Back Door Roth-IRA Conversion: A Tool To Build Tax-free Wealth
Photo by Morgan Housel / Unsplash

Back Door Roth-IRA Conversion: A Tool To Build Tax-free Wealth

OMG! Retirement!

So you want to build long-term wealth AND you don't want to pay taxes? Asking a lot, aren't you? You're in luck. Congress gave you a tool to do just that. It's called Roth-IRA.  

What is Roth-IRA?

Roth-IRA is Individual Retirement Account (IRA) to which one contributes post-tax money and since the money has already been taxed, you never have to pay taxes on the balance in Roth-IRA account. This is even true for any gains you might have in the account. Roth-IRA is a dream come true for any long-term investor who wants to build wealth over time.

Why is a Roth-IRA Conversion Needed?

Simple, if you make over the income limits set by IRS, you can't contribute directly to a Roth-IRA and you must use the Roth-IRA converion to get around the income limits.

There are rules associated with how and who can contribute to a Roth-IRA account. There are income limits and contributions limits to a Roth-IRA conversion. First, let's tackle the income limits and to help you understand this, I created the below flow chart to hopefully make it easy for you to figure out if you qualify.

The income limits in the flow chart are for tax year 2023.

Now that we have covered who can and cannot contribute to a Roth-IRA, let's now talk about how much you can contribute. Below is a simple table to help you figure out how much you can contribute:

*2023 IRS limit for Roth-IRA contribution is $6,500
*If you're over the age 50, you can contribute an additional $1,000

When contributing  to a Roth-IRA, you typically use post-tax dollars, meaning money is already in your bank account. Once you deposit that money into a Roth-IRA, you can never be taxed on it again. This is precisely the reason rich people use this wealth generation strategy to grow their money over a long period.

Pro tip: there are many variables that go into figuring your taxes and qualification for Roth-IRA contribution. If you're not sure, please consult a financial advisor or a tax consultant.

Mechanics of Roth-IRA conversion

By now you've probably figured out Roth-IRA conversion is not a normal financial transaction. So how do you use the back door Roth-IRA? Once you've figured out your income limit restrictions, it's a fairly simple process.

  1. First, you contributed up to $6,500 (for tax year 2023) into a traditional-IRA account
  2. Wait for funds to clear and settle in the traditional-IRA account, usually takes a few days.
  3. Your brokerage should have a button that's labeled "convert to Roth-IRA" available to you, click this button to convert Traditional-IRA to Roth-IRA. You may have to call your brokerage firm to do this over the phone.
  4. Once you've converted the funds from a Traditional-IRA to Roth-IRA, the only thing left to do is to invest the money and enjoy twax-free growth.

Consider choosing a ETF or stock that offers dividends to take advantage of compound interest. Roth-IRA accounts should hold investments that generate income and growth and since you don't have to ever pay taxes on any gains, it's a perfect strategy for wealth creation.