Today we’re talking about the (elusive!) Backdoor Roth IRA.
Specifically, guest host Jeremy Schneider is sharing three big things:
- What the Backdoor Roth IRA strategy is
- Why you should (or shouldn’t) pursue it
- How to execute a backdoor Roth IRA contribution the right way
If you’re interested in learning more about this unique strategy for getting more money into a Roth IRA, you’re going to love this episode!
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- Jeremy Schneider:
- How to do a Backdoor Roth IRA at Fidelity: Step-by-Step Instructions for 2023
- Form 8606
- Traditional IRA vs Roth IRA: Which One is Right For You
Backdoor Roth IRA: What It Is, Pros & Cons, and Steps to Execute
Jeremy Schneider: Welcome to the Stay Wealthy Podcast with Taylor Schulte. I'm your host Jeremy Schneider, filling in for Taylor for the month of August.
Today I'm sharing with you all about the elusive backdoor Roth IRA. Specifically, I'm sharing what is a backdoor Roth IRA, why you may or may not want to use one, and the steps to take to actually execute a backdoor Roth IRA. If you've been wondering about backdoor Roth IRAs and how to use them, today's episode is for you.
For all the links and resources mentioned in today's episode, head over to youstaywealthy.com/195.
This is the fourth summer in a row I'm filling in for Taylor for a month, and today is my second of four episodes I'm covering during the month of August. So if you're annoyed that your favorite financial host Taylor isn't here, which is totally understandable, you only got me for two more weeks.
But in the meantime, let's talk about the backdoor Roth IRA. Since you are a listener of the Stay Wealthy Podcast, I imagine you already know that a Roth IRA is an investment account that can be used to grow after tax money tax-free, but it comes with some strings attached.
One of those strings is restricting who can contribute money based on income. If you make too much money, you're not allowed to contribute new cash to a Roth IRA in 2023. If you make over $138,000 as a single tax filer or over $218,000 as a married couple filing jointly, you can't make the Max Roth IRA contribution.
Technically, there's a phase-out period of income where you can make a smaller contribution, but that has always seemed like a logistical mess to try to get the exact right contribution based on an income. You won't even know until the tax year is over. So if you are near or over this income limit, it may make sense to do a backdoor Roth IRA.
What is a backdoor Roth IRA? It's a strategy to subvert the Roth IRA income limit so that you can contribute new money to a Roth IRA at any income level, and it's a strategy that has been confirmed legal by the IRS, although there have been some in Congress pushing to close what they're calling a loophole.
Personally, I think the income limit does more damage, confusing middle income earn than it provides benefits by keeping billionaires from investing their $6,500. But that's neither here nor there. It is what it is.
So how does the backdoor Roth IRA actually work? Well, it's a three-step process.
Step one, clear out any money you have in any traditional or rollover IRAs by rolling them over to your employer 401K.
Step two, contribute cash. Generally the $6,500 maximum to or now empty traditional IRA and step three, convert that traditional IRA to a Roth IRA. This strategy works because the IRS allows for non-deductible contributions to a traditional IRA at any income level. The IRS also allows for conversions from traditional to Roth at any income level.
So you put money into a traditional IRA that is after-tax money and don't claim the traditional tax break and then convert to Roth. No tax is due on that conversion because all the money in your traditional IRA has already been subjected to income tax. The end result is your $6,500 sitting in your Roth IRA exactly as if you had contributed it directly. But with all beautifully simple things, it's not always that simple.
Let's circle back to step one, which is clear out any money you have in traditional or rollover IRAs by rolling them over to your employer 401K. What is this step about? Well, there's this little wrinkle called the pro rata rule. It says that if you're converting money from a traditional to Roth IRA and there's both pre-tax and post-tax money in any of your traditional IRA retirement accounts, you have to convert the money in proportion or pro rata.
For example, imagine you have a hundred thousand dollars pre-tax in a rollover IRA. Then you wanna do a backdoor Roth IRA by contributing 6,500 post-tax dollars to your traditional IRA. When you go to click convert on that traditional IRA, the IRS doesn't let you convert just the new money. It wants the conversions to be made in proportion or pro rata.
So if you convert $6,500, you're gonna end up owing tax on about 94% of that conversion, which is likely not what you want and creates kind of a bookkeeping headache tracking which money is which.
So what do you do to avoid this pro rata complication? Get all of your money out of traditional and rollover IRAs by rolling it over to your employer's 401K plan money stored in your 401K doesn't count towards this pro rata rule.
Note that traditional rollover, simple and SEP IRAs all do count. If you have significant money in any of those accounts and you don't have or don't want to roll them over to your current employer's 401K, then sadly your backdoor Roth IRA dreams likely die here partially because it gets too messy to track pre and post-tax money floating around in your IRAs, but primarily because it would cause you to take the tax hit on converting lots of IRA money, which likely would leave you worse off than just skipping the Roth IRA tax break and investing that money elsewhere.
The actual process for moving your money out of your traditional IRAs into a 401K isn't very romantic. Basically, you fill out some forms with your IRA provider and your 401K provider to get them to move and accept the money. It usually takes at least a week or two for all those forms to go through. I have a longer article on this topic that shows more details in the steps along with screenshots and I've linked that in the show notes.
Okay, so let's say you're still in the running for a backdoor Roth IRA. You've got your traditional IRAs empty out, so now it's time for step two, which is contribute cash. Generally the $6,500 maximum to your now empty traditional IRA. This step is a little easier. You start by logging into your IRA provider clicking the contribute button and transferring in the $6,500.
It's important that this is counted as a non-deductible contribution so that you're not double-taxed when you do the conversion. I'm not aware of any brokerage that actually gives you an option to denote a contribution as nondeductible. Instead, you have to fill out yet another form. This one is called IRS Form 8606.
It's a pretty simple form that basically lets the IRS know you put post-tax money into an IRA so you can prove later that they shouldn't be taxing you on it when you do the conversion. There's also a line on your form 1040 where you put in your IRA deduction as zero. I've also linked both of those in the show notes.
Okay, that was step two. We put money into a traditional IRA and let the IRS know that we're not taking the tax break for the traditional IRA contribution onto step three, which is convert that traditional IRA to a Roth ira.
In theory, this step can happen seconds after step two, but in my experience, you have to wait a couple of days for the contribution to your traditional IRA to settle before we can click the convert button, but doing the step is pretty easy. You log into your brokerage and basically move the money out of your traditional IRA into your Roth IRA.
Your brokerage should recognize this as a conversion because you're going from a pre-tax bucket to a post-tax bucket. They may even show a warning about owing taxes on the amount converted, but you won't owe any taxes on the conversion since it was all post-tax non-deductible money being converted in your traditional IRA.
I'm gonna add one final step three A here, which is to invest that money once it lands in your Roth IRA. If you do all this work just to leave cash sitting in a retirement account, you haven't really done anything as that cash isn't going to grow, log into your Roth IRA brokerage and buy yourself some shiny new index funds.
I'd highly recommend documenting this whole process and making sure to log it correctly at tax time and or share it with your tax repair to make sure you're not paying double tax or not getting credit for this whole backdoor Roth IRA you just executed.
In closing, I'd like to comment that if you are a high-income earner making over the Roth IRA contribution limit, executing a backdoor Roth IRA isn't really that big of a deal. We're talking about $6,500 per year. You could always invest that money elsewhere like a 401K or even a regular old brokerage account.
The headache of trying to jump through these hoops to put a little more money in a tax advantage account may not be worth it. The ultimate freedom, flexibility, and simplicity of a regular old brokerage account may be the more attractive option. Personally, I made a lot of my money all at once when I sold an internet company that I started, and that has resulted in about 95% of my money being invested in a regular old brokerage account. And don't worry, I'm doing just fine.
That is all I've got for today.
For all the links and resources mentioned in today's article, head over to youstaywealthy.com/195.
Next week is my third of four episodes this August when I'm filling in for Taylor and I will see you then.
Episode Disclaimer: This podcast is for informational and entertainment purposes only and should not be relied upon as a basis for investment decisions. This podcast is not engaged in rendering legal, financial, or other professional services.