Vanguard Backdoor Roth: a Step by Step Guide

This year, I made my fifth pair of “Backdoor Roth” contributions with Vanguard. If you’ve heard of the Backdoor Roth, that’s great! You’ve been paying attention.

If not, I’ll give you a brief overview, and a number of links to additional articles with more complete descriptions of the history and important caveats.

Set For LifeI want this site to be a source of both good information and quality, relevant resources. I won’t re-invent the wheel of cheese, but I will cut you off a slice by walking you through the steps, complete with screen shots. I’ll also show you one goof that I made, and how I corrected it. It’s always nice to learn from somebody else’s mistake, isn’t it?

Vanguard is the company I use, and tends to be favored among many index fund investors, so that’s what you’ll see. The process should be similar (but not substantially identical 😉 ) with other brokerages.

 

Backdoor Roth: An Overview

 

Money contributed to Roth accounts does not result in a tax deduction, unlike contributions to tax deferred accounts. Both Roth and tax deferred accounts benefit from tax-free growth, unlike a taxable account that is subject to tax drag (which can be minimized). The Roth dollars, unlike tax deferred dollars, will not be taxed when withdrawn.

One of the first world problems of earning a solid income is the inability to contribute directly to a Roth IRA or tax-deductible IRA. A modified adjusted gross income (MAGI) of $196,000 for a couple filing jointly, or $133,000 for an individual makes you ineligible to contribute to a Roth IRA in 2017. Many physicians are thus excluded from making either deductible IRA contributions or direct Roth IRA contributions.

Now, that doesn’t mean you can’t get any money into a Roth account. You may have a Roth option within your 401(k) or similar account, although I would argue you’re probably better off with the tax deduction offered by making tax deferred contributions if you’re in the 28% or higher tax bracket.

Another important distinction is that a high income does not prevent you from making Roth conversions. The income limits were lifted in 2010, and I took advantage by making a Mega Roth conversion when it was believed the income limits would be reinstated. However, there are still no income limits, and hence, the backdoor remains wide open.

The income limits for a traditional tax deferred IRA contribution are even lower than the Roth contribution limits. If you participate in a workplace retirement plan, you won’t be eligible to contribute as an individual earning more than $72,000 or as a couple earning more than $119,000.

Before Attempting a Backdoor Roth

 

While income limits are a non-issue for the backdoor, there exists one important prerequisite to be able to properly execute the backdoor Roth.

You cannot have money in a tax deferred IRA in your name. That includes traditional IRA, SEP IRA, and SIMPLE IRA, but does not include 401(k), 403(b) or similar acounts. If you do hold tax deferred IRA dollars, you’ll be subject to taxes when making your conversion per the pro-rata rule.

If you do have these types of accounts, you’re not hosed, but you need to either have a strategy to move that money elsewhere or forget about the backdoor Roth.

If the balances are small and you can afford the taxes on the conversion, you can convert it all to Roth. This would be a good idea for those in lower tax brackets — residents and students, for example.

Another option for employees may be to roll the IRA into an employer’s 401(k) plan. Not all plans accept rollovers, but mine does, and this was the route I chose with my SEP-IRA a few years ago. Fortunately, my 401(k) offers institutional Vanguard index funds. If I had lousy options, a rollover might not have been worthwhile.

It might also a good idea to avoid having a SEP-IRA in the first place by putting your independent contractor earnings into a solo 401(k) instead. The White Coat Investor covers some of the advantages in this article.

Here’s how I make my backdoor Roth conversion with Vanguard.

 

Step 1: Make a non-deductible IRA contribution.

 

If you haven’t done so already, you’ll need to open a Traditional IRA. I won’t walk through all the steps, but it should be straightforward. You’ll start by selecting “Open an account” from the top of the page, leading you to a page that looks like this.

 

 

Since I opened mine years ago, I start by making a contribution to my existing IRA, an account that Vanguard thankfully leaves open, even when the balance is zero.

Open your Traditional IRA account, select “Buy and sell” then “Buy Vanguard Funds

 

 

Next, you’ll tell Vanguard where the money is going (and where it’s coming from). I put mine in the Prime Money Market Fund so day-to-day volatility is a non-issue.

 

 

I’ve selected Traditional IRA, and entered $5,500. If I were age 50 or older, I could contribute $6,500.

 

 

Step 1.5: Wait?

 

There is a thing called the “step transaction doctrine” that has some people believing it’s best to do nothing for anywhere from one statement cycle (a month) to a full year. Most people move on to step 2 without much of a waiting period, and I’m not aware of anyone having issues with the IRS after doing so. For more on the subject, see this article from Ann Marsh or this recent thread at Bogleheads.

 

Step 2: Convert to Roth

 

I move on to Step 2 the next day. Navigate to your Roth IRA (or open an account if you don’t have one). Select “Retirement contributions and distributions.”

 

 

Next, you’ll see a screen that looks like this. Notice the “Tax Year 2016“. I didn’t.

 

 

Yes, I completed the entire process under the 2016 tax year. That’s what I get for multitasking. I appropriately applied my palm to forehead, then went about fixing it. Fortunately, a phone call to Vanguard got the transaction cancelled, and I was able to repeat it the same day for the 2017 tax year.

Now, if I hadn’t made a backdoor Roth contributions a year ago, there would have been no issue. In fact, if you’ve never done the Backdoor Roth, are eligible and financially able, now is a great time to make one contribution for 2016 and another for 2017. If you’ve got an eligible spouse (and by eligible I’m referring to backdoor Roth eligibility), the two of you can sneak $22,000 into Roth accounts this way. Consider that just the tip of the day.

Now, on to the “Tax year 2017” which I accessed via the dropdown indicated by the arrow in the upper left hand corner.

 

 

I select “Convert to a Roth IRA” in the lower right hand corner dropdown. Next, we tell Vanguard where the money is coming from (Traditional IRA) and where it’s going (Roth IRA). I chose the REIT fund since that is a little underweight based on my desired allocation.

 

 

You’ll be warned that a conversion is a taxable event. This would true if the original IRA conversion wasn’t a non-deductible contribution. We can ignore these, choose “Do not withhold” and move on. We’ll account for it appropriately on our 1040.

 

 

That’s pretty much it. Confirm and receive your confirmation. You should get an e-mail, and you can also access your transaction history to see that it went through, and check your Roth IRA balance.

 

 

Step 2.5: Repeat for Spouse (as appropriate)

 

Step 3: Fill out Form 8606

 

The IRS has instructions here and the form here. I see no need to repeat them. The Finance Buff tells us it what it should look like in this post, which includes instructions for TurboTax, H&R Block, and Taxact.

 

Additional Resources

 

If you have additional questions, they might be answered in the following posts.

 

Is It Worth the Hassle?

 

I would say “Yes.” If you’re considering the backdoor Roth, the $5,500 or $11,000 most likely takes the place of a portion of your investments that would otherwise be invested in a taxable account.

As long as the money remains in a Roth account, it will grow without tax drag. Currently, my tax drag is nearly 0.6%, but with the right investments (index funds) and an ability to land in the 15% tax bracket in early retirement, tax drag can be quite close to zero.

Also, as a taxable account appreciates, you can end up with substantial unrealized gains, which may eventually force you into a higher tax bracket as you realize those gains to have spending money in retirement. Clearly, Roth money is more valuable from a tax perspective than money in a taxable account. I see no reason not to take advantage of this opportunity, as long as it exists.

Have you taken advantage of the backdoor Roth?


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59 comments

  • Great guide, PoF!

    I will definitely be using this when I make my Backdoor Roth contribution for 2017. Now to just save that $5,500 first…

  • Nicely done , PoF! This is a great step-by-step guide for any first-time backdoor-er. Also, strong work on the asset location, putting the tax-inefficient (REIT) and high-volatility asset classes (EM, mid-cap, small-cap) in the Roth.

  • That was a great explanation of the entire process. I know the back-door Roth conversion gets tossed around quite a bit in this FIRE realm and I’m not sure how many readers truly understand it or understand how to do it. A post well done. And congrats on your successes with the conversion!

    Mrs. Mad Money Monster

  • I made one way back when they first came out. During the dark days of the market crash I converted a defined contribution pension over to a Roth IRA using a simple call to fidelity. Down markets are a great time to roll if there are tax ramifications.

  • Nice summary PoF. If you’re a high income earner and already maxing out a 401k or other tax deferred plan through an employer, a backdoor roth is a good way to get more tax free growth. For me, I have a lot of tax deferred dollars from old 401k plans rolled into an IRA. So I would have to roll it into my company 401k plan. The problem with that is the plan only offers high cost funds (all over 1%). Not a huge deal though, as my focus now after maxing out my 401k is building an after-tax portfolio to access in early retirement.

  • Thank you good sir – have been reading more about this since your post a few weeks back.

    Mistake noted! Happy to learn from yours

  • I made my first Mega Back Door Roth conversion in 2015, and love the creative way of building “tax diversification” into retirement funds even if we’re over the income limits!

    Great post, will definately be sharing with some of my friends who I’ve explained the concept to (Thank You, you just did the work with an excellent explanation, saves me having to write a post on the same topic….I’ll just share yours!).

    • Thank you, Fritz.

      I was actually listening to your recent podcast interview as I was doing this, inadvertently neglecting to notice the 2016 tax year.

      So I have you to blame for that one, as far as I’m concerned. 🙂

      Cheers!
      -PoF

  • Nice. I keep my Roth in an E-Trade and Fidelity. Just happened to have legacy accounts prior to discovering Vanguard.

    I believe that there have been multiple finance forums online where some naysayers fear impending elimination of the Roth IRA benefits, but I figure that it would be difficult to reverse any rules for people who already have funds in existing Roths.

    What are your thoughts about using Roth 401k’s? Those might not apply for me (employer doesn’t offer them), but I have heard that some people with large amounts of 401k space who might end up with too much retirement start funding the Roth 401k instead.

    • Hey Smart Money MD. I have a Roth 401k option with my partnership but have decided not to fund it at this point. With my wife’s income, we’re currently in the top tax bracket, so I figure anything I can do to lower our taxable income is the higher priority. If I end up working part-time and our combined income falls enough, I might start funneling contributions to the Roth 401k side. But for now I think we’re better off with the up-front tax break.

      • Agreed. If you are in the higher(ish) tax brackets, it would make sense to lower your taxable income as much as possible. Interestingly, I have colleagues who believe that tax bracket rates will go even higher in the future so they opt to fund their Roth 401k and WL accounts more.

        I’d say that if you truly think that you’d be in a higher income tax bracket at retirement no matter what laws change, you’ve probably done quite well for yourself already.

        • ikomrad

          I’m with you on using tax deductible investments if you are in a high tax bracket, but even then a Roth account isn’t a bad place for an emergency fund.

          it’s been a while since my savings were so low that every unexpected expense was an emergency, but not so far in the past that I don’t feel the need to have an emergency fund. As a mental compromise, I’m slowly moving my emergency fund from a savings account into a Roth account.

          The back door method just became necessary this year , and I’m glad that I found your instructions on how to go about it!

    • Right — it only makes sense to do Roth instead of tax-deferred contributions if, and only if, you anticipate being in a higher tax bracket as a retiree.

      That seems unlikely for most physicians, and almost certainly untrue for an early retiree.

      The backdoor Roth doesn’t take the place of any tax deferred money. It’s an alternative to a portion of your taxable investing.

      Best,
      -PoF

  • I’ve heard of backdoor Roths but never understood the mechanisms of them, so I thank you, sir!

  • I love the Finance Buff’s step by step process to reporting the IRA conversion. I have used it 3 years in a row. I was actually doing my taxes last night (still pending some 1099-M forms) and went through the IRA conversion. It feels good to see the refund stay level despite placing these amounts in.

    Regarding the money market account for the traditional IRA- great idea. I have not done this and some years by the time I have moved monies I am either $20 lower or higher than when I first placed the $5500. I have yet to do my 2017 contributions but now know what to do!

    -EJ

  • Bah! Just yesterday I collected Vanguard screenshots as I did my backdoor Roth for 2016 to write exactly this article . I mean it is a good article and all but I groaned when I saw it appear in my inbox this morning.

    One question that occurred to me yesterday was: I do a mega backdoor Roth for Mr. BITA because his 401k plan allows for it (mine does not) and regular old backdoors for me. Is there a reason that I can’t also do a regular backdoor Roth for Mr. BITA? I think not, and that would mean and extra $5500 a year in Roth space.

    • Mine doesn’t allow it, at least that’s what the last rep said. Of course, he had never heard of it, either, so I had to break it down for him.

      We have a new rep — it might be worth asking again.

      Anyway, the two should not interfere at all. They are mutually exclusive, so to speak.

      Go ahead and write that post, and shoot me a link when you’re done. Yours probably has zero screw-ups!

      Best,
      -PoF

  • Thanks for this step-by-step guide! I’ve heard about the backdoor roth from Mad Fientist in the past, but always seemed to go over my head a bit. This explains it a little more and clarifies some things. I also kept hearing of the mega backdoor roth, but not sure it applies to us.

    So far we’ve already maxed out the 2016 & 2017 Traditional IRAs so maybe we’ll have to look at this in the future. I’ve also heard in the long run the calculation for traditional vs. roth is exactly the same in the end? Our plan is when we retire to do the roth ira laddering.

    • You’re very welcome.

      I would disagree with the assertion that the Roth v. traditional is the same in the end. If you’re in a lower marginal tax bracket in retirement compared to your working years, traditional, tax-deductible contributions will win out. If you’re in a lower bracket while working compared to retirement, making Roth contributions makes more sense.

      Your traditional IRAs will prevent you from making a backdoor Roth contribution, unless you roll them over into a 401(k).

      Best,
      -PoF

  • Nicely explained process, but I have a question outside of the mechanics of doing that. We built up a lot of cash last year and are looking to dump it somewhere soon. So, if I set up an account, made 2016 and 2017 contributions, then that would cover $11k of it. Here’s where I get tied up with the “why”.

    So, if we already paid taxes on it at our higher tax rate, the bonus of putting it into an IRA and then coverting it is what? That we don’t pay taxes on the growth of that account later on? Sorry to be so dense, I’ve just always gotten hung up on that aspect of it and never had it explained to me. I think you did it sort of in your last paragraph, but before I try to make both of those contributions, I wanted to make sure I understand the “why”.

    Thanks and again, nice article pointing out the mechanics behind it. Timely for us indeed!

    • Yup. You either pay taxes on it now or later. Roth IRA allows you to diversify your investment buckets.

    • Yes. I would describe the advantage as three-fold.

      One, you get tax-free growth (no taxes on dividends throughout the year).

      Two, you’re not locked in to a particular investment. You can trade as much or as little as you like in the Roth account without tax consequences. I’d argue for very little trading, but there can be good reasons to change asset classes.

      Three, you will pay no capital gains taxes when you sell to spend that money, which could be decades later.

      Now, you could have a taxable account that acts a lot like a Roth if you buy a zero-dividend fund /stock (Berkshire Hathaway), remain in the 15% federal tax bracket (no tax on QD & LTCG) and remain in the 15% bracket when you sell.

      Best,
      -PoF

  • Thanks for another great article. I do my Roth IRA at Vanguard too, but my screen shots and steps are different. I’ll have to take a deeper look and see why – but I literally just click a “convert to Roth IRA” button after funding the TIRA.

  • Exactly the reason that I didn’t roll my 401(k) into an IRA was because I wanted to keep the IRA space open in order to give myself the flexibility to do a backdoor Roth since we anticipate our household to earn above the income limit for contributing to a Roth (turns out dentists do pretty well – lawyers…eh).

    The step transaction thing is what’s always slightly concerned me. I once tried to ask a lawyer friend of mine who does tax law about it and he had no idea.

    Being able to roll an IRA into a 401(k) is something I only recently learned was even possible. I was always under the impression that if you had an IRA with money in it, you basically were screwed unless you wanted to take the tax hit and convert it to a Roth.

    And +1 for the solo 401k. It’s exactly why I’m using it for my side hustle income.

  • Thanks for sharing! I was so paranoid about making a mistake the first time I did my Backdoor Roth that I must have cancelled my transaction multiple times. I also find The Finance Buff’s TurboTax tutorial to be quite helpful because apparently I can never remember how to do it correctly.

  • Great step by step guide. I’ll be taking advantage of this for the first time this year 🙂

  • A heads up to your readers-
    Most readers of your site are probably more knowledgeable about finances than their accountants. We do our own taxes now (usually with Turbo Tax) for this reason, as when we tried to use a CPA she was not familiar with a backdoor Roth and we had to file an amended return to add form 8606.

  • complete_newbie

    Question: I was reading somewhere but you CAN take money out of Roth any time without penalty correct? Just can’t take the dividends/capital gains (that has 10% penalty)

    Please let me know. Thank you.

    • Indeed. You can take out your Contributions any time without penalty.

      http://www.rothira.com/roth-ira-withdrawal-rules

      Cheers!
      -PoF

      • complete_newbie

        So got a REALLY dumb question

        Lets say I have 50,000 401K. Can I roll all of that into a traditional IRA and then put ALL 50K into a roth IRA? (backdoor?) Basically, is there a limit on how much per year I can do back door IRA?

        And I have heard about “Mega” back door roth – what is that then?

        Confused!

        • The Backdoor Roth relies on a NON-deductible IRA contribution. The $50K traditional IRA was tax-deductible (and tax deferred), so you would owe taxes at your marginal rate on the converted amount of $50k. You can do it, and it would be wise to do in residency when it’s cheaper to do so, but not so wise as an attending.

          That being said, I did convert a large SEP-IRA and paid a six-figure tax bill to do so back when it looked like the ability to convert regardless of income level was going to be short-lived.

          Mega Back Door Roth is done within a retirement plan. If your plan (401(k) or similar) allows non-deductible contributions and in-plan Roth conversions, you can do the Mega. Mine does not.

          And there are no dumb questions. Only dumb people. 😉 I kid, I kid.

          Best,
          -POF

  • Nice job.
    These are exactly the steps I take each January (although I have done it all over the phone in prior years). It seems routine to me now but I’m sure this will be helpful to people who haven’t done it before.

  • JLL

    My husband and I both have rollover IRA’s containing funds from our 401k’s at previous employers. We also both have traditional IRA accounts that we have been contributing the max to over the last several years. The total for all of these IRA’s is around $440K. I understand that if we wanted to do a backdoor Roth, all of the money would have to be emptied from the current IRAs. What sort of accounts could we move the IRA money to in order to prepare for a backdoor Roth?

    • If you have a current employer’s 401(k) that accepts rollovers, you can roll it over into there.

      If not, you could start a solo 401(k) based on a tiny amount of income earned as an independent contractor. It could be lawn mowing, “consulting,” or filling out online surveys for cash.

      I just opened an ETrade individual 401(k). Here’s a thread on several options and pros and cons.

      • JLL

        Thanks! My group is terminating our hospital employee contracts and moving back to being a physician owned group so we will have a change in our employer offered retirement options in July. I will check out the thread on an individual 401k but probably wait to make any final decisions until I see what my new employer options will be. Appreciate all the info!

  • NewRad

    This is my first attending year, and I have contributed/converted for both 2016, and now 2017.

    My wife does not work. I would like to make a spousal IRA for her. Our MAGI will probably be around $190k for this year. She has an old account rolled into a traditional IRA worth $15k. Do I directly make and contribute to a Roth for her, and not have to worry about the traditional IRA. Or do I have to do the same backdoor method and thus either convert or trigger pro rata?

    Also, I wasn’t able to find if there was a MAGI limit for spousal IRA.

    Thanks in advance!

    • If you can get your MAGI below $186k, then you should be able to contribute directly into a Roth IRA without a backdoor. Otherwise, you will trigger pro rata if there has been any growth inside her Traditional IRA.

  • Drsan1

    Thank you for this. With your post with the screen shots and the post from finance buff with Turbotax screen shots I was able to do it successfully. Thanks again!

  • HospitalDoc

    PoF,
    Are you not worried about the step transaction?
    They are recommending to wait a year before doing the next step.
    Thanks!

  • My wife does not currently earn an income. Can we still both make $5500 non-deductible contributions (total of $11,000) to new traditional IRA’s and then both convert to Roth IRA’s?

    • I ran into that too. The IRA account showed the balance ( $5500 ) but it wasnt’ available for any activities . It had a special status that I should have noted the name of. eventually the funds became available and I was able to complete the “convert to Roth IRA” transaction.

      It was a new IRA acccount create just for the conversion, so that may have had something to do with the delay. Perhaps when I reuse the account next year, the process will go more smoothly.

  • Dean Collins

    Only comment is…..if you fund your initial IRA payment via a bank account Vanguard makes you wait 7 days before making the cash available from your IRA being able to be converted into a ROTH IRA if doing it online.

    Do the online steps and on the last page it will say cannot be completed call 800 XXX XXXX and then tell them you are trying to do a backdoor roth conversion and they’ll be able to manually over ride the system no probs.

  • Casey

    FYI, there is now a Vanguard Federal Money Market Fund (VMFXX) available that has a slightly lower ER than the Vanguard Prime Money Market Fund, but also slightly lower yield. I’m not sure if there are any other major differences as far as this topic is concerned; hopefully it doesn’t matter (I chose to use the Federal Money Market Fund as I wanted to minimize earnings prior to the conversion).

    • I see. I only leave the money in there for a day, and pennies are ignored. If you are worried about the step doctrine, and choose to let the non-deductible contribution sit for awhile, you might as well use the lower cost / lower yield fund.

      Thanks for the heads up!
      -PoF

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