A backdoor Roth IRA is a great additional retirement savings plan for high earning professionals. Since I get many questions on how to make a backdoor Roth IRA contribution, I thought it would be good to help set the record straight and explain the Backdoor Roth IRA rules and answer the common questions that confuse people.
The Backdoor Roth IRA is very simple: Make this year’s contribution to your traditional IRA account, then transfer the money to your Roth IRA account.
But what sounds simple, in the hands of congress, becomes complicated. There are a set of rules you must follow and required paperwork that must be completed in order to fund a backdoor Roth IRA without any IRS troubles.
The Roth IRA was established in the Taxpayer Relief Act of 1997, the summary of which is almost 500 pages long. I will cover the most important concepts, but there will be some nuances not discussed in order to keep this article to a reasonable length. Please consult your CPA to confirm which details pertain to your situation.
For simplification purposes, all examples apply to the 2023 tax year and are based on the married filing jointly tax category. If you need the information for a different tax situation or year, the IRS provides charts for other years and categories. If in doubt, discuss it with your tax preparer. Also, I will refer to your tax year’s modified adjusted gross income, with the abbreviation MAGI. MAGI is the adjusted gross income on line 11 of IRS form 1040 plus any untaxed foreign income, tax-exempt interest, and non-taxable social security benefits. For most people MAGI is simply their adjusted gross income.
What differentiates Traditional IRAs from Roth IRAs?
The traditional IRA contribution may or may not be tax deductible, depending on your MAGI. During the accumulation years, anyone at any income level may contribute to a traditional IRA with a potential tax write-off based on your MAGI. When money is later withdrawn from a traditional IRA, any gain (interest or capital gains) or any contribution that was given a tax write-off will be taxed at the current year’s income tax rate.
Because taxes have not been paid over the life of the traditional IRA, and will be owed only upon withdrawal, the government will not let you postpone paying the taxes forever. They require you to start taking required minimum distributions (RMD), based on your life expectancy. The first RMD will be due by April 1st of the year following the calendar year in which you turn 72.
The Roth IRA is funded with after tax dollars and none of the contributions or gains will ever be taxed in the future. Only people with a low MAGI may contribute directly to a Roth IRA. High income earners (see below) will need to use the backdoor to get their retirement money into a Roth IRA account.
Because taxes will never be owed in your lifetime, the IRS doesn’t care if you distribute the money or not so there is no RMD requirements.
IRAs are for the purposes of retirement funding so the government wants you to wait until you retire to use the money. Therefore, you can only take the money penalty free before age 59 ½ if you follow special rules. Do not withdraw any IRA money before you retire!!! This is not a savings account for the down payment of a house or to pay for college. You will need it when you retire, at which time the withdrawals will support your lifestyle.
What is a backdoor Roth IRA?
High income earners, those with a MAGI of $228,000+, are not eligible to make a direct contribution to a Roth IRA, but anyone at any income level can make a traditional IRA contribution. Also, anyone can convert any amount of money from a traditional IRA to a Roth IRA at any time.
When you combine those concepts you can get around the income limits of the Roth IRA, thus the ‘Backdoor’ reference. High earners first make a traditional IRA contribution and then within a few days do a conversion to their Roth IRA. The taxes will be due on the amount of the conversion. Since the money was contributed to the traditional IRA after taxes and has earned no interest or capital gains yet, there is nothing to tax on the conversion made to the Roth IRA, so the tax bill is zero.
The ending effect is the same as if you made a direct contribution to your Roth IRA. But due to the conversion, you must fill out IRS form 8606 when you do your taxes.
Now the money is in a Roth account that will never get taxed during your lifetime. Your withdrawals will be tax free during retirement and you will not have a required minimum distributions to make.
The most pertinent rules you need to know:
1: Anyone can contribute to a traditional IRA, up to a maximum limit, with money they have earned that year. You can also make a contribution for your spouse even if they don’t earn any income. Consider maxing out the IRA contributions for both you and your spouse every year.
2: The traditional IRA deposit can be tax deductible in the following conditions:
2a: If your MAGI is less than $116,000 or you and your spouse have no qualified employee retirement plan that year, then you can write off the full deposit for the tax year.
2b: If your MAGI is between $116,000 and $136,000, the tax deduction phases out on a sliding scale.
2c: If your MAGI is greater than or equal to $136,000 then you get no tax write off.
Note: Most medical students and residents will qualify to take a tax deduction for their traditional IRA contributions. Most attending physicians will not qualify.
3: You can contribute directly to a Roth IRA with after tax earned income:
3a: If your MAGI is less than $218,000, then you can contribute the maximum amount.
3b: If your MAGI is between $218,000 and $228,000, then your contribution is limited on a sliding scale.
3c: If your MAGI is greater than or equal to $228,000 then you may not make a direct contribution.
Note: Most medical students and residents will qualify to make a direct Roth IRA contribution. Most attending physicians will not qualify to make a direct Roth IRA contribution but can use the backdoor Roth IRA work around.
4: Limits of IRA annual contributions are $6,500 plus an additional $1,000 catch up contribution if you are age 50+. This limit increases periodically. It does not need to be deposited all at once, but doing so will make your backdoor Roth IRA process easier.
5: You can fund an IRA for a given tax year anytime between Jan 1st of the current tax year and April 15th of the next tax year. If you didn’t make last year’s IRA contribution, then before April 15th of the next year you can make a contribution for last year. If you want to keep your tax life simple, always do your contribution and your conversion in the same calendar year for your backdoor Roth IRA. Doing the 2022 contribution in 2023, even though it is OK to do, will make the paperwork more confusing.
6: Money in traditional IRA accounts can be converted to Roth IRA accounts at any time. When you make the conversion, you are withdrawing the money from the traditional IRA, thus taxes are owed on any taxable portion. The balance is then deposited into a Roth IRA. This is not a Roth IRA contribution. The taxes are owed in the tax year the conversion takes place.
7: Roth IRA conversions are made when money is transferred from a retirement account that requires the withdrawals to be taxed, such as a traditional IRA, into a Roth IRA account which will never be taxed. There are no limits to the amount you convert or the frequency of the conversions. There is, however, a 10% penalty for withdraws made from the Roth IRA funds within five years of converting them to the Roth account. IRS form 8606 needs to be filled out for each conversion. There is no waiting period between contributing to your traditional IRA and converting it to a Roth IRA.
8: Beware of the pro-rata rule for the traditional IRA. When money is converted from a traditional IRA to a Roth IRA the tax owed from the withdrawal from the traditional IRA is based on the total of all the traditional IRA money you have that was not yet taxed. For example, if you have no money in the traditional IRA and you make a post-tax contribution of $6,500 to the account, then there is no money in the account that has taxes due upon withdrawal. If you then convert that entire amount to your Roth IRA, since there has been no accumulation of untaxed funds, no taxes are owed in the conversion.
If, on the other hand, you had $30,000 in your traditional IRA before you made the recent $6,500 contribution, and $10,000 of that balance had never been taxed as it was interest and capital gains over the last few years, then when you make the Roth conversion you will have a $36,500 balance in the traditional account, $10,000 of which has never been taxed. This means 27% of the traditional IRA account needs taxing. If you make a $6,500 conversion, then 27% of the $6,500 you convert will be taxable. $1,755 will be subject to your income tax rate. Because of this pro rata rule, be sure there is no balance in ANY traditional IRA account before depositing your current year’s IRA contribution when doing a backdoor Roth IRA conversion or you will owe taxes.
What is the financial effect of adding an IRA?
First off remember the backdoor Roth IRA should only be used after you have filled your office retirement plan. If your income tax rate is 40%, then getting the tax write off of the office 401(k) plan is very hard to beat. It is an instant 40% tax deferred return.
When you add the backdoor Roth IRA you gain additional retirement flexibility and income. Let’s say you start making Roth IRA contributions every year, either direct or through the backdoor, at age 30 and retire at age 60. Your contributions will begin at $6,500 each year, then at age 50 increase to $7,500 each year. This does not take into account any increased maximum contribution limits.
If we assume an 8% average rate of return, then when you retire, your Roth IRA account balance will be $883,865. If you spend the money using the 4% rule, then in your first year of retirement you can withdraw $35,354 tax free. If your spouse also maxes out their Roth IRA account, then during your retirement, as a couple, your Roth IRA withdrawal at 4% will provide you with over $70,000 per year of additional tax-free income.
Steps in making a backdoor Roth IRA contribution
1: Open both a traditional and a Roth IRA account at the same brokerage firm. Do this for each spouse. It is not required that you have the accounts with the same firm, but it makes the conversion much easier if you are transferring the money between accounts at the same firm.
2: Make sure you don’t have any money sitting in any IRA accounts that don’t have Roth in the title. If you do, either make the conversion to a Roth account before adding this year’s deposit, or add this year’s deposit and do the backdoor Roth conversion with all of the money in the account, knowing you will be paying taxes on this first conversion. If you have a very large sum of money in a traditional IRA account, you must decide if you wish to make a large conversion and pay all the taxes, or abandon the backdoor Roth idea. Another option for these large accounts would be to do a rollover to a 401(k) or 403(b) account. The goal is to have no money in any IRA accounts that will have taxes due in the future such as a traditional IRA, a SIMPLE IRA or a SEP-IRA.
3: Make a contribution for you and your spouse to each of your traditional IRA accounts. For 2023 the maximum contribution is $6,500 if you are under 50 years old or $7,500 for those 50 or older. You are not required to make the full maximum deposit. If you find you can only afford to make a $4,000 deposit this year, that is OK.
4: Leave the money in the account as cash, do not invest it. The money will only be in this account for a couple of days, so don’t put it into a mutual fund or a stock, leave it as cash.
5: Transfer the money in the traditional IRA to your Roth IRA account. First, wait until you know the deposited funds have arrived into your traditional IRA account. Since there is a time delay, from the time you make the contribution to when the account has received the money from the prior institution, make sure the money is sitting in the traditional IRA account (funds are available) before you proceed. Once the money is in the account, simply transfer the money to the Roth IRA account. Your IRA contribution has now arrived in your Roth IRA account through the backdoor.
6: Invest the money in the Roth IRA account. Once the money has arrived safely in your Roth IRA account, you are free to make your long-term investment. I recommend you invest the money in index mutual funds such as an S&P 500 index, or a bond index fund.
7: Use an IRS form 8606 for this year’s taxes, one form for each conversion. Since IRAs are individual, each spouse needs to fill out a form for the tax year. The conversion is a taxable event, but since you made a nondeductible contribution of $6,500 and then converted the same $6,500, the gain is zero and no taxes will be owed.
8: Repeat this process every year until you retire. The most important aspects of investing are to be consistent and start early. So once you start, keep it up and you will have a nice Roth IRA nest egg when you retire.
Common questions answered
Following are some of the most common questions I am asked.
My financial advisor says I can only make one Roth Conversion per year.
The financial advisor in question had confused a Roth conversion with a rollover. A rollover is not a taxable event and moves funds from one retirement account to another of the same taxable type, such as rolling a traditional IRA into a 401(k) account, both of which are tax-deferred. A rollover can only be done once a year. The Roth conversion is transferring money from a traditional IRA to a Roth IRA and paying the taxes due. Rollovers are not the same as conversions and conversions have no limits.
I deposited last year’s and this year’s contribution to my traditional IRA, I then converted it all to my Roth IRA. What year do I file tax form 8606?
Tax form 8606 is filed in the year the conversion was made. Although a conversion can be made at any time, which could be many years from the day you made the contribution. Whatever year you make the conversion, that is the tax year you need to fill out the 8606 form. Contributions for a given year can be made up until April 15th of the next year. But conversions happen on the day they occur. They can’t be assigned to the prior year.
Can I do a backdoor Roth if I already have $10,000 in my traditional IRA?
Yes you can. If you have a balance in your traditional IRA account, you will owe taxes when the $10,000 conversion occurs. The taxes will be on the portion that was deposited using a tax write-off and on the amount of interest and/or capital gains that has accrued. After this conversion, your traditional IRA has a balance of zero, so the next time you want to do a backdoor Roth no taxes will be owed.
If I retire before age 59 ½, how do I get my money?
I mentioned earlier that you only want to take money out of an IRA account when you have retired and want to live on the money. If you retire before you are 59 ½, like I did, you can get your money using a formula called Substantially Equal Periodic Payments (SEPP) or rule 72(t). If you click on the link it will show you exactly how it’s done. After calculating your annual payments, they must be taken for five years or until age 59 ½, whichever comes last. There are other ways that will allow you to take money from your IRA account before age 59 ½, you can Google them, but please don’t use them. I’m not listing them because I don’t want you to be tempted to use them.
I made a contribution to my traditional IRA and forgot to make the conversion to the Roth. Now $50 of interest has accumulated. What do I do with the $50 that is now over my Roth contribution limit?
Do not mistake a contribution with a conversion. Contributions are limited and conversions are not. The additional $50 you have earned in your traditional IRA will be taxed when you convert the money in your traditional IRA to the Roth IRA. Since you contributed the $6,500 maximum to your traditional IRA account and have now earned $50 in interest, $6,550 can be converted to a Roth IRA account. The year of the conversion you are required to fill out form 8606 where you will account for the $50 interest earned. The taxes owed on the interest will be paid with your income taxes that year. Pay it, and next time do the backdoor Roth conversion right away before you earn any interest, which will make the process easier.
I have $10,000 in my IRA and my wife doesn’t have an IRA. Can she do a backdoor Roth if I have money in my IRA?
The ‘I’ in IRA stands for individual. When you are doing a backdoor Roth IRA only the amounts in your traditional IRA count towards any pro-rated taxes you will owe. Your IRA money will have no bearing on your spouse’s transaction. If your spouse has no money in a traditional IRA, they can do a clean backdoor Roth conversion. Your conversion will cost you some taxes as you didn’t start with a traditional IRA balance of zero.
You now have a good feel for how the backdoor Roth IRA works. Start with nothing in your traditional IRA, make a contribution, transfer it to your Roth IRA, invest it, and fill out form 8606 at tax time. Repeat this process every year, watching your money grow until you retire. If you are a medical student or resident, your income is probably low enough that you can make a contribution directly to your Roth IRA, saving the conversion hassle. When you become an attending, you can then start using the backdoor. Contribution to both spouses IRA accounts every year will add more than a million dollars to your retirement fund.