I continue to receive regular inquiries about how to set up a Backdoor Roth IRA. As a result, I decided to create a basic step-by-step instructional that people can refer to when performing this task. Before I begin, keep in mind that you can donate DIRECTLY to a Roth IRA if you are a low-income earner and bypass this Backdoor Roth IRA method. A low earner is defined as someone with a Modified Adjusted Gross Income of $124,000-139,000 ($196,000-206,000 married) in 2020 and $125,000-140,000 ($198,000-208,000 married) in 2021. Certain physicians, including residents or attendings in lower-paying specialties who are married to a non-earner, can contribute directly to a Roth IRA.
Additionally, a Backdoor Roth IRA is a two-step process that begins with an IRA contribution and ends with a Roth conversion. If you understand the rules for both of these procedures, combining them should be straightforward.
Married physicians should contribute to both their personal and spousal Roth IRAs and will typically have to fund both indirectly (i.e., through the back door). Not only does this provide an additional $6,000 in tax-protected and (in most states) asset-protected space for 2020 and 2021, but it also allows for increased tax diversification in retirement. This enables retirees to select their tax rate by determining how much money to withdraw from tax-deferred funds and how much money to withdraw from Roth funds. Bear in mind that IRA stands for INDIVIDUAL RETIRED ACCOUNT. Therefore, even if the pro-rata rule (described below) prevents you from participating in the Backdoor Roth IRA, it does not necessarily prevent your spouse from participating. Each spouse declares their Backdoor Roth IRA on a different 8606, which means that my tax returns always contain two 8606s.
Contribute to Your Traditional IRA in 5 Easy Steps
Step 1 Contribute to Your Traditional IRA in 5 Easy Steps
Contribute $6,000 ($7,000 if over 50) to a non-deductible conventional IRA for yourself and your spouse. You can continue to use the same traditional IRA accounts year after year—they spend most of their time with no money in them. Most fund companies, including Vanguard, do not cancel an account simply because it is empty. This is something I do every January 2nd. To make the calculations simple, keep it in cash (i.e., a money market or settlement fund) while in the traditional IRA. Between the contribution and conversion steps, you do not want any losses or significant gains.
2020/21 Contribution Limits
Step 2 Convert the Traditional IRA to a Roth IRA
Following that, convert your non-deductible traditional IRA to a Roth IRA by transferring funds from your traditional IRA to your Roth IRA at the same fund firm. If you do not already have a Roth IRA in that location, you must open one. This may be accomplished in a matter of minutes or seconds online at Vanguard and is substantially identical to the process for starting a traditional IRA. This is something I do the day after I contribute. It’s pretty simple. When you make the payment, the website will display a frightening banner that reads, “THIS IS A TAXABLE EVENT.” That is correct. It is subject to taxation. It’s just that the tax bill is zero because you had paid taxes on the $6,000 and were unable to claim it as a deduction due to your high income. You can now invest the funds according to your investment strategy. You can proceed to step 2 almost immediately after completing step 1. Certain businesses will allow you to do so on the same day. Other businesses will require you to wait until the following day, or possibly a week or more. However, there is no reason to put it off for months.
Step 3 Exercise Caution Regarding the Pro-Rata Rule
Remove any funds from your SEP-IRA, SIMPLE IRA, conventional IRA, or rollover IRA. The total value of these accounts on December 31st of the year in which you perform the conversion step (Step 2) must equal zero to avoid a “pro-rata” computation (see line 6 on Form 8606) that can erase the majority of the advantage of a Backdoor Roth IRA.
You can delete these accounts in three ways: Withdraw the funds (not recommended, as the funds will be subject to tax and penalties, in addition to reducing your tax-advantaged/asset-protected investment space). Convert the whole account balance to a Roth IRA. Only if the amount is small and you can pay the taxes out of current earnings or taxable investments on a high basis. Convert the funds to a 401(k), 403(b), or Individual 401(k) (k). 401(k) plans are not included in the pro-rata computation discussed previously. Some physicians have even formed an Individual 401(k) with Fidelity or eTrade to facilitate a Backdoor Roth IRA (the Vanguard Individual 401(k) does not accept IRA rollovers).
4th step Complete IRS Form 8606 Properly
The second stage of the Backdoor Roth IRA is completed months later when you (or your accountant) file your tax return using IRS Form 8606. Don’t forget to do it, or a $50 penalty will apply. Bear in mind that you will require a separate form for each spouse. INDIVIDUAL RETIRED AFFILIATIONS. You must double-check this to ensure it is completed correctly, even if you employ a professional. Advisors have informed me that they have had to assist customers in rectifying many similar errors made by tax preparers. If you don’t do it correctly, your Backdoor Roth IRA contribution will be taxed twice.
The illustration on Page 1 (below) depicts a “distribution” from your non-deductible IRA. Since the money has already been taxed, the taxable portion of your dividend is zero. Line 1 is the amount of your contribution that is not tax-deductible. On-Line 2, your basis is zero because you did not have any money in a traditional IRA as of December 31 of last year (this may not be zero if you have been carrying a non-deductible IRA for years). In a regular year, line 6 is zero. Note that Turbotax may fill this in slightly differently (for example, it may leave lines 6-12 blank), but the result is the same. Because line 13 is identical to line 3, the tax due is nil.
You demonstrate the Roth conversion on page 2 (below). I’m not sure why you have to perform this twice (you’re only moving the values from lines 8 and 11 and then removing them), yet the form requires it. As you can see, converting a non-deductible conventional IRA contribution to a Roth account without any gains is a taxable event; the difference is that the tax obligation is nil.
When double-checking your tax preparer’s work, focus on lines 2, 14, 15c, and 18, and ensure that they have a tiny sum, such as zero, rather than a tremendous amount, such as $6,000. In addition, the paperwork may become more onerous if you are converting additional Roth accounts concurrently or if you made a contribution the prior year (i.e., made your 2020 contribution in 2021). For additional information, please see the section below.
Note that the form contains no space for you to provide the date of your contribution or conversion. Therefore, it is also not included on the document your IRA custodian submits to the IRS (1099-R).
The Finance Buff, a site run by Harry Sit, offers an excellent lesson on how to fill out form 8606 using Turbotax, which, believe it or not, is trickier than completing it by hand.
Step 5 Repetition the Following Year Each Year, Contribute and Convert
You are not required to wait any period between contribution and conversion. Each year, I contribute to a Traditional IRA on January 2 and then convert to a Roth IRA the following day. This puts my investment money to work immediately and simplifies record keeping. Unfortunately, Vanguard will not allow you to do so on the same day; therefore, I will have to wait one day regardless. If you discover that you have a few pennies remaining in the account and are concerned about being pro-rated, see this post: Pennies and the Backdoor Roth IRA.
The Step Transaction Doctrine
There was once worry that the IRS might oppose the backdoor Roth due to an IRS rule known as The Step Transaction Doctrine. This rule essentially states that if the aggregate of several lawful steps is illegal, you cannot perform them. Some questioned whether this backdoor conversion from regular to Roth IRA was permitted under this approach. Whether those worries are valid or not, they are no longer relevant. In early 2018, the IRS indicated that no waiting period is required between the contribution and conversion portions of the Backdoor Roth IRA, thereby endorsing the entire operation. Waiting only complicates the 8606 situations, as detailed in Pennies and the Backdoor Roth IRA.
Contributions Made Late to the Backdoor Roth IRA
While it is preferable to make your donation and conversion in the same calendar year, you may make your contribution up to the end of the following year’s tax filing season. Contributions Made Late to the Backdoor Roth IRA contains additional information on how to do this but has not been updated in a while, so let’s do it now. The key to accurately completing Form 8606 for contributions made after the calendar year is to remember that the contribution step is reported for the tax year. The conversion step is reported for the calendar year. As an example, consider the following in the calendar year 2021:
Contributed to a 2020 IRA (reported on 2020 8606) Did you convert the contribution to a Roth IRA? (reported on 2021 8606) Contributed to a 2021 IRA (reported on 2021 8606) Did you convert the contribution to a Roth IRA? (reported on 2021 8606)
Your forms would seem as follows:
Form 8606 2020 (you only need to complete part I)
Take note that this merely acts as a reporting basis for the following year. There is no tax due. Due to the fact that no conversion was performed during the calendar year 2020, you simply need to complete lines 1-3 and 14.
Form 8606 – 2021 (parts I and II must be completed)
Take note of a few points here. First, you must do all of Part I plus Part II for this year because, unlike the previous year, you completed the conversion phase (2020). Second, do not be misled by the fact that line 4 of this form states “2020.” This is the 2020 form; however, you will be completing the 2021 form. Because the IRS has not yet issued the 2021 form, I was forced to utilize the 2020 form for this presentation. Therefore, multiply everything you see here by one year. Let’s proceed line by line through this.
I Line 1 – This is the amount of money you contributed for the year 2021. Line 2 – This is your starting point. Because you made a contribution for 2020 but did not convert it throughout the year, your base is $6,000 for 2020. Line 3 – 6,000 plus 6,000 equals 12,000 Line 4 – Keep in mind that this is a question about 2022, not 2021, and that you will not make the same mistake with your donation again, this will be zero. Line 5 – $0 – $12,000 = $12,000 Line 6 – This is the line that causes the pro-rata calculation to occur. Even though you made a 2020 contribution AFTER December 31, this line would remain zero if you filled it out for 2020, which you did not do because you did not conduct a conversion in 2020 and so avoided lines 4-13. However, this is the 2021 form, and due to the fact that you converted your entire traditional IRA, this will be $0. Line 7 – This does not take conversions into account. Due to the fact that you did not withdraw any funds from your conventional IRA this year except for the conversion, this is $0. Line 8 – You converted a total of $12,000 to a Roth IRA this year, which equals $12,000. Line 9 – 0 + 0 + 12 = 12 Line 10 – $12,000 divided by $12,000 equals one Line 11 – $12,000 multiplied by one equals $12,000 Line 12 – $0 multiplied by 1 equals $0 12,000 – 12,000 + 0 Equals 12,000 Line 14 – $12,000 – $12,000 – $12,000 = 0 Keep in mind that if you complete this form for 2022, line 2 will be $0. (Line 14 of the 2021 form is equal to Line 2 of the 2022 form.)
As you construct your portfolio, your Roth IRA contributions will need to pass through the “backdoor” numerous times.
Line 15a – – – – – – – – – – – – – – – – Line 15b – You did not withdraw funds from an IRA to assist you in surviving a calamity, thus $0 Line 15c – – – – – – – – – – – – – – – – Section II Line 16 – Line 8 is $12,000, making the total $12,000 Line 17 – 11 equals $12,000, so $12,000 Line 18 – $12,000 – $12,000 – $12,000 = 0
As straightforward as this all appears, there are a couple ways to muddle the process. To discover how to screw up a backdoor Roth IRA, see 17 Ways to Screw Up A Backdoor Roth IRA and How to Fix Backdoor Roth IRA Screw-ups.
What are your thoughts? Are you a practitioner of Backdoor Roth IRAs? What are your reasons for or against? Any concerns about it? Leave a comment below!