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Backdoor Roth IRA

wealth Jan 18, 2021

Roth IRAs are one of the best tax-favored accounts to use for retirement investing. 

You invest "after tax" dollars (meaning your contributions are not tax deductible). The contribution limit for 2021 is $6000, unless you qualify for a catch up contribution. After age 59 and 1/2, all of the funds in the account can be accessed TAX FREE. Yes, you read that right. In addition, Roth IRAs have several other benefits:

  • You can withdraw your contributions (not the growth) at any time.
  • You can make a withdrawal without 10% penalty before 59 and 1/2 if you use the funds for qualified educational expenses (you will still pay income tax on the earnings portion).
  • You can make a withdrawal of up to $10,000 without any taxes or the 10% penalty before age 59 and 1/2 if you use the funds for a first time home purchase as long as you made the contribution >5 years ago (if it has been less than 5 years, you'll pay income taxes on the distribution).
  • No required minimum distributions in retirement (as opposed to a 401k).

However, there are income limits to contributing directly to a Roth IRA. For 2021, the limit is a modified adjusted gross income of $140,000 if single or $208,000 for married filing jointly. That being said, there is a perfectly legal way to contribute to Roth IRAs if you are above the income limit. It's called a "Backdoor Roth IRA" contribution.

Steps to a "Back Door Roth IRA" Contribution:

1. Open a Roth IRA account, but DO NOT directly contribute to it. Ours is at Vanguard, but Fidelity is another excellent option. A new account can be opened online in just a few minutes.

2. Open a traditional IRA account, ideally at the same brokerage firm for simplicity.

3. Make a contribution to the traditional IRA account.

4. As soon as the money becomes "available" within the account, which may take a day or two, click the button to "Convert to Roth". 

5. Report the non-deductible contribution to your traditional IRA on IRS form 8606 when you file your taxes.


Tax Rules:

- You cannot deduct the Traditional IRA contribution on your taxes if you roll it over to a Roth IRA. If you already deducted the traditional IRA contribution and then decided later to convert it, you'll need to pay that tax deduction back. 

- You owe taxes on whatever money the investment earns in the time period before you converted it to Roth (which should be minimal if you do it right away).

- These contributions must sit for 5 years before you can access them if you are under 59 1/2. This is DIFFERENT than direct Roth IRA contributions.

- There is a relatively complex rule called the pro-rata rule to determine the taxes related to the conversion. The easiest way to avoid this rule entirely is to have a zero balance in all traditional IRAs, SEP IRAs, and SIMPLE IRAs at the end of the year. If you are doing additional retirement investing in these types of accounts, a backdoor Roth IRA may not be a good solution for you. 


So who is the backdoor Roth best for? High income earners who are doing their other pre-tax retirement investing in 401(k)s or 403(b)s through their employer. 

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