[Editor’s Note 1/23/2020: This popular backdoor Roth IRA post has been updated with 2019/2020 contribution limits where possible. However, take notice that the video and Form 8606 were created in 2017 and contain contribution limits for that year. The process of filling out the form is still the same regardless of how future contribution rates change so I’ve left them as is. If you’ve hesitated to make a Backdoor Roth IRA contribution on your own in the past, this guide will give you the confidence to go ahead and make the conversion yourself.]
I’m still getting frequent questions on how to do a Backdoor Roth IRA. So I thought I’d put together a basic, step by step, tutorial people can refer to when they do this. Before I get into it, realize that if you are a low earner you can just contribute DIRECTLY to a Roth IRA and skip this Backdoor Roth IRA process. Low earner is defined as a Modified Adjusted Gross Income under a phaseout range of $124,000-139,000 ($196,000-206,000 married). Some docs like residents or peds/family practice/preventive medicine docs married to a non-earner can usually just contribute directly.
Note also that a Backdoor Roth IRA is primarily a two-step process, an IRA contribution and a Roth conversion. If you understand the rules of both of these steps, putting them together is no problem.
Most physicians should be using a personal and spousal Roth IRA, and will usually need to fund one indirectly (i.e. through the back door). Not only does this provide an additional $6,000 each ($7,000 each if you and your spouse are over 50) of tax-protected and (in most states) asset protected space, but it allows for more tax diversification in retirement. That allows you to determine your own tax rate as a retiree by deciding how much to take from tax-deferred accounts and how much from Roth accounts.
5 Steps to Making the Backdoor Roth IRA Contribution
Step 1 Contribute to Your Traditional IRA
Make a $6000 ($7000 if over 50) non-deductible traditional IRA contribution for yourself, and one for your spouse. You can use the same traditional IRA accounts every year, they just spend most of the time with $0 in it. Most fund companies, including Vanguard, don’t close the account just because there is nothing in it. I do this every January 2nd. I just place it into the Prime Money Market Fund to keep the math simple. Since it yields something like 0.04% and doesn’t go down in value, the sum when you convert will be exactly the same as when you contribute. No gains, no losses.
Step 2 Convert the Traditional IRA to a Roth IRA
Convert the non-deductible traditional IRA to a Roth IRA by transferring the money from your traditional IRA into your Roth IRA at the same fund company. If you don’t already have a Roth IRA there, you’ll need to open one. This can be done in a minute or two online at Vanguard and is essentially the same process as opening the traditional IRA. I do this the very next day after I make the contribution. It is very straightforward. When you transfer the money, the website will throw up a scary banner saying something like “THIS IS A TAXABLE EVENT.” That’s true. It is taxable. It is just that the tax bill is zero for it since you’ve already paid taxes on the $6000 and couldn’t claim it as a deduction because you make too much money. You can now invest the money as per your investing plan.
Step 3 Beware of the Pro-Rata Rule
Get rid of any SEP-IRA, SIMPLE IRA, traditional IRA, or rollover IRA money.The total sum of these accounts on December 31st of the year in which you do Step 3 must be zero to avoid a “pro-rata” calculation (see line 6 on Form 8606) that can eliminate most of the benefit of a Backdoor Roth IRA.
You can get rid of these accounts in 3 ways:
- Withdraw the money (not recommended, as the money would be subject to tax and/or penalties, not to mention DECREASING your tax-advantaged/asset-protected investment space.)
- Convert the entire sum to a Roth IRA. Only recommended if it is a relatively small amount and you can afford to pay the taxes out of current earnings or taxable investments with relatively high basis.)
- Roll the money over into a 401K, 403B, or Individual 401K. 401Ks don’t count in the aforementioned pro-rata calculation. Some physicians have even opened an Individual 401K at Fidelity or eTrade (the Vanguard Individual 401K doesn’t accept IRA rollovers) in order to facilitate a Backdoor Roth IRA.
Step 4 Fill Out IRS Form 8606 Correctly
The second part of The Backdoor Roth IRA is done 15 months later when you (or your accountant) fill out your IRS Form 8606 on your taxes. Don’t forget to do it or there is a $50 penalty. Remember that you need one form for each spouse. You need to double check this to make sure it is done right, even if you hire a pro. Advisors have told me that they have had to help clients fix dozens of these that tax preparers had done improperly. If you don’t do it right, you’ll pay taxes twice on your Backdoor Roth IRA contribution.
[Update 2020: To help you get step 4 right, back in 2017 I put together this Form 8606 Tutorial video AND a correctly filled out 8606 form. Both show in detail how Form 8606 should be completed in a typical year. Yours will look different if you did your conversion in a different year from your contribution, or if you had an additional Roth conversion this year. And remember, contribution limits at the time were $5,500 for an individual but are $6,000 in 2020.]
Page 1 (below) shows a “distribution” from your non-deductible IRA. Since the money was already taxed, the taxable amount on your distribution is zero. Line 1 is your non-deductible contribution. On Line 2, your basis is zero because you had no money in a traditional IRA on December 31 of last year (if you’ve been carrying a non-deductible IRA for years this may not be zero.) Line 6 is zero in a typical year. Note that Turbotax may fill this out a little differently (may leave lines 6-12 blank) but you end up with the same thing. Line 13 is the same as line 3, so tax due is zero.
On page 2 (below), you are showing the Roth conversion. I’m not really sure why you have to do this twice (since you’re just transferring the amounts from lines 8 and 11 and then subtracting them), but that’s what the form calls for. As you can see, a Roth conversion of a non-deductible traditional IRA contribution without any gains is a taxable event, it’s just that the tax bill is zero for it.
When double-checking your tax-preparer’s work, you want to concentrate on lines 2, 14, 15c, and 18, and make sure they’re a very small amount, like zero, and not a very large amount, like $5500.
Notice how there is no place on the form to put the date when you made the contribution or the date when you made the conversion. It isn’t on the form your IRA custodian sends to the IRS (1099-R) either.
Harry Sit’s blog, The Finance Buff, has a nice tutorial showing how to fill out form 8606 using Turbotax, which, believe it or not, is trickier than doing it by hand.
Step 5 Repeat Next Year
Contribute and Convert Each Year
You do not have to wait any period of time between the contribution and conversion. Each year, I make my Traditional IRA contribution on January 2, then convert to a Roth IRA the next day. That gets my investment money working as soon as possible and simplifies the record keeping. Vanguard won’t let you do it the same day, so I have to wait one day anyway.
The Step Transaction Doctrine
There used to be concern that the IRS would have a problem with the backdoor Roth due to an IRS rule called The Step Transaction Doctrine. This rule basically says that if the sum of a bunch of legal steps is illegal, then you can’t do it. Some wondered if this backdoor conversion from traditional IRA to Roth was a legal transaction considering this doctrine. Those concerns, valid or not, are no longer an issue. The IRS clarified in early 2018 that no waiting period is required between the contribution and conversion steps of the Backdoor Roth IRA and essentially given its blessing on the whole process. Waiting just makes things more complicated on the 8606, as discussed in Pennies and the Backdoor Roth IRA.
Late Contributions to the Backdoor Roth IRA
While it is “cleaner” to make your contribution and your conversion all in the same calendar tax year, you can make your contribution up until your tax filing date of the next year. Late Contributions to the Backdoor Roth IRA has more details about doing this but hasn’t been updated in a while, so let’s do it now. The key to filling out the 8606 correctly when you make a contribution after the calendar year is to recognize that the contribution step is reported for the tax year and the conversion step is reported for the calendar year. So imagine you did the following during the calendar year 2018:
- Made a 2017 IRA contribution (reported on 2017 8606)
- Did a Roth conversion of that contribution (reported on 2018 8606)
- Made a 2018 IRA contribution (reported on 2018 8606)
- Did a Roth conversion of that contribution (reported on 2018 8606)
Your forms would look like this:
2017 Form 8606 (only have to fill out part I)
2018 Form 8606 (must fill out parts I and II)
Notice a couple things here. First, you’ve got to do all of Part I plus Part II for this year because you did the conversion step, unlike last year. Second, don’t get confused by the fact that this form says “2017” and line 4 asks about 2018. This is the 2017 form and you would actually be filling out the 2018 form. But since the 2018 form didn’t exist yet at the time, I had to use the 2017 form for this demonstration. So add one year to anything you see here. But let’s go through this line by line.
- Line 16 – Line 8 is $11,000 so $11,000
- Line 17 – Line 11 is $11,000 so $11,000
- Line 18 – $11,000 – $11,000 = $0
As simple as this all seems, there are a few ways to screw up the process. Read 17 Ways to Screw Up A Backdoor Roth IRA to see them.
What do you think? Are you doing Backdoor Roth IRAs? Why or why not? Any questions about it? Comment below!
Originally posted at https://www.whitecoatinvestor.com/backdoor-roth-ira-tutorial/