5 Steps to Create a Backdoor Roth IRA
If you make too much to be eligible to contribute to a Roth IRA, Money Girl explains how to create a backdoor Roth – and whether doing so is a smart move for your situation, and your financial needs.
Laura Adams, MBA
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5 Steps to Create a Backdoor Roth IRA
Everyone likes to make more money, but sometimes being a high earner disqualifies you from certain tax benefits—like making contributions to a Roth IRA. It’s the only type of retirement account that locks the doors when your income exceeds certain annual limits.
However, the good news is that even if you make too much to be eligible to contribute to a Roth IRA, there’s actually a strategy you can use to create one. It’s known as a backdoor Roth IRA, and in this episode, I’ll explain what it is, and whether creating one is a smart move for your situation.
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What Is the Benefit of a Roth IRA?
A Roth IRA or Individual Retirement Arrangement is a type of account that allows to you to save for retirement while getting some terrific tax benefits. You make contributions to a Roth on an after-tax basis, and then never pay tax on contributions or earnings in the account again. So when you take withdrawals to spend in retirement, they’re completely tax-free.
Additionally, unlike a traditional IRA, with a Roth you can make contributions at any age, and are never required to take minimum distributions. That means if you don’t need to spend the money, it can continue to grow and be passed along to your heirs, if you like.
These tax benefits are about as good as they get. However, as I previously mentioned, if you’re fortunate enough to be a high earner, you can’t make Roth IRA contributions.
The income cutoff for 2015 if you’re married and file taxes jointly is $193,000. If you’re single, the income limit is $131,000.
So how does a backdoor Roth IRA fit into this picture? Well, first you need to understand the concept of doing a Roth conversion.
See also: Which is Best: A Roth or Traditional Retirement Account?
What Is a Roth Conversion?
Since the tax benefits of a Roth IRA are so attractive, you’re allowed to convert a traditional IRA into a Roth IRA, no matter your income. However, when doing this you take an immediate tax hit.
Remember that funds go into a Roth on an after-tax basis. So doing a Roth conversion means you have to settle up your tax bill with the government. And paying all that tax at once is a bummer.
For instance, if you convert $100,000 from a traditional IRA to a Roth and have a tax rate of 25%, you’ll owe $25,000. Even worse, if you dip into the account before reaching age 59½ to pay the tax, you’ll also be charged a 10% early withdrawal penalty. Now you’ll owe 35% or $35,000—not a good idea.
Since converting a traditional IRA to a Roth requires such a big tax hit, I don’t recommend it. However, there’s another kind of traditional IRA that’s nondeductible or taxable. This is how you can sneak into a Roth IRA, even if you earn too much.
Free Resource: Retirement Account Comparison Chart (PDF download)
What Is a Backdoor Roth IRA?
Creating a backdoor Roth IRA is a completely legal strategy that begins with opening up a nondeductible traditional IRA. This after-tax account can be converted into a Roth IRA regardless of your income.
Since contributions to both a nondeductible traditional IRA and a Roth IRA are made on an after-tax basis, making a conversion doesn’t require you to pay any additional tax on contributions.
Let’s say you’re single and earn $135,000. That makes you ineligible to contribute directly to an existing Roth IRA. But you are eligible to convert a traditional IRA into a Roth IRA. See the difference? There’s an income limit on contributions, but not on conversions.
See also: 10 IRA Facts Everyone Should Know
5 Steps to Create a Backdoor Roth IRA
Here are 5 steps for creating a backdoor Roth IRA for people who earn too much to make contributions directly to one:
Step #1: Open Up a Nondeductible (Taxable) Traditional IRA
Some of the best places to open up your IRA or get retirement account advice include:
Step #2: Make Your Contribution
Contribute up to $5,500 (or $6,500, if you’re over age 50) to a nondeductible traditional IRA. That’s the contribution limit for 2015, but it’s likely to increase in future years.
Step #3: Convert the Account to a Roth IRA
Ask your account custodian or adminstrator to immediately convert the account to a Roth IRA. If you already have a Roth, the converted amount can be put there. If not, the custodian willopen a new Roth IRA for you.
By the way, there used to be an annual income limit on Roth conversions, but that’s no longer the case – and anyone can convert.
Step #4: Pay Tax on Any Earnings
You can repeat this backdoor Roth IRA process every year that you earn more than the income limit. Unless the IRS tightens down on this loophole, it’s a guarantee that money you convert into a Roth IRA will grow on a tax-free basis.
Since you already paid taxes on the money you put into your new nondeductible traditional IRA, there is no tax due on the contribution.
However, if there are earnings in the account from the time you opened it and converted, there may be a small amount of taxable gain. You’ll receive a statement at the end of the year to include when you file your income taxes.
Step #5: Repeat the Steps Above
Remember that even though you’ve created a backdoor Roth IRA, you still can’t contribute additional funds directly to it when you earn more than the income limits. Creating a backdoor Roth is a workaround strategy to have a Roth IRA, and basically accomplishes the same thing.
You can repeat this backdoor Roth IRA process every year that you earn more than the income limit. Unless the IRS tightens down on this loophole, it’s a guarantee that money you convert into a Roth IRA will grow on a tax-free basis.
Tax Pitfalls of a Backdoor Roth IRA
But there’s still a tricky tax pitfall to be aware of with a backdoor Roth. What most people don’t realize is that the tax on a Roth conversion is based on all of your IRA accounts.
You have to pay tax based on the ratio of your after-tax IRA assets to your pre-tax IRA assets. For example, if your nondeductible(taxable) contribution equals 25% of all your retirement accounts, then only 25% of your Roth conversion would be tax-free. If this sounds confusing, it’s because it is!
Just remember that if you have other IRA funds that haven’t been taxed yet—such as a traditional IRA, SIMPLE IRA, or a traditional 401k rollover from a previous employer—you could still end up with a tax bill when you create a backdoor Roth IRA.
A backdoor Roth is the perfect move if you don’t have any other IRAs, but it gets a little complicated if you do. So always seek advice first from your IRA custodian or a tax professional.
There are some tax solutions, such as doing a series of small Roth conversions over time, or doing a reverse rollover to move your traditional IRA assets into a Solo 401k (if you’re self-employed), or into a retirement plan at work, if available.
See also: 3 Common IRA Mistakes That Steal Your Wealth
Should You Create a Backdoor Roth IRA?
So who should consider creating a backdoor Roth? In general, I recommend maxing out a retirement plan at work before contributing to an IRA.
Many workplace retirement plans also offer a Roth option, which, unlike a Roth IRA, has no income limit. Workplace plans have higher contribution limits than IRAs: $18,000, or $24,000 if you’re over age 50, for 2015. Plus, they might also offer additional employer matching funds.
All these perks make them the optimal savings vehicle for retirement, if available. But if you don’t have access to a workplace plan or consistently max one out, a backdoor Roth IRA is something to consider. As I previously mentioned, though, if you already have traditional IRA funds, creating a backdoor Roth won’t be completely tax free.
So proceed with caution, and make sure to seek advice so you fully understand the pros and cons of a backdoor Roth for your situation.
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About the Author
Laura Adams received an MBA from the University of Florida. She’s an award-winning personal finance author, speaker, and consumer advocate who is a frequent, trusted source for the national media. Money-Smart Solopreneur: A Personal Finance System for Freelancers, Entrepreneurs, and Side-Hustlers is her newest title. Laura’s previous book, Debt-Free Blueprint: How to Get Out of Debt and Build a Financial Life You Love, was an Amazon #1 New Release. Do you have a money question? Call the Money Girl listener line at 302-364-0308. Your question could be featured on the show.