What is a Backdoor Roth IRA?
A Roth IRA is an individual retirement account (IRA) containing investments benefiting from tax-free growth, and qualified tax-free distribution or withdrawal (pending exemptions). You pay taxes on the amounts contributed to a Roth IRA today in exchange for not having to pay taxes in the future. Roth IRAs are a great strategy for making sure you have access to before-tax and after-tax dollars in retirement.
Congress has limited those who can contribute to a Roth IRA to taxpayers who earn below $132,000 for single filers and $194,000 for joint filers (these numbers change ever year). However, since 2010, the government allows anyone, regardless of income, to convert a Traditional IRA to a Roth IRA by paying income tax on any account balance being converted that has not already been taxed.
Therefore, each year I make a Traditional IRA contribution of $5,500 (the contribution limit as of 2017). Because my income is too high to allow for this contribution to be tax-deductible, my contribution is known as a non-deductible contribution. In other words, I’m not deducting it from my income in the current year, so I will pay income taxes on the $5,500 contribution (i.e. it counts as part of my taxable income).
Because I am allowed to convert a Traditional IRA to a Roth IRA regardless of income, I then convert the non-deductible Traditional IRA to a Roth IRA and pay income tax on any amount of the account balance being converted that has not already been taxed. In our case, that’s zero since we’ve included the contribution amount in our taxable income, so we pay no taxes on the conversion.
The end process leaves me with a $5,500 contribution to my Roth IRA. This is known as the “backdoor” Roth IRA contribution. Congress and the IRS are very aware of the loophole and so far have decided not to close it. Vanguard even publishes guidance on the benefits of the backdoor conversion.
Do I Need To Contribute via the Backdoor?
If you make less than $117,000 as a single person (or $184,000 married filing jointly), you can make a regular contribution to a Roth IRA. There is no reason to use the “backdoor”.
If your income is above these amounts, you should make a backdoor contribution to your Roth IRA.
Ready to make a backdoor Roth IRA contribution? Let’s get started. Each step below tells you what to do and how to do it.
STEP 1) Convert/Remove “Other” IRAs
If you don’t have any Traditional, SEP or SIMPLE IRAs with pre-tax money, go directly to step 2. You might have a Traditional IRA if you made pre-tax contributions to an IRA before law school or you changed jobs and rolled a previous 401(k) balance to a Traditional IRA.
If you do have pre-tax money in an IRA, you must decide if you want to pay taxes on the conversion today (if so, jump to step 2). If you have a high income, you probably don’t want this money taxed at your current marginal rate and would prefer to keep it pre-tax so you can withdraw it in retirement later at what’s likely to be a lower effective tax rate.
Assuming you don’t want it taxed, you need to remove the pre-tax money. This is because the IRS won’t let you just convert the non-deductible portion of your IRA. You must convert both the non-deductible portion and the pre-tax money, pro rata, when you convert to a Roth IRA. If you’re not careful and skip this step, you’ll end up having to pay taxes on the pro rata portion of the pre-tax money since you’re converting it from pre-tax to after-tax. By December 31st of the each tax year you do a Backdoor Roth IRA, you can’t have any pre-tax money in your IRAs (unless you’re planning on paying taxes on any pre-tax money you convert).
You have a few options to remove the pre-tax money in any existing IRAs:
- Pay Taxes Now. As discussed above, you can pay taxes on the conversion today. The pre-tax money will be counted as part of this year’s taxable income.
- Reverse Rollover. The IRS allows you to transfer existing pre-tax money to an employer retirement plan (see IRS Publication 509A). Essentially, you can take all of your pre-tax money and drop it into your work’s 401(k) plan (or something similar). If you have good investment options in your workplace’s 401(k) plan, rolling the money over is a good idea anyway as you’ll consolidate your pre-tax money in one place. For this, your work’s retirement plan must accept incoming rollovers. Check with your HR department.
- Solo 401(k). If your work’s plan does not accept incoming rollovers, you’ll need to have some self-employment income so you can establish a solo 401(k) plan. You don’t need to make a lot of self-employment income to set this up, just a little money will allow you to set up a Solo 401(k) for yourself which you can then use to accept the incoming transfer from your traditional IRA.
STEP 2) Make a Non-Deductible Contribution to a Traditional IRA
Now that you don’t have any pre-tax money in your IRAs, it’s time to make the non-deductible contribution to a Traditional IRA. Even if your income is “too high” you can make a non-deductible contribution. If you don’t have a Traditional IRA account, you’ll need to open one. If you do have one, it should have a zero balance like mine does below. There are no special steps to make it a “non-deductible” contribution, just make the contribution.
STEP 3) Wait At Least One Day
Vanguard forces you to wait one day for the funds to settle before you can convert your Traditional IRA to a Roth IRA. Some people believe you should wait longer and point to the Step Transaction Doctrine as evidence. In short, the step transaction doctrine is a judicial determination that a series of formally separate steps can be collapsed into a single step for tax purposes. In other words, theoretically the contribution to the Traditional IRA and subsequent conversion to a Roth IRA could be viewed as a direct contribution to the the Roth IRA, which would be prohibited. I have never heard of the IRS invoking the step transaction doctrine for a backdoor Roth IRA contribution. Please let me know if you are aware of it ever being invoked. Personally, I make the conversion the very next day.
STEP 4) Convert From Traditional to Roth
From the Vanguard website, go to your Traditional IRA Brokerage Account and click on “Convert to Roth IRA”.
On the conversion page, select that you’d like to convert all of the account into your Roth IRA. If you have an existing Roth IRA, the conversion will roll the funds into your current account. If you need to open a new Roth IRA account, you can do that too. At the end of the day, you only need one Roth IRA account and each year you will roll that year’s contribution into the single account.
After you click on “Continue”, the website will display a scary tax notice (Update 2018: This year I didn’t see the scary tax notice, so don’t be alarmed if you don’t get it). Remember, as we discussed earlier, the conversion from a Traditional IRA to a Roth IRA is a taxable event. In your case, the taxes will be zero, so it’s not a problem. Why? Because you made a non-deductible contribution to your Traditional IRA. Income tax would only be due if you are converting a deductible Traditional IRA (i.e. pre-tax money) into a Roth IRA (i.e. post-tax money). You’re converting post-tax money into post-tax money, so no taxes are due.
After the conversion, congratulations! You’ve made a successful “backdoor” contribution to your Roth IRA. You are now free to invest the money in your Roth IRA account.
STEP 5) Report the Contribution Correctly on Your Tax Return
When you report your taxes, you’ll need to make sure you have a correctly completed Form 8606. It’s a short form but there are opportunities to screw it up and confuse the IRS. Your Form 8606 should look like this, unless you’re doing a conversion in a different year from your contribution. If you’re checking your tax-preparer’s work, focus on lines 2, 14, 15 and 18. All should be a very small amount, likely zero, unless you earned a little interest in the period between making the contribution and doing the conversion. Make sure those lines aren’t large amounts like $5,500.
One interesting aspect of the form is that there’s no place to insert the date you made the conversion (your IRA custodian doesn’t report this either).
Below is a generic Form 8606 from 2016:
STEP 6) Repeat Next Year
Most IRA custodians will keep an account open for a year even if the balance is zero, therefore your empty Traditional IRA should be available next year for you to use again. Just remember, you cannot end the taxable year on December 31st with any pre-tax money in your IRA accounts. So, if later this year you leave your employment, you can’t roll your former job’s 401(k) into a Traditional IRA unless you “remove” it again as described in Step 1.
Will Congress Close the “Backdoor”?
You’re probably also wondering if one day Congress will close the Backdoor Roth IRA. There have been many discussions about closing the loophole, but as of 2017 it’s still available. Some people speculate that Congress is happy to keep the “backdoor” open because each year some people will convert existing pre-tax money in their Traditional IRA to a Roth IRA, thus generating taxable income for the year and raising tax receipts. Time will tell if the “backdoor” gets closed. Until then, you can take advantage to build a Roth IRA balance even if your income doesn’t allow you to contribute directly.
Related Backdoor Roth IRA Guides: