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Whats the difference between a Roth IRA and a traditional IRA?
A Roth IRA is very similar to a traditional IRA: You can make consistent contributions to your Roth, which will be invested in the market allowing the money to grow over time so you have a healthy savings when you reach retirement age.
But Roth IRAs have a few components that make them stand out from your traditional IRA. Here's what makes them unique:
- When you withdraw your contributions from a Roth IRA in retirement, those withdrawals are generally tax free (as long as your account has been open for at least five years) and they don't count as income. Withdrawals in retirement from a traditional IRA and 401(k) will be taxed as income.
- Contributions into a Roth IRA use after-tax dollars, unlike contributions to a traditional IRA or 401(k), which are not taxed. This may be a bigger hit to your finances in the short term, but your money will grow tax free.
- If you withdraw earnings you've made on investments in a Roth IRA before age 59 and a half, you'll incur a 10% early withdrawal penalty and may be subject to income tax.
- There are exceptions to the early withdrawal penalty on Roth IRAs, including taking out funds for first-time home purchases, college expenses and birth or adoption expenses.
- Your tax filing status and income level determine whether or not you can contribute to a Roth IRA: if married filing jointly, the annual income threshold is below $208,000; if single, the income threshold is below $140,000; if married filing separately and you lived with your spouse, the income threshold is below $10,000.
We dig into these differences a little bit more in the FAQs below.
The Pro-Rata Calculation Formula
With the pro-rata rule, the IRS considers all IRAs as one IRA. That includes balances in traditional IRAs, SEP IRAS, and Simple IRAs.
Roth IRA and inherited IRA balances do not count in the calculation. Non-IRA employer plan balances get excluded as well. Here’s how to calculate the pro-rata rule:
Total after-tax amounts in all applicable IRAs (those listed above) / Total balance of all applicable IRAs = % of the tax-free distribution.
Because Katy has $95,000 in a traditional IRA consisting of pre-tax money, she will be subject to the pro-rata rule. Instead of the $6,000 conversion being tax-free, only 5.90% or $354.00 is tax-free. The remaining $5,646 gets taxed at her ordinary income tax rate.
Here is the calculation – $6,000/101,000=5.90% or $354.00(5.90% X $6,000). Katy is married. Their combined income falls into the 24% tax bracket. *That means the tax due on the conversion $1,355.00 ($6,000- $354 =$5,646 x 24%). I’m sure Katy would not be happy getting the extra tax bill.
* The calculation may not represent Katy’s actual tax. The above example does not take into consideration tax deductions and other factors that impact the tax paid. It is meant to show how the pro-rata calculation is done.
How to Contribute to a Backdoor Roth IRA through Fidelity
Vanguard and Fidelity are two of the largest providers of IRAs and retirement plans. Below are the steps to implement a backdoor Roth IRA at Fidelity. For a look at the Vanguard process, see this post.
Step 2: Convert Fidelity Traditional IRA to Roth IRA
If you don’t yet have a Roth IRA at Fidelity, you can open one up from the exact same place you opened up the traditional IRA from.
Log back in the next business day and hit “Transfer” at the top.
Just transfer $6,000 from your traditional IRA to your Roth IRA.
Do not have taxes withheld because there will not be any due.
Convert the entire balance. Be sure to leave the account open for next year.
To determine which Roth IRAs are the best for investors, Select analyzed and compared Roth IRAs offered by national banks, investment firms, online brokers and robo-advisors. We narrowed down our ranking by only considering those that offer commission-free trading of stocks and ETFs, as well as a variety of investment options so you can best maximize your retirement savings.
We also compared each Roth IRA on the following features:
- $0 minimum deposit: Most of the Roth IRAs on our ranking don't have minimum deposit requirements.
- Low fees: We considered each Roth IRA's fees, commission trading fees and transaction fees.
- Bonus offered: Some Roth IRAs offer promotions for new account users.
- Variety of investment options: The more diversified your portfolio, the better. We made sure our top picks offer investments in stocks, bonds, mutual finds, CDs and ETFs. Most also offer options trading.
- A hub of educational resources: We opted for Roth IRAs with an online resource hub or advice center to help you educate yourself about retirement accounts and investing.
- Ease-of-use: Whether accessing your Roth IRA via your laptop at home or on your smartphone while on the go, it's important to have an easy user experience. We noted when an investment platform excelled in usability.
- Customer support: Every Roth IRA on our list provides customer service available via telephone, email or secure online messaging.
After reviewing the above features, we sorted our recommendations by their appeal to beginner investors who are likely just starting out in their careers since Roth IRAs are the most effective retirement savings vehicles if you're in a lower tax bracket.
Your earnings on contributions to a Roth IRA depend on any associated fees, the contributions you make to your account and the fluctuations of the market.Editorial Note: Opinions, analyses, reviews or recommendations expressed in this article are those of the Select editorial staff’s alone, and have not been reviewed, approved or otherwise endorsed by any third party.