Vanguard Backdoor Roth 2018: a Step by Step Guide
This year, I made my sixth 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.
This post has been updated with fresh screenshots from my 2018 contribution and conversion, which was completed on January 3, 2018. I like to contribute the first day it’s allowed to start the tax-free earnings as soon as possible, but you have until Tax Day in 2019 to make a 2018 Backdoor Roth contribution.
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 with other brokerages, but the screens will be different.
Backdoor Roth 2018: 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 The Roth dollars, unlike tax deferred dollars, will not be taxed when withdrawn.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 $199,000 for a couple filing jointly, or $135,000 for an individual makes you ineligible to contribute to a Roth IRA in 2018. 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 $73,000 or as a couple earning more than $121,000 in 2018.
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 have a strategy to move that money elsewhere or you can 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 and just pay tax on the conversion. This could 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 such as your checking account or a money market). I invest my non-deductible IRA contribution 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. You’ll be asked to consent to the investment you’re making.
Next, you’ll have a chance to review and submit. Look over everything to be sure everything looks right.
Everything looks good. Click Submit and Vanguard will politely thank you.
You should also receive an e-mail confirmation.
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.
[Update: Congress has officially blessed the steps of the backdoor Roth as allowed under current law in 2018. See forum thread and links in the White Coat Investor Forum.]
Step 2: Convert to Roth
I move on to Step 2 the next day. If you’re presented with a page like this, you won’t find the right option.
Navigate “My Accounts” “Balances and holdings”
Scroll to your Traditional or Roth IRA (or open a Roth account if you don’t have one). Click on “Retirement contributions and distributions.”
On the next screen, be sure to select the correct tax year. Vanguard defaults to the previous year. If you’re making your 2018 Backdoor Roth contribution, be sure to select Tax Year 2018.
Note: if you’ve never done the Backdoor Roth, and you’re financially able, now is a great time to make one contribution for 2017 and another for 2018. 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 year as long as you complete the 2017 contribution by mid-April, 2018.
Look for the dropdown menu in the lower right labeled “I want to…” and select Convert to a Roth IRA.
Next, we tell Vanguard where the money is coming from (Traditional IRA) and where it’s going (Roth IRA). I chose the Emerging Markets fund since that is a little underweight based on my desired allocation.
You’ll be warned that a conversion is a taxable event. This is false because the initial IRA contribution was a non-deductible contribution. This can safely be ignored.
New this year is a warning that the contribution cannot be reversed. Tax Reform has eliminated the ability to undo Roth conversions.
Since it’s not actually a taxable event, do not withhold any federal income tax.
Click “CONTINUE” one last time and you’re done! A polite note from Vanguard appears.
Step 2.5: Repeat for Spouse (if you’ve got one)
Step 3: Fill out Form 8606 in your 1040
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, you may find answers 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 0% capital gains 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. [Update: According to this Forbes article, Congress has officially sanctioned the Backdoor Roth steps as perfectly legal and legitimate, regardless of the taxpayer’s income.
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Have you taken advantage of the backdoor Roth? What’s holding you back?