Tax season always seems to have one special issue du jour. But every year, backdoor Roth IRAs are a hot topic, especially on the White Coat Investor forum. Because of that, I’ve written this blog post to help beginners understand what they are, why they are important for high-income professionals (“HIPs”), and how they work.
Let’s start with the basics and assume you are setting up a Roth to invest for retirement, meaning we won’t discuss details like the 5-year rule:
- A Roth IRA is a personal retirement account you can deposit up to [2022 limits] $6,000/year ($7,000 if age 50+) into as long as you have at least that much earned income but don’t earn too much money (see below).
- It is a privately-owned account as opposed to an employer account. The two have no correlation.
- You get no tax deduction for putting money in a Roth IRA but everything that comes out is tax free, no matter how you use it. This gives you a fabulous incentive to grow your Roth as much as possible.
- If your spouse does not work, you can also contribute the same amount to a spousal Roth IRA as long as you make at least twice the annual limit (enough for you and enough for your spouse).
- You can pass your Roth to your heirs and it is tax free to them, also.
- Note: your Roth beneficiary(ies) may be required to empty the Roth over a 10-year timeline under the SECURE Act (bg 1/1/2020)
- You do not have to take Required Minimum Distributions (RMD’s) at age 72, as you do for TIRAs and 401k’s.
You won’t find a bigger cheerleader for Roth IRAs than I. I think everyone should contribute to a personal Roth for both spouses and consider contributing to a work Roth IRA if offered. Maybe that should be an upcoming article.
But there’s a problem: Most of our clients don’t qualify to contribute directly to a personal Roth IRA because they make too much money. In fact, most attendings are barred from contributing to a Roth IRA.
That’s where the “backdoor Roth” comes in. Due to a quirk in the tax laws, the wealthiest businessperson can take advantage of the tax-free growth of a Roth IRA by contributing indirectly via a circuitous route known as the “backdoor Roth”. If you have any pre-tax money in IRA accounts, including SEP, SIMPLE, rollover IRAs, or Traditional IRAs (known as TIRAs), you will be taxed on the conversion.
Here’s why it works:
- The government affords taxpayers two ways to move money into a Roth IRA –
- By a direct contribution and
- By a conversion from a Traditional IRA (or “TIRA”).
A backdoor Roth takes advantage of the option to convert funds from a TIRA. Instead of one step (direct contribution), you move money into a Roth IRA in two steps and then report the transaction (step 3) as follows:
- Step 1: make a nondeductible contribution to a TIRA.
- Anybody with earned income can contribute to a TIRA because there are no income limitations. The only question is whether or not your contribution is deductible.
- This contribution should be kept in a MMF (Money Market Fund) and not invested until you complete Step 2.
- Step 2: convert the balance in the TIRA to a Roth IRA
- Anybody can convert an IRA to a Roth IRA. There are no longer any income limitations.
- You’re now ready to invest in a well-balanced equity portfolio.
- Step 3 is to report both step 1 and step 2 on IRS form 8606 for the applicable year(s). Form 8606 is a very important form because it records your “basis” with the IRS.
- The nondeductible contribution to the TIRA is reported on the front of form 8606, or page 1.
- The conversion to the Roth (any conversion to a Roth IRA) is reported on page 2, the back of form 8606.
A word about your “basis”: Your “basis” is the amount of your IRA contribution that you have already paid taxes on. If the IRS does not have a record of your basis, it can attempt to tax not only your original contributions, but all of the earnings on your Roth IRA since inception. Form 8606 is your official notification to the IRS that you have “basis” in your nondeductible TIRA (step 1) and in your Roth conversion (step 2). So, as you can see, it is very important to file those forms 8606 to record your backdoor Roth IRA basis with the IRS every year for both step 1 and step 2.
The backdoor Roth maneuver is really not a difficult process. So why is there so much confusion over it? A couple of reasons.
First of all, for timing reasons.
- Your Step 1 initial TIRA contributions are made on a tax-filing year basis. That means you have from 1/1/x1 until 4/15/x2 to contribute to your nondeductible TIRA. That also means you can contribute to a TIRA for 2 years at once from 1/1/x1 through 4/15/x1. That’s confusing!
- Your Step 2 backdoor conversion is reported on a calendar year basis. That means if you contribute to a nondeductible TIRA on 2/1/22 for the year 2021 and convert it on 2/10/22, you will need to report the process on tax returns for 2 years (2021 for the contribution and 2022 for the conversion. Even though you have done this in 2 days, you have to wait a year to report both transactions!
Second, a lot of tax preparers don’t know anything about backdoor Roth IRAs. This is a “maneuver”, not something that is implicitly explained in black and white in the tax code (even though Congress okayed this maneuver in TCJA 2017) . Have you ever noticed how CPAs tend to dress in black and white and wouldn’t think of signing a form in blue ink? If we haven’t listened to the sermon, it’s not in our bible, if you know what I mean.
Every tax filing season, new clients contact us who have had to teach their CPA how to do a backdoor Roth conversion or whose tax preparer has not filed the form 8606 for the conversion. Yes, you can catch up and file those old forms 8606, but you may have to pay $50 for every year you file late. Yes, I think your tax preparer should pick up the tab.
You have until your tax filing due date (not including extensions) to complete step 1 of your backdoor Roth. Go ahead and contribute to your TIRA and file form 8606, even if you’ve already filed your income tax return. Open IRA accounts at your custodian of choice and contribute $6,000/$7,000 per spouse for 2019.
So why are we so big on Roth IRAs at Fox Wealth Management? Only $6,000 a year – how much difference can that make, anyway? And why would a family earning a cool million+ a year want to contribute $6,000 to an account that won’t even give you a tax deduction? You might be surprised.
Instructions for Backdoor Roth IRA’s
Roth conversions: How to build wealth part 1 of 2
Fiscal Fitness News 
I’m torn on what to do as I missed on critical step in attempting my first back door Roth for 2016. I opened a new TIRA and converted to a Roth a few days later (now valued at ~6K) BUT…I also had an existing TIRA from an old 403b rollover with 25K in it that I didn’t realize I needed to get rid of BEFORE Dec 31st of 2016 and now it’s too late! I realize I should probably recharacterize the Roth back into the TIRA to avoid the prorata taxes and then rollover my other 25K TIRA into my 401k. But then what do I do with the ~6K TIRA in 2017? This is after tax money…do I roll it into my 401k as well and then start the back door process all over again? Do I convert this 6k back into the Roth and pay taxes? I am so confused.
LikeLike
Hi, Amy,
You are correct that you need to recharacterize the Roth back into the TIRA. This will put you back at having completed step 1 of the backdoor process. Then roll your $25k pre-tax TIRA into your 401k OR convert it into a Roth IRA (your choice, the first will be tax-deferred and the 2nd will require you to pay taxes now). Do this before 12/31/17 and you won’t owe any taxes on the backdoor conversion for 2017. You can go ahead and convert your $6k after-tax TIRA into your Roth (step 2 of your backdoor Roth) now.
You will have to file an 8606 in 2016 and in 2017. All you are doing is processing the backdoor process in 2 separate years. Hope this helps.
LikeLike
Thank you for the writeup. I think I understand the basics of this process better now. My only question (and I see that you mentioned you’d cover this in a latter article) is how to eliminate the money I currently have in a IRA.
I have a Traditional IRA with $6,400 at Capital One and would like to perform the backdoor conversion in a newly opened Schwab investment account to take advantage of their low cost index funds. Whats the most financially solvent thing for me to do with that $6,400?
Thanks for your advice.
LikeLike
You have several choices:
1. Convert the TIRA to a Roth IRA and pay the taxes
2. Roll the TIRA into your current employer plan if it accepts rollovers.
3. Use some IC (Independent Contractor) or other SE (Self Employed) income as the basis for setting up a SOLO-401k and roll the TIRA into that.
Remember that the only date that matters is 12/31 of the year that you make Step 2. You need to have zero in the TIRA on 12/31. If you cannot, you can always wait until a later year to make Step 2.
LikeLike
Trying to see if I have it straight. I made my 5500 nondeductible contribution for 2016 prior to 4/15/17. Can that now be converted, as long as I do it before 12/31/17? And I might as well contribute and convert another 5500 for 2017?
My prior basis in tIRA was 0 on 12/31/16; do I just mail in a 8606 for 2016 showing the 5500 I put in pre-filing deadline? I don’t think one was done when we filed.
LikeLike
You can convert any time you want, 10 years from now if you decide. You report conversions on a calendar year basis. Yep, go ahead and get 2017 out of the way, too. Yes, you’ll need to file the 8606 for 2016 and another for 2017.
Just make sure you don’t have any pre-tax IRAs (including SEPs and SIMPLEs) in your name on 12/31 of the year in which you convert.
LikeLike
I am new to backdoor roth. I have opened a traditional IRA account at Vanguard and have contributed $5,500 for 2017 (planning to contribute $5,500 for 2018 after few months).
I have two basic questions:
(1) For my wife to contribute her $5,500:- Can this be done through my vanguard traditional IRA account. If not, she will open her new traditional IRA account at Vanguard.
(2) For us to contribute $5,500 for 2018:- Can this be done during later part of this year, and converted to backdoor roth IRA then.
Thanks again for this helpful post.
LikeLike
Hi, Dr. Singh, 1) IRAs are tracked by individual so your wife will need to open a separate account (2 accounts, actually – the TIRA and the Roth). 2) You can contribute to the IRA for a specific year at any time between 1/1/x1 and 4/15/x2. The conversion can be made at any time and in any year after the money is contributed. Be sure that neither of you have a pre-tax TIRA in your names on the last day of the year in which you have done a backdoor Roth conversion or the conversion will be taxed under the pro-rata rule. For more about the pro-rata rule, please see my post at https://blog.foxwealthmgmt.com/2017/07/13/the-pro-rata-rule-a-backdoor-roth-land-mine/. Thanks for your questions!
LikeLiked by 1 person
I have one follow up question. I did my first backdoor roth conversion of $5,500 for tax year 2017. I did this conversion in Jan 2018.
I am about to file taxes and our CPA is new to 8606 form.
I have question regarding following two lines in this form, if value entered is correct:-
Line 4. Enter those contributions included on line 1 that were made from January 1, 2018, through April 17, 2018 = $5,500.
Line 5. Subtract line 4 from line 3 = $0.
After reviewing various websites for physicians, I found out that everyone is making Line 4 =$0 and Line 5 =$,5,500.
Am I doing this right.
LikeLike
I rolled my 401K into my traditional IRA Oct 2017. The IRA now contains only 401K pre-taxed money from the rollover. I have some available cash in the account from the rollover, but most of the funds were used to buy stocks. Also, I am currently living and working outside the US, and I expect my taxable income to exceed my contribution limit.
Question, can I use the IRA containing the rolled-over pre-taxed 401K money (with some available cash) to perform the back door conversion to my Roth IRA? Meaning can I make a $6500 contribution from my checking account to my IRA (now containing pre-taxed rolledover 401K money), and then transfer that $6500 from my IRA to my Roth?
Thanks
LikeLike
Thanks for asking – need a little clarification. Is the money “pre-taxed” or “pre-tax”? Pre-taxED means you have previously paid taxes on it. Pre-TAX means the opposite (at least to me). I am going to presume you mean pre-TAX for purposes of this answer.
You can contribute to an IRA with only personal cash, not money that is already inside another retirement account. This is a good thing because that means that, in addition to your current IRA, you can contribute another $6,500 to an IRA.
Now for the bad news: you will be subject to the “pro-rata” rule if you have a balance in a pre-tax IRA as of 12/31 of the year that you make a backdoor Roth conversion. To avoid the pro-rata rule, you can either:
1. Convert your current pre-tax IRA into a Roth IRA,
2. Roll your current pre-tax IRA into your current employer’s plan (you need to be working for a US-based company with a retirement plan that accepts rollovers for employee IRAs), or
3. Set up a solo-401k plan with IC income and roll your IRA into that.
LikeLike
Hi Johanna,
My wife and I have been contributing after-tax income(we’re both W-2’s) to non-deductible TIRA’s(along with a joint taxable account) with Vanguard for the past 10 yrs. We each also have much smaller Roth IRA’s with VG when we first opened the accounts since we qualified under the income limits at the time. I have a no-match401k through my work that doesn’t allow any rollover(my wife has none) that I contribute in order to reduce my taxable income. So you’re stating that if we convert our TIRA’s to our existing Roth IRA’s we won’t be subject to the pro-rata rule?
LikeLike
Hi, Andy,
That’s correct, the pro-rata rule does not apply according to the facts you presented. You should convert asap, as a nondeductible TIRA is the most tax inefficient method of saving. You’ll pay tax on all growth in the year of conversion, as it’s never been taxed. In the future, you need to contribute the maximum annually at one time (if possible) and then convert as soon as your funds clear. Hope that helps.
LikeLike
Hello,
My wide had a Rollover IRA from her previous work about $2k. Today, we have funded after-tax TIRA for $6k for 2019. Our plan is to make the backdoor conversion to Roth today. I have questions and lots of confusion about the pro rata rule
1) Is there a deadline to when the conversion to ROTH can be done?
2) Does the Rollover IRA affect the pro rate rule?
3) What is the best action to take moving forward.
I have been reading but could not find best solution into move forward and how best to fill from 8606
Thanks,
TJ
LikeLike
Hi, TJ,
1. There is no deadline. It will be reported (p2 of form 8606) in the calendar year you convert (tax filing year 2020 or later). Your nondeductible TIRA contribution will be reported for 2019 (p1 of 8606)
2. Yes, it does
3. Since it’s only $2k, I recommend she convert to her Roth before 12/31/20 and pay the tax. She can almost certainly roll it into her work retirement account, if applicable – check to see if allowed. See my article, The Pro-Rata rule for Backdoor Roth IRAs for a list of solutions: https://blog.foxwealthmgmt.com/2017/07/13/the-pro-rata-rule-a-backdoor-roth-land-mine/
LikeLike