Overview: Many people incorrectly assume that they make too much money to contribute to the all important Roth IRA. Direct Roth contributions do have an income limit, but Congress has made an easy work-around. Everyone should be maxing out their Roth IRA. It is too important not to. If over the income limit, simply contribute to a traditional IRA and then convert it to a Roth.
Have you ever heard of the backdoor Roth? I don’t like the term, as backdoor has negative connotations, but they have been around and legal since 2010.
Roth IRA’s have always had earned income limits on those who wish to make contributions. This is unfortunate, because like I’ve said previously, Roth money is fantastic and some of the most valuable money you can have. You can stretch them by allowing a family member to inherit them for an extra decade of tax free growth, they have no RMD’s or age limits, and offer lots of flexibility on withdrawals prior to age 591⁄2.
Thankfully, in 2010, Congress removed the income limit on conversion of IRA’s to Roth IRAs, so even if you make more than $153k being single or $228k for married filers [2023], you can still contribute. You just need to use the backdoor instead.
Traditional IRA’s have no income limits for depositing earnings into them, but after you earn $83k single or $136k married [2023] you can no longer deduct the contribution from your taxes. This is important, because if you still contribute to what would now be called a ‘non-deductible traditional IRA’ you will pay tax on the money when you put it in AND the earnings when you withdraw it in retirement. Try not to do this. Having money grow tax free in a Roth is much more desirable. So how do you do it? It’s harder to write about it than actually do it.
“Hide” Traditional IRA money
If you have money sitting in an Traditional IRA, or a SEP/Simple IRA, that money needs to be moved into a 401(k) by the end of the year in which you do your Roth conversion. This is due to the pro-rata rule which states that you’ll owe taxes on all the gains from all your IRAs, not just the $6,500 [2023] Roth conversion amount. With a traditional IRA balance of $100k and you do a Backdoor Roth conversion, you’ll owe income tax on all the gains from that $100k. Hide that money first. Don’t have a 401(k) to move the traditional IRA money into? Start a business walking a neighbor’s dog, babysit, or mow a lawn, and earn $10. Open a Solo 401(k) and deposit the $10. Roll your IRA money into your solo 401(k). This is one of several ways to make this work.
Note: If you have a Traditional IRA with a small balance in it, you might also simply choose to pay the tax due by just converting it to a Roth. You might owe a bit of tax, but that might be preferential to setting up a Solo 401(k).
Contribute your money
Make a ‘non-deductible traditional IRA’ deposit to your now zero balance IRA. Preferably, put $13k in on January 2nd ($6.5k for you and $6.5k for your spouse).
Wait a few days
Wait a few days for your funds to clear your bank.
Convert
Now, inside your online IRA account, convert your IRA funds to a Roth. Inside my Vanguard account, this is simply done with one click. A warning will say that this is a “taxable event”! Don’t sweat this. In just a day or two, you will have no capital gains. Without capital gains, there will be no taxes due.
Report
You or your CPA fill out form 8606. The form takes 90 seconds to fill out. (Hopefully, it’s you and not your CPA. This way you can learn and be savvy about the tax code while saving money) Harry Sit has a step by step on how to fill out this form if you are using TurboTax here. Use caution: many tax preparers screw this simple form up; even CPA’s. Use the link above to check their work.
Caveats
This really is an easy and fantastic thing to do. You want Roth money, especially in a high tax bracket where an IRA or taxable account will cause more tax drag. However, you should be maxing out all tax-deferred space first, prior to doing a backdoor Roth. Don’t put money into a Roth at a high marginal tax rate if you still aren’t maxing out a 401(k) or Solo 401(k).
There used to be concerns about Step-Transaction doctrine. If you don’t know what that is, don’t worry. The 2018 Tax Cut and Jobs Act got rid of any concerns over it.
Consider front loading. It isn’t just for washing machines! Put the $12k into the market the day it opens on January 2nd so you have all year to reap the gains. I’m a believer that lump sum beats DCA (Dollar Cost Averaging) in cases like this.
Is your 401(k) unusually flexible? You can also do a Mega-Backdoor Roth potentially gaining $43.5k more in Roth dollars (66k limit – 22.5k elective deferral = 43.5k) [2023]. This won’t be right for everyone based on tax rates, but it is worth looking into.
The backdoor Roth really is a great benefit for high income earners, so I hope you make use of how easy it is to do. You can read more about the steps to accomplish this here.
Here are the Backdoor Roth steps graphically (click to enlarge):
