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.
I 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 The Roth dollars, unlike tax deferred dollars, will not be taxed when withdrawn.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.
If you have additional questions, they might be answered in the following posts.
- The Finance Buff: Backdoor Roth: A Complete How-To
- White Coat Investor: Backdoor Roth IRA Tutorial
- Michael Kitces: How To Do a Backdoor Roth IRA (Safely) and Avoid the IRA Aggregation Rule and Step Transaction Doctrine
- Vanguard: The benefits of a “backdoor” Roth
- Morningstar: Backdoor Roth IRA? Avoid These 6 Mistakes
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?