Backdoor Roth IRA Conversion: A Guide
Roth IRA and Drawbacks
Unlike the Traditional IRA, Roth IRAs don’t result in a tax deduction. So why would you contribute to a Roth IRA over a Traditional IRA?
While you may not get a tax deduction or any immediate tax benefit for contributing to a Roth IRA, you will not have to pay taxes on any future gains! That means your Roth IRA can grow to any amount and you can withdraw it completely without paying any taxes (as long as you’re eligible to withdraw without penalty)!
Roth IRA also allows you to take the amount you contributed into the account at any time, but not any amount that includes unrealized gains. The drawback to the Roth IRA is that after you make solid income, you cannot directly contribute anymore. But there’s a legal loophole available.
Roth IRA Income Limits
As of 2023, you are ineligible to contribute ANY amount directly into a Roth IRA if you have a modified adjusted gross income (MAGI) of $228,000 as a couple filing jointly or a MAGI of $153,000 as an individual.
In other words, if you make really good money relative to the average American, you cannot directly contribute because the Roth IRA is THAT good.
Even worse is that contribution amounts begin to phase out earlier as you reach the top income limits.
The phase out begins at $138,000 for single filers and $218,000 for married people filing jointly. The Roth IRA income limits apply to a lot of people who are in industries like tech, finance, and consulting.
To avoid the risk of contributing more than you’re allowed, you’re better off using the backdoor Roth IRA method to avoid tax complications.
Important Rules For The Backdoor Roth IRA Method
Before attempting the Backdoor Roth IRA, you should not have tax-deferred money in an existing IRA. This includes the Traditional, SEP, and SIMPLE IRA. Tax-deferred 401(k)s are fine.
The reason for this is because of the IRS’s aggregation rule. To utilize the backdoor Roth IRA method, you must make a non-deductible contribution to an IRA, but if there is an existing IRA with tax-deferred money, all the money will be aggregated for a conversion with a tax consequence at a pro-rata basis across all accounts even if the non-deductible contribution was made to a separate new IRA.
Effectively, any existing IRA with tax-deferred money (except for inherited IRAs) eliminates the ability to utilize the backdoor Roth IRA method. Ideally, you should not have any other Traditional IRA assets when using the backdoor Roth IRA method.
Because the IRS’s IRA aggregation rule only applies to IRAs, there is a workaround if you do have tax-deferred funds in an IRA. If an existing pre-taxed IRA account can be rolled over into an employer’s retirement plan like a 401(k), it would allow for the non-deductible funds in the IRA to be converted to a Roth IRA. The employer’s retirement plan must allow roll-ins though, which many do. If a rollover is possible, the pro-rata rule would not apply and pre-taxed funds would be rolled-over. You’ll want a zero dollar balance in your tax-deferred IRA accounts after the rollover.
Capitalize offers free rollover services and may be able to assist you. It makes the process completely hands-off and the representatives are knowledgeable on the process. I used Capitalize to rollover my old employer’s 401(k) to my current employer’s plan.
Lastly, if you do a backdoor Roth IRA conversion every year, you must wait five years to withdraw each portion you converted. If not, you risk paying additional penalties on money that’s already been taxed. This wouldn’t apply if you’re 59 ½ or older, if you become disabled, or die
Step-By-Step Instructions
Assuming this is a new account, you can start with step 1. If you already rolled-over tax-deferred funds, you can begin with funding your account with non-deductible funds. I use Vanguard for my retirement accounts so this will be specific instructions with screenshots from Vanguard, but the steps are similar for other brokerages like Charles Schwab and Fidelity.
- Click “Open an account”.
- Click “Start your new account”.
- Fund your new account using electronic bank transfer.
- Choose “Retirement (IRAs).
- Choose Traditional IRA.
- Fill out bank account information.
- Select “No” to this question.
- The funds will take several days to clear. Check your account periodically by going to “My Accounts” and “Balance and Holdings”. Your funds will have cleared when the funds are in the Vanguard Federal Money Market Fund. Click on “Convert to Roth IRA”.
- Convert the entire account.
- Click on “Do not send a tax withholding notice”.
- Select the Roth IRA account to convert to.
- You will see the confirmation of the conversion.
- Funds in your Roth IRA account will include the converted funds from the Traditional IRA.
Once the conversion is complete, you have successfully completed the backdoor Roth IRA method and you can use those new funds to invest! Your funds with have the benefit of growing tax-free and a great retirement vehicle to have for tax diversification!
When it’s tax filing time, you need to complete Form 8606 with your tax return.
