Saving and investing for retirement early in your career is essential. There are many different retirement plans to choose from, but the Roth IRA can be one of the best options.
That’s because your income will be lower earlier in your career compared to later in your career, so the amount you pay in taxes will be lower at that time as well.
But, overtime, your income will hopefully rise by receiving raises at your current job, changing to a job that will pay you more, or starting a physical therapy side hustle or occupational therapy side hustle.
In any case, if your income increases high enough, it could limit the amount you are allowed to contribute to a Roth IRA or even disqualify you from contributing to one at all.
The Solution: The Backdoor Roth IRA strategy.
This article will address what the Backdoor Roth IRA strategy is and how to going about implementing it.
Let’s get started.
What Is An IRA?
The term “IRA” is simply an acronym for Individual Retirement Account. It’s a category of retirement plans that includes the following:
Since the focus of this article is the Backdoor Roth IRA strategy, this article will largely discuss the traditional IRA and the Roth IRA since both are instrumental in this process.
But we’ll circle back later to the SEP IRA and the SIMPLE IRA and discuss why you also don’t want to forget about those accounts if you have them.
Before jumping right into the Backdoor Roth IRA strategy, it’s important to understand the tax implications of using a traditional IRA compared to a Roth IRA, so we’ll cover both of those next.
How Do Taxes Work With A Traditional IRA?
The money contributed to a traditional IRA is pre-tax money.
Contributing money without readily paying taxes on that money allows you to get a tax deduction for making those contributions.
However, when you later withdraw money from your traditional IRA account, you will have to pay tax on that withdrawn amount. That amount will include both the contributions that you originally made to the account and also the earnings that were hopefully made by investing those contributions.
How Do Taxes Work With A Roth IRA?
The money contributed to a Roth IRA is after-tax money.
Paying taxes on the money you will contribute to your Roth IRA doesn’t garner you a tax deduction.
However, when the time comes to make a withdrawal, you don’t pay any taxes on that amount since you already paid taxes on the amount you originally contributed. In other words, both your original contributions along with the earnings you made by investing your contributions can be withdrawn tax free.
While not having to pay taxes on your Roth IRA’s earnings probably sounds appealing, the problem is that not everyone qualifies to contribute directly to a Roth IRA. That’s because the IRS restricts your ability to contribute directly to a Roth IRA if, in their eyes, you make too much money.
The IRS uses the value of your Modified Adjusted Gross Income (MAGI) when determining if your income is too high to contribute directly to a Roth IRA. Below are the specific cutoffs for year 2023:
If You File Taxes As Single
- If your MAGI is less than $138,000 then you can contribute up to the annual limit
- If your MAGI is $138,000 or greater but less than $153,000 then you can contribute at an amount that is less than the annual limit
- If your MAGI is $153,000 or greater then you cannot contribute
If You File Taxes As Married Filing Jointly
- If your MAGI is less than $218,000 then you can contribute up to the annual limit
- If your MAGI is $218,000 or greater but less than $228,000 then you can contribute at an amount that is less than the annual limit
- If your MAGI is $228,000 or greater then you cannot contribute
If You File Taxes As Married Filing Separately And You Don’t Live With Your Spouse
- If your MAGI is less than $138,000 then you can contribute up to the annual limit
- If your MAGI is $138,000 or greater but less than $153,000 then you can contribute at an amount that is less than the annual limit
- If your MAGI is $153,000 or greater then you cannot contribute
If You File Taxes As Married Filing Separately And You Do Live With Your Spouse
- If your MAGI is less than $10,000 then you can contribute to a Roth IRA at an amount that is less than the annual limit
- If your MAGI is $10,000 or greater then you cannot contribute to a Roth IRA
If your income limits your ability to contribute directly to a Roth IRA, then the backdoor Roth strategy might be a good option for you.
How Does The Backdoor Roth IRA Strategy Allow Those Who Don’t Qualify To Contribute Directly To A Roth IRA Still Contribute To A Roth IRA?
After reviewing both the traditional IRA and the Roth IRA, you may have realized that there are income restrictions on who can contribute to a Roth IRA but there are no income restrictions on who can contribute to a traditional IRA.
The backdoor Roth IRA strategy uses this opportunity by having you contribute pre-tax money to a traditional IRA and then convert that money to a Roth IRA by paying taxes on that contribution. Your money can then grow tax-free, just like it would for those who contribute directly to a Roth IRA.
This Feels Too Good To Be True – Is The Backdoor Roth IRA Legal To Do?
Yes!
The IRS acknowledges that the backdoor Roth IRA strategy is a completely legal way to bypass the income limits required to contribute directly to a Roth IRA.
How Does A Backdoor Roth IRA Work?
The IRS lists 3 legal ways to perform the Backdoor Roth strategy by moving money from a traditional IRA account to a Roth IRA account:
- Taking money out of your traditional IRA account in the form of a check and then depositing that check into your Roth IRA account
- Opening up a Roth IRA account at a company different than the company your traditional IRA account is with and asking the company that has your traditional IRA to transfer money from that account to the company who has your Roth IRA
- Opening up a Roth IRA account at the same company that has your traditional IRA account and asking that company to transfer money from your traditional IRA account to your Roth IRA account.
I find the third option to be the simplest, so I’m going to break down how to perform the backdoor Roth IRA strategy using that method:
Step 1. Timing Is Everything
The first thing you’ll want to do is to make sure that you are initiating with the Backdoor Roth IRA strategy no earlier than January 1st of your current tax year and no later than April 15th (the typical deadline for filing your taxes) of the following year.
Even if you plan on filing an extension to pay your taxes, do not start this process after April 15th.
For example, for tax year 2023, start the Backdoor Roth IRA process between January 1st, 2023 and April 15th, 2024.
While that may seem like a large window, it doesn’t surprise me that many of the Money Mobilizer readers I’ve discussed the Backdoor Roth IRA strategy with have told me they don’t procrastinate – they do their conversions in January or February of each year.
Below is one reason why you should not procrastinate and then after that is one reason why it’s not the end of the world if you do:
Why You Shouldn’t Procrastinate: Your Money Is Invested For A Longer Period Of Time
The longer your money is invested tax-free, the longer it can have to potentially make investment gains tax-free compared to someone else that did the process later in the year.
This is not a guarantee, of course, since your invested money could either do well or do poorly during that time. But many believe that “time in the market beats timing the market,” so this is something to consider.
Why Procrastinating A Little Bit Is Not The End Of The World: The 5-Year Withdrawal Rule
The IRS states that money you convert from your traditional IRA to your Roth IRA cannot be withdrawn from your Roth IRA for 5 years, otherwise you’ll have to pay a 10% penalty.
The good news is that the 5-year clock always starts on January 1st, even if you do the conversion later in the year. For example, if you did a conversion on January 15th, 2023 the 5-year clock will actually start on January 1st, 2023. Or if you did the conversion on December 1st, 2023 the 5-year clock will still start on January 1st, 2023.
Also, keep in mind that if you do a Backdoor Roth each year then each of those years has its own 5-year waiting period. For example, the money you converted from your traditional IRA to your Roth IRA on January 15th, 2023 can first be withdrawn penalty free on January 1st, 2028 but money you may convert on January 15th, 2024 can first be withdrawn penalty free on January 1st, 2029.
Step 2. Open A Traditional IRA Account And A Roth IRA Account
You will need both a traditional IRA account and a Roth IRA account.
If you don’t have them, you’ll need to open them up. I recommend opening both accounts with the same company.
Once you have both accounts set up you can continue to reuse them for this process each year you do the Backdoor Roth IRA strategy.
Step 3. Start With An Account That Has A $0 Balance
It’s best to make your contribution to a traditional IRA account that doesn’t have any money in it.
If there is money in it before you start the Backdoor Roth IRA process then you may end up paying more taxes than you originally anticipated.
Step 4. Make A Contribution
Now that you have a traditional IRA account, you will need to contribute to it.
You can do so up to the allowable amount for that year. In 2023, that amount is $6,500 ($7,500 if you’re 50 years or older).
If you can afford it, you may want to consider contributing the entire $6,500 ($7,500 if you’re 50 years or older) all at once rather than in monthly installments. That way, you only have to do the Backdoor Roth IRA process once each year instead of once each month.
Just like any other typical bank transaction, it may take a few days for the money to actually move from your personal bank account to your traditional IRA account.
Once the money is in your traditional IRA, though, don’t invest it in anything – just leave it sitting there.
Also, when the time comes to file your taxes, it’s important that you don’t deduct this contribution since you will be moving this money to a Roth IRA.
Step 5. Consider Waiting For 1 Month To Pass
Now that you have your money in your traditional IRA account, you’ll want move it to your Roth IRA account.
But there are two reasons you should wait.
a.) The Holding Period
Some companies require you to keep your money in your traditional IRA account for a short amount of time (e.g. 24 hours). This is often referred to as a holding period.
Although not all companies have a holding period, if the company you are using does then you will need to wait the required duration of time before you can move your money from your traditional IRA to your Roth IRA.
b.) The Step Transaction Doctrine
The IRS’s Step Transaction Doctrine states that “a series of transactions designed and executed as parts of a unitary plan to achieve an intended result. . .will be viewed as a whole regardless of whether the effect of so doing is imposition of or relief from taxation.”
In other words, the process of performing the sequential multiple steps needed to perform the Backdoor Roth strategy could be seen by the IRS as one large step to avoid paying taxes and therefore not be allowed.
That is why some people who perform the Backdoor Roth IRA strategy choose to wait up to 1 month before proceeding forward with Step 6 (covered next).
Why 1 month? Because that allots enough time for a financial statement to be produced, thereby documenting that money has been deposited into your traditional IRA.
Not everyone bothers waiting this long, or at all – some people do Step 6 the day after performing Step 4. Talk to your tax professional to find out what they recommend.
Step 6. Convert your traditional IRA funds to Your Roth IRA
You are now ready to move the money from your traditional IRA account to your Roth IRA account. Doing so is called a conversion.
When you do this, don’t be surprised if the company provides you with some sort of tax warning. However, you shouldn’t end up having to pay any taxes on your conversion since you already paid taxes on this money when you contributed it to your traditional IRA in Step 3. You also didn’t invest any of that money when it was in your traditional IRA so there are no investment gains to pay taxes on.
Step 7. Invest Your Roth IRA Money
Now that your money is in your traditional IRA, you don’t want to just leave it sitting there – you’ll want to invest it.
Decide how you would like to invest it and move forward with actually doing so.
Step 8. Follow The Pro Rata Rule And Mind Your IRAs
The IRS stipulates that if you have both pre-tax and post-tax money in the same account, then a distribution taken from that account will consist of money that is both pre-tax and post-tax, proportionally.
The IRS provides this easy-to-understand example: Let’s say you have $100,000 in your IRA account, of which $80,000 (or 80%) is pre-tax and $20,000 (or 20%) is post-tax. If you were to request a distribution of $50,000, then that $50,000 would be made up of $40,000 (80% of $50,000) pre-tax money and $10,000 (20% of $50,000) post-tax money.
In other words, you can’t take a distribution of only post-tax money and move it to a Roth IRA account.
The IRS refers to the concept of taking a distribution of both pre-tax and post-tax proportionally based on your current account balance of pre-tax and post-tax money as “pro rata,” which is why this is often referred to as the “pro rata rule.”
Now, here’s the important part – recall how we previously covered that there are 4 different types of IRAs:
In the case of doing the Backdoor Roth Strategy, the IRS views all of the IRAs you have as being one big account (even though they are actually separate accounts).
Since you now have a Roth IRA account with post-tax money in it, you’ll want to avoid having any pre-tax money in any other type of IRA account (ie Traditional IRA, SEP IRA, or SIMPLE IRA) as per the pro rata rule – otherwise the IRS will consider this a mix of having both pre-tax and post-tax money in the same account.
Therefore, if you have any other IRA account that has pre-tax money in it, you should roll that over into one of the following depending on which you qualify for:
- An Employee 401(k)
- An Individual 401(k)
- A 403(b)
Your other option would be to withdraw your money from these accounts, but then you’d have to pay taxes on that money (both the contributions you’ve made and also the investment earnings) and you probably don’t want to do that.
Since taxes are calculated by the IRS on a yearly basis, you need to do this by the end of the tax year in which you do the Backdoor Roth strategy so that all of these accounts don’t have any money in them when December 31st of the tax year comes around.
Step 9. Pay Taxes
Remember how, in Step 5, you moved money you haven’t yet paid taxes on from your traditional IRA to your Roth IRA?
Well, at some point you do have to pay taxes on that money – after all, a Roth IRA is a post-tax account.
The good news is you don’t have to pay taxes right after you do your Roth conversion. Rather, you can do so when you file your tax return by the typical April 15th deadline. When you do, though, make sure your tax professional fills out Form 8606 so the IRS understands that you did the Backdoor Roth IRA strategy.
Final Thoughts. . .
I hope this article gave you a better understanding on what the Backdoor Roth Strategy is and how it works.
After reading this article, the next logical question you’re probably asking yourself is “Should I do the Backdoor Roth Strategy?”
In an attempt to avoid making this article too long, I will try to help you answer that very question in a separate, future article. That said, as always, feel free to reach out to me with your questions.
