There's a certain appeal to the phrase, "Backdoor Roth".
I find it's one of those terms people often recognize, but don’t know if it applies to them.
I also find people over complicate it. And I hate complicated things.
So in today's newsletter I have one goal: create the most concise guide to the Backdoor Roth. It's that simple.
I will cover 5 things:
- Intro to the IRA
- What is the Backdoor Roth?
- How do you execute it?
- Where do folks go wrong?
- Is the Backdoor Roth right for you?
Intro to the IRA
Let's quickly knock out the basics. IRA standards for "Investment Retirement Account."
There are two types of IRA accounts: Traditional and Roth.
Traditional accounts are tax-deductible. Meaning you contribute pre-tax dollars today. Those contributions grow tax-free. You pay tax when you withdraw from the account years later.
Roth accounts are the opposite. You contribute post-tax dollars today. Those contributions grow tax-free and you pay no tax when you withdraw from the account later.
Contributing to a Roth account when you are in a lower tax bracket (early in life) is widely considered a smart thing to do.
And I agree.
However, things get a bit more complicated for high income households.
What is the Backdoor Roth?
In 2023, if your Modified Adjusted Gross Income "MAGI" (line 11 of your tax return) is greater than $228,000 for a couple filing jointly, or $153,000 for an individual, you are ineligible to contribute directly to a Roth IRA.
Is all hope lost? No.
Enter: The Backdoor Roth, a simple workaround that allows high earners to take advantage of the tax benefits of a Roth account.
Note: For the avoidance of doubt, if your income is below the thresholds noted above, you can avoid the Backdoor Roth and directly contribute to your Roth IRA. I almost always recommend doing so.
How do you execute it?
It’s surprisingly easy to execute the Backdoor Roth.
Just follow these steps:
- Open a Traditional IRA (at a brokerage like Vanguard).
- Make a Non-Deductible contribution to that Traditional IRA.
- The next day, convert that contribution from your Traditional IRA to your Roth IRA.
It’s really that easy.
Once you complete these simple steps, you will also want to invest the funds (why else have a Roth account?) and make sure your CPA fills out Form 8606 in your 1040 for that taxable year.
You can execute the Backdoor Roth for a given tax year up until April 15th of the following year.
So for example, you can complete a Backdoor Roth conversion for tax year 2022 up until April 15, 2023 (assuming you meet the restriction noted below).
Where do folks go wrong?
In order to qualify for the Backdoor Roth, you cannot have tax-deferred money in a Traditional IRA, SEP IRA, or SIMPLE IRA in your name as of 12/31 of the calendar year in which you made the Roth conversion.
If you do have money in these accounts, you can do one of two things:
- If the amount is relatively small, just convert the money in those accounts to Roth and pay the tax on the conversion.
- Rollover the money into a 401k plan — this could be your employer’s plan or your own Solo 401k plan if you have your own side hustle (or own a business).
So to be clear, because of the 12/31 restriction, if you had a tax-deferred account with a balance as of 12/31/22, it is likely too late for you to execute a Backdoor Roth for tax year 2022.
However, there’s nothing stopping you from doing it for the 2023 tax year NOW.
In fact, I’d highly recommend setting an annual reminder to complete the Backdoor Roth as early in the tax year as possible.
If you need some guidance on converting or rolling over your existing accounts, shoot me an email and I'll try to help.
Go Deeper: 17 Backdoor Roth IRA Mistakes to Avoid
Is the Backdoor Roth right for you?
As always, it really depends.
And for our purposes it’s really a matter of whether a Traditional (tax-deductible) contribution or a Roth (non-deductible) contribution is better.
As a general rule, if your household income is less than the MAGI limitations, you should almost always contribute directly to a Roth IRA.
That’s because your marginal bracket will likely be higher in the future (when you earn more later in your career).
However, for high earners, it can be more complicated.
So here’s your simple framework:
- If you expect to be in a lower tax bracket when you’re no longer earning an income (i.e. retire), you should choose Traditional contributions today.
- If you expect to be in a higher tax bracket as a retiree than you are right now, go with the Backdoor Roth.
Not sure where your income will be in 20+ years? Join the club.
I generally favor a tax diversification strategy — a mix of Traditional and Roth retirement accounts.
I just choose to hold my Traditional accounts in a Solo 401K so I can still execute the Backdoor Roth.
Wait, I have to contribute to a Traditional IRA to complete the Backdoor Roth, but I also can’t have a Traditional IRA? I’m confused.
Here's the nuance: you need an open Traditional IRA, but only to make a contribution.
The very next day you will convert that contribution from your Traditional IRA to your Roth IRA. That way, come 12/31 of each tax year, you will have $0 balance in your Traditional IRA.
How much can I contribute to my Roth IRA? Is it the same maximum for the Backdoor Roth?
2023 Roth IRA contribution limits:$6,500 if you're under age 50$7,500 if you're age 50 or older
Phaseout ranges where you can make a smaller Roth IRA contribution (less than $6,500) start at income of $218,000 and $138,000 for couples who are married filing jointly and single filers, respectively.
As we’ve discussed, you can workaround these income limitations via the Backdoor Roth, and yes, the contribution limits are the same.
Can I have an employer-sponsored 401K plan and still complete the Backdoor Roth?
Yes, an employer-sponsored 401K shouldn't prevent you from completing the Backdoor Roth conversion. Again, the key is you can't have cash in your Traditional, SEP or SIMPLE IRA at year-end. Money in a Traditional 401K plan is fine.
Is this whole thing legal? Haven’t you heard of the step doctrine thing?
Yes, it’s completely legal as long as you follow the rules.
Footnotes 268, 269, 276, and 277 of the Conference Committee’s explanatory report on the Tax Cuts and Jobs Act validated the backdoor Roth IRA contribution. See here.
And that’s a wrap.
Obviously tax planning can get tricky, so if you have additional (more nuanced) questions I’d speak with your CPA or Financial Planner.
However, I’ll do the best I can to help. Just send me an email.