on long-term holdings. As your assets increase in value, the total amount of money in your account grows, making room for even more capital gains. That’s how stock market earnings increase over time exponentially.

But in order to best take advantage of that exponential growth, you need to start building your portfolio as early as possible. Ideally, you’ll want to start investing as soon as you’re earning an income — perhaps by taking advantage of a company-sponsored 401(k) plan.

To see exactly how much time can affect your nest egg, let’s look at an example. Say you stashed $1,000 in your retirement account at age 20, with plans to hang up your working hat at age 70. Even if you put nothing else into the account, you’d have over $18,000 to look forward to after 50 years of growth, assuming a relatively modest 6% interest rate. But if you waited until you were 60 to make that initial deposit, you’d earn less than $800 through compound interest — which is why it’s so much harder to save for retirement if you don’t start early. Plus, all that extra cash comes at no additional effort on your part. It just requires time — so go ahead and get started!

2. Continue to invest regularly

Time is an important component of your overall portfolio growth. But even decades of compounding returns can only do so much if you don’t continue to save.

Let’s go back to our retirement example above. Only this time, instead of making a $1,000 deposit and forgetting about it, let’s say you contributed $1,000 a year — which comes out to less than $20 per week.

If you started making those annual contributions at age 20, you’d have saved about $325,000 by the time you celebrated your 70th birthday. Even if you waited until 60 to start saving, you’d wind up with about $15,000 — a far cry from the measly $1,800 you’d take out if you only made the initial deposit.

Making regular contributions doesn’t have to take much effort; you can easily automate the process through your 401(k) or brokerage account, depositing a set amount each week or pay period.

3. Set it and forget it — mostly

If you’re looking to see healthy returns on your stock market investments, just remember — you’re playing the long game.

For one thing, short-term trading lacks the tax benefits you can glean from holding onto your investments for longer. If you sell a stock before owning it for a full year, you’ll pay a higher tax rate than you would on long-term capital gains — that is, stocks you’ve held for more than a year.

While there are certain situations that do call for taking a look at your holdings, for the most part, even serious market dips reverse themselves in time. In fact, these bearish blips are regular, expected events, according to Malik S. Lee, CFP® and founder of Atlanta-based Felton & Peel Wealth Management.

So-called market corrections are healthy, he said. “It shows that the market is alive and well.” And even taking major recessions into account, the market’s performance has had an overall upward trend over the past hundred years.

4. Maintain a diverse portfolio

All investing carries risk; it’s possible for some of the companies you invest in to underperform or even fold entirely. But if you diversify your portfolio, you’ll be safeguarded against losing all of your assets when investments don’t go as planned.

By ensuring you’re invested in many different types of securities, you’ll be better prepared to weather stock market corrections. It’s unlikely that all industries and companies will suffer equally or succeed at the same level, so you can hedge your bets by buying some of everything.

5. Consider hiring professional help

Although the internet makes it relatively easy to create a well-researched DIY stock portfolio, if you’re still hesitant to put your money in the market, hiring an investment advisor can help. Even though the use of a professional can’t mitigate all risk of losses, you might feel more comfortable knowing you have an expert in your corner.

How the stock market can grow your wealth

Given the right combination of time, contribution regularity and a little bit of luck, the stock market has the potential to turn even a modest savings into an appreciable nest egg.

Ready to get started investing for yourself? Check out the following MagnifyMoney articles:

Advertiser Disclosure: The products that appear on this site may be from companies from which MagnifyMoney receives compensation. This compensation may impact how and where products appear on this site (including, for example, the order in which they appear). MagnifyMoney does not include all financial institutions or all products offered available in the marketplace.

Jamie Cattanach
Jamie Cattanach |

Jamie Cattanach is a writer at MagnifyMoney. You can email Jamie here

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