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.
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.
- First, you contributed up to $6,500 (for tax year 2023) into a traditional-IRA account
- Wait for funds to clear and settle in the traditional-IRA account, usually takes a few days.
- 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.
- 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.