[Last updated on July 14, 2014, with new contribution limits and links to follow-up articles on tax reporting.]
Although I believe a traditional deductible IRA is often better than a Roth IRA, a Roth IRA is still better than a taxable account if you aren’t eligible for a deductible contribution to a traditional IRA. When you aren’t allowed to contribute to a Roth IRA because your income is too high, there’s still a backdoor. It takes some effort but it’s worth it.
So here it goes: a complete how-to for the Backdoor Roth.
What is the Backdoor Roth?
The Backdoor Roth is an indirect way to contribute to a Roth IRA when you are not eligible to contribute directly due to high income.
Who should consider the Backdoor Roth?
If your income is “too high” for contributing to a Roth IRA, you should consider the Backdoor Roth. For 2014, the modified AGI phaseout starts at $114,000 for single, $181,000 for married filing jointly, and $0 for married filing separately.
If your income isn’t above those thresholds, stop reading — this article doesn’t apply to you. Instead, consider a deductible contribution to a traditional IRA if you qualify for one or contribute to a Roth IRA directly.
Why should someone consider doing the backdoor Roth IRA?
When you have money in a taxable account, you pay taxes on interest and dividends. When you eventually sell the assets, you also pay taxes on the capital gains. If you put money in a Roth IRA, you don’t pay those taxes.
Ready? Here it goes:
Step 1 – “Hide” other IRAs
If you don’t have any traditional IRA (say as the result of a rollover from a previous 401k or 403b), SEP-IRA, or SIMPLE IRA, you are in good shape. Skip to step 2. If you are married, please note IRAs are owned by one and only one person. Each spouse should look at his or her IRAs separately.
If you have a traditional IRA, SEP-IRA or SIMPLE IRA, and you don’t mind paying taxes to convert all of them to a Roth IRA now, also skip to step 2. When your balances in those IRAs are small, the taxes you will have to pay when you convert them are also small.
If you have a traditional IRA, SEP-IRA or SIMPLE IRA, but you don’t want to convert them and pay taxes at a high rate just yet, rollover almost all the pre-tax money to an employer sponsored retirement plan: 401k, 403b or 457. Most employer-based plans accept incoming rollovers.
Everything in the traditional IRA, SEP-IRA, and SIMPLE IRA, except any non-deductible contributions you made in the past, is pre-tax money. For example if your traditional IRA has $34,000 in it and you made $10,000 non-deductible contributions in the past, $24,000 is pre-tax money. Move $24,000 to an employer sponsored plan. If you never made any non-deductible contributions in the past, all $34,000 is pre-tax money.
If you’ve made non-deductible contributions to your traditional IRA in the past, a key requirement is that you leave enough money behind in the traditional IRA — at least equal to your past non-deductible contributions. Don’t cut it too close. Consider market fluctuations and leave yourself a small cushion to show that on the day the money goes from your IRAs to your employer plan, you still have slightly more money in the IRAs than your past non-deductible contributions.
You are allowed to rollover only pre-tax money from a traditional IRA to an employer plan because of a special rule. Read more about this special rule in IRS Publication 590. Look for “Tax treatment of a rollover from a traditional IRA to an eligible retirement plan other than an IRA” near the end of page 23.
If your plan doesn’t accept incoming rollovers or if you don’t like your plan, create some self-employment income and set up a solo 401k plan, also known as a self-employed 401k plan or individual 401k plan.
House-sitting, dog-walking, tutoring, helping neighbors set up computer equipment, etc. are all good ways to earn self-employment income. Remember you don’t have to make a living on it. You just need a little self-employment income in order to qualify for setting up a solo 401k plan. See Solo 401k When You Have Self-Employment Income.
Step 2 – Make a non-deductible contribution to a traditional IRA
After Step 1, you either don’t have any traditional IRA, SEP-IRA, or SIMPLE IRA, or you only have a traditional IRA with non-deductible contributions in it (maybe plus a bit of earnings). You make a non-deductible contribution to a traditional IRA. As long as you have earned income, even if your income is “too high,” you can still make a non-deductible contribution to a traditional IRA.
The maximum contribution for 2014 is $5,500 per person if you are under 50. $6,500 per person if you are 50 or over.
Step 3 – Wait
The law does not impose any waiting period between a contribution and a conversion (step 4). However, some are concerned that if you convert too soon, it can be seen as an abuse.
There is no official guideline for how long you should wait. Some say a few days; some say 30 days; some say 6 months; some say wait until the next year. Pick a time you feel comfortable with.
Having the money sit in a traditional IRA for a short period of time is not going to kill you. The tax on the earnings won’t be much because you won’t have a lot of earnings.
Step 4 – Convert the traditional IRA to Roth IRA
Ask your IRA provider how to do this. Some can do it online. Some will want a signed form. There is no income limit for the conversion. Because your Roth IRA conversion comes primarily from your non-deductible contributions, there will be very little taxes on the conversion.
Step 1 is necessary because if you didn’t do it, your conversion will be taxed by the percentage of pretax money in all IRAs (the “pro-rata rule”). Money in employer sponsored plans doesn’t count in the pro-rata rule.
Step 5 – Report on your tax return
Since you made a non-deductible contribution to a traditional IRA in Step 2, you will need to include Form 8606 when you file your taxes. It’s a very simple form. If you use tax software, it will be included automatically if you answer the questions correctly.
You report on the tax return your non-deductible contribution to a traditional IRA *for* that year and your converting to Roth *in* that year. If you contribute for the previous year and then convert, you will have to report in two separate years. It’s much simpler if you contribute for the current year and then convert. See Make Backdoor Roth Easy On Your Tax Return.
If you use TurboTax, see How To Report Backdoor Roth In TurboTax for a step-by-step guide. If you use H&R Block software, see How To Report Backdoor Roth In H&R Block Software. If you use TaxACT, see How To Report Backdoor Roth In TaxACT.
Here’s an filled-out example of Form 8606. Click on it to see the numbers on page 2.
Step 6 – Repeat Steps 2 to 5 next year
Step 1 is a one-time task. After it’s completed, you just repeat Steps 2-5 every year.
Most IRA custodians will keep an account open for a year even after the balance goes to zero. In such case next year you just contribute to the same empty traditional IRA and convert into your existing Roth IRA. It’s not necessary to open new accounts.
No Rollover to Traditional IRA
When you are repeating steps 2 to 5 every year, remember not to rollover from an employer-sponsored plan to a traditional IRA in the same year, either before or after you do the Roth conversion. You can rollover from one plan to another plan, or to your own solo 401k, just not to a traditional IRA. If you must rollover to a traditional IRA, you will have to “hide” it again using Step 1.
Reverse the Order?
Some readers asked about reversing the order: do Step 1 after Step 4 but before December 31 in the same year. I don’t recommend it, although it works the same on the tax form.
When you rollover from your traditional, SEP or SIMPLE IRA to a qualified plan, you are explicitly allowed to pick pre-tax money only. Not so when you do the conversion; you are not supposed to pick only after-tax money. The tax forms don’t show exact dates. If you reverse the order, you can probably get away with it if you are not audited, but I think it’ll be messier if you must explain to an auditor.
It’s too much trouble. Why don’t they just open the front door and let everyone contribute directly to a Roth IRA?
If the front door is wide open and everyone can contribute directly to a Roth IRA, the government will lose too much revenue. The income limit is imposed to reduce the revenue impact. Only those who know about the backdoor and are willing to perform the necessary steps can take advantage of the backdoor Roth IRA. Diligence brings rewards.
Will they close the backdoor?
While anything can happen, I don’t think the backdoor will be closed. The backdoor exists because the income limit for Roth IRA conversion was removed. Roth IRA conversion was extended to all income levels because the government wants revenue from the conversion. If you are afraid the backdoor will be closed, you should do it now, when the backdoor is still open.
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