What is a backdoor Roth?
A Roth IRA is a retirement account that is funded using after-tax earned income. You earn $X annually. You pay your taxes on $X, leaving you with $Y. You can take up to $5500 (in 2017. Check the IRS link for the latest limits) out of $Y and put it into your Roth IRA. That $5500 is allowed to grow unmolested by taxes. When you eventually withdraw from your Roth IRA you owe no taxes on any of your withdrawals. No income tax. No long term capital gains taxes. No taxes, period.
So, what is the catch? If you earn more than a particular limit set by the IRS, you aren’t allowed to contribute to a Roth IRA.
What you are allowed to do is contribute your after-tax dollars to a traditional IRA (a tIRA) and then you can roll that money over into a Roth IRA. Since you weren’t allowed to enter the Roth IRA via the front door, you sneakily enter it using the back door, via a tIRA.
Why does this bizarre loophole exist? Don’t ask me. I don’t make the rules. I just play by them.
Do you need some backdoor action in your life?
In 2017, if you are married filing jointly, you can’t contribute directly to a Roth IRA if your Modified Adjusted Gross Income (MAGI) is >= $196,000. See this IRS link for all the income limits that apply depending on your MAGI and filing status.
If your MAGI is less than that magic number, this article probably is not for you. Stop reading now and let your money go forth merrily through the front door. If you are fortunate enough to make a tidy chunk of change, read on.
Why do a backdoor Roth?
Why go through the hassle of doing a backdoor Roth? Why not just accept with good grace that the front door is closed to you, and dump your money in your taxable brokerage account instead?
- Your Roth IRA account grows tax deferred. What this means is that for the years that you choose not touch your Roth dollars, you will pay nothing in taxes as the money in the account grows. For example, assume that your Roth dollars are invested in a fund or in stocks that produce dividends. You will owe 0 taxes on these dividends. If instead this money was in a taxable brokerage account you would owe taxes on the dividends even if you reinvested them.
- Once you get appropriately old and wrinkly, withdrawals from your Roth IRA are all tax free. Yes, you read that right. Let us say that over the years you contributed $50,000 to your Roth IRA. You are now 60 years old and your Roth IRA balance is $110,000. That $60,000 of growth in there? You owe no income tax on it. You owe no capital gains tax on it. You owe no tax on it period. In this same scenario, if the money was in a taxable brokerage account, you may owe taxes on the capital gains when you withdraw (unless you are in a low enough income tax bracket at that time that the capital gains tax that you owe is 0%. As of 2017 if you are married filing jointly and have income less than $75,900, you owe 0% in long term capital gains taxes).
Physician on FIRE has a post where he explains why Roth dollars are the coolest, bestest dollars you will ever meet.
What are the gotchas?
Pre tax money in an IRA
If you have any IRA account with pre-tax dollars in it, you will need to beware the pro-rata rule. Michael Kitces explains the rule (with many examples) far better than I ever could. The short version? Don’t mix after-tax and pre-tax dollars in your IRAs. You need to ‘clear out’ your IRA space before you attempt to do a backdoor Roth conversion. The article I referenced above also explains how one can go about doing this sort of clean up. Biglaw Investor’s IRA guide also explains the strategies you can use if you find yourself in this position. The rest of this guide is going to assume that your tIRA (if you have one) is cleaned up and good to go.
‘Converted’ dollars aren’t quite the same as front door dollars
Typically your contributions to your Roth IRA account can be withdrawn any time penalty-free. Note that if you try to touch your earnings, there are all sorts of rules to be followed, but your contributions are yours if and when you need them. ‘Converted’ Roth dollars are a little bit different than Roth dollars that made their way into the account via the front door. Your ‘converted’ contributions can be accessed penalty-free five years after they were ‘converted’ to Roth dollars. You probably want to set up a nice little spreadsheet that keeps track of what got converted when. This will come in handy when you start to withdraw from your Roth account. Note that the 5 year clock starts at the start of the tax year in which you made the conversion, so if you converted your dollars in say November, you actually have to wait only 4 years and one month before you touch your contributions penalty-free. You can read more about the 5 year rule here.
The ‘Waiting’ period
The Step Transaction Doctrine says that a series of legal steps may be considered a single or whole transaction and that that whole transaction may be deemed illegal even if each individual step is legal. In this context funding your tIRA with non-deductible after-tax dollars is legal. Converting your tIRA to a Roth IRA is legal. But theoretically if the IRS challenges your conversion the court could maybe decide that you performed these two legal steps with the sole intent of bypassing the income contribution limits to illegally fund a Roth IRA. Michael Kitces is wary of the Step Transaction Doctrine and explains what he does to avoid it here. The White Coat Investor sums up popular opinion on the subject, which is that being worried about the doctrine is silly and one does not need to wait particularly long before doing the conversion. I wait about a week. Why a week? Because I am a bit of a wimp and waiting a week makes me feel better.
You will fund your tIRA with after-tax money and move this money into your Roth IRA to grow tax free (and eventually be withdrawn tax free). So why do you have to worry about taxes? Your after tax dollars will sit in your tIRA for anywhere from 1 day to however long you decide to wait to avoid the step transaction doctrine. During this waiting period your money might grow. It might grow very little if it is sitting in a money market account. It might grow a lot if you wait a long time and invest the money while you are waiting. You will owe taxes on this growth when you do the backdoor conversion. Later in this guide we’ll talk about how to report this growth and deal with taxes, but I just wanted you to be aware that the world of backdoor Roths isn’t entirely a tax-free paradise.
How to do a backdoor Roth
We will now go over each of these steps in detail, with screenshots where applicable. The screenshots I use are from Vanguard, which is where I hold my tIRA and Roth IRA accounts.
Step 1 and 2: Open a traditional IRA and fund it
I detail the steps involved in opening a new tIRA account and funding it with $5500. If you already have an existing tIRA account that contains no pre-tax dollars in it, you can fund it with up to $5500 and skip ahead to step 2. The one thing to look out for is that Vanguard will ask you which tax year you are making the contribution for. Up until April 15th 2017 you are allowed to make a contribution for tax year 2016, so look for the tax year question/option and characterize your contribution correctly. Physician on FIRE has screenshots for funding a tIRA that already exists, so check that out too.
Once all your personal information has been handed to Vanguard they ask for the contribution amount for the tIRA. The interesting thing is that it gives you a choice about whether these contributions should be characterized for tax year 2016 or 2017. You can contribute to your tIRA for 2016 up to April 15th of 2017. In this example I choose to fund a tIRA for 2016. Later this year I can do another one for 2017.
You then need to choose how you will get that $5500 into your new tIRA account. In the screenshot below I do this by linking to my bank account. In order to verify the new bank account Vanguard will make two small (< $1.00) deposits into your bank account. This will take a day or two. Then you have to log back into your Vanguard account and enter the exact amount of the deposits. Once that is done your bank account will be linked to Vanguard.
The last thing you need to do is choose what you want to do with any capital gains and dividends. If you (like me) plan to keep the money uninvested until you ‘convert’ to Roth, this isn’t particularly important. I just choose to keep any gains in my money market settlement fund.
Step 3: Wait
It will take a couple of days to confirm your bank account and for Vanguard to actually pull the money from your bank account. Other than this mandatory waiting period, how long you choose to wait to avoid any risk of the Step Transaction Doctrine that I mentioned above is entirely up to you. For no particular reason I typically wait about a week. You could wait a day, or an entire year. I’ll leave that up to you.
Step 4 and 5: Convert your tIRA into a Roth IRA
Now you are ready for the backdoor magic. Even though the name sounds sneaky and underhanded, the actual process is prosaic, boring even. Note that you are transferring dollars from one account to another, and in the process “converting” your dollars into Roth dollars. You aren’t actually converting your account. Your tIRA will continue to exist, but it will have $0 in it and the money that was in your tIRA will now be in your Roth IRA. The next time you want to do a conversion you can probably reuse the same tIRA. Most providers will allow you to keep the tIRA open for a year even with $0 in it.
When you hit that magic convert button, if you don’t have a Roth IRA account, Vanguard will helpfully ask if you want to open one. I’m not going to do screenshots of opening a Roth IRA account because it is essentially the same process as opening a tIRA account, and we’ve already covered that.
Remember that I funded my tIRA with $5500. You can see that I now have $5500.43. I already paid taxes on the $5500 because I used after-tax dollars to fund the tIRA. But taxes have not been paid on the 43 cents, and I’ll have to deal with that when I file my returns in Step 7.
Assuming you do have your Roth IRA all set up, this is what you will see when you hit the magic convert button.
Step 6: Invest the money in your Roth
Don’t forget this step. Once the conversion is complete, and your money is Roth money, put that money to work. How you invest it will depend on your asset allocation across your entire portfolio. Remember that your Roth dollars are protected from taxes so this is a good place to hold bonds or REITs. Whatever you do, don’t forget about the money and leave it sitting in your money market account, earning next to nothing.
Step 7: File form 8606
The Finance Buff has a post detailing exactly how to fill this tax form, and I see no need to reproduce his most excellent work. He includes examples for how to report your backdoor Roth if you are using TurboTax, H&R or TaxAct. His example also includes how to report any pesky earnings while your dollars were in your tIRA (remember my 43 cents?).
Step 8: Rinse and repeat
You can repeat all these steps for your partner and then repeat them all again next year. Two backdoors give you the ability to sock away $11,000 in Roth dollars every year.
And that is all there is to it. Remember to check if your 401k provider gives you access to a mega backdoor Roth so that you can sock away even more of those juicy Roth dollars. You can read all about the mega backdoor Roth (with screenshots) here.