How to do a Backdoor Roth IRA
We all love Roth IRAs. What’s not to love? Instead of putting excess income into a brokerage account that has its dividends and income taxed each year, as well as being subject to capital gains tax when you sell, you put your money into a Roth IRA where you’ll never pay taxes of any kind. Did I mention that you will never pay taxes on the account? Also, unlike a regular IRA, it’s not subject to Required Minimum Distributions (RMDs) at age 72.
Obviously, if there were no limits then we’d all put all our savings into a Roth IRA--but there are limits. There are income limits for 2022 where if your modified AGI is above $144,000 ($214,000 if you’re married filing jointly) you can’t contribute any money to a Roth IRA.* There are also contribution limits for 2022 where (if you don’t reach the income limit) you can only contribute $6,000 for the year ($7,000 if you’re 50 or older).
If you’re single and have a modified AGI of $140,000 does that mean that a Roth IRA is off the table for you? Not necessarily.
Right now you may not be contributing to a traditional IRA because your income is too high and prevents you from allowing the contribution to be tax-deductible. If you can’t deduct the contribution to your IRA, why bother?
BUT…regardless of your income you can contribute to the IRA and not take the tax deduction, then immediately “convert” that non-deductible/after-tax/traditional IRA into a Roth IRA. Once the money’s in a Roth then you’ll never pay taxes on it. Yay!
Here are step-by-step instructions to do a backdoor Roth IRA:
- If you already have a “traditional” or “rollover” IRA, don’t go any farther. Having an existing IRA creates a whole level of complexity that increases the chance of doing it wrong and getting in trouble with the IRS, as well as decreasing the tax savings you receive from doing the backdoor Roth. However, if you do have an old IRA you may look into having it transferred into your 401k. That’s one way of getting rid of your IRA (while maintaining its tax-deferred status) and opening up the door to a backdoor Roth IRA.
- Confirm that you’re eligible to make a non-deductible Traditional IRA contribution. You can check with your tax accountant, financial planner, or do you own research at IRS.gov.
- Open a Traditional IRA at any discount brokerage (i.e. Vanguard, Schwab, Fidelity, TD Ameritrade, etc.). You will not be taking the tax deduction for any contributions made to this account. For clarity, I recommend you label this as “after-tax”. For example, “Amy’s After-Tax IRA”.
- Deposit your contribution limit (probably $6,000 or $7,000) to the account. Leave it in “cash”.
- Once the check has cleared and the money is available to invest fill out the paperwork ("Roth Conversion") to convert everything in this account into a new Roth IRA. The brokerage will be in charge of moving the cash in your After-Tax IRA to your new Roth IRA. Once it arrives in your Roth IRA, you may now invest the money. (Normally, you would have to pay tax on any appreciation from when you first put the money in the After-Tax IRA to when you converted it to a Roth IRA, but since you left it in “cash” there shouldn’t be any appreciation and therefore it’s not a taxable event.)
- Repeat next year. Since you already have the After-Tax IRA and Roth IRA set up, you won’t have to create new accounts. Just deposit your contribution into your After-Tax IRA then convert it to your Roth IRA and invest. Note: For the majority of the year there will be $0 in your After-Tax IRA but most brokerages will allow the account to stay open.
*There’s actually a phase-out period where if your modified AGI is between $129,000 and $144,000 ($204,000 and $214,000 if you’re married filing jointly) then you can only contribute between $1 and $5,999 to a Roth in 2022. Here’s a link to IRS.gov that will help you calculate the correct amount.