The Roth IRA first came into effect in 1997, which happened to be the year I turned 18. I faithfully contributed each year for a number of years. But after a couple of years as a lawyer, my income grew to the point where I was disqualified from contributing to a Roth IRA. I knew I needed to look into traditional IRAs or starting some other investment vehicle, but after surviving through a couple of market crashes (2001 and circa 2008), I wasn’t really in a rush to keep cramming more money into the market. I was tired of saving diligently only to have the next crash take me back down to roughly the amount of my principal contributions. Finally, last year, after taking a several-year hiatus from contributing to my Roth-IRA, I finally started researching retirement options again. I started a solo 401(k) for my side hustle income, but I wanted to do more. To my surprise, I found that even though I was technically ineligible to contribute to a Roth IRA, I could still do what’s called a Backdoor Roth IRA.
A Backdoor Roth IRA involves two simple steps
The first step is to make a traditional IRA contribution. This may or may not be tax-deductible, depending on whether you have the ability to participate in an employer-sponsored retirement plan (including a solo 401(k) that you’ve set up for yourself).
The second step is to convert it to a Roth IRA. If your initial traditional IRA contribution was tax-deductible, then you will need to recognize the converted funds as income, and pay tax on them. Effectively, you’re just reversing the tax deduction that you received for contributing the traditional IRA funds in the first instance. If your initial traditional IRA contribution was not tax-deductible, then there will be no additional tax owed on the converted funds.
If you are converting funds from a pre-existing traditional IRA that was funded with both tax-deductible and non-tax-deductible contributions, the calculation for the amount of tax you have to recognize on conversion gets a bit more complicated. Say your non-deductible contributions into your traditional IRA total $40,000 from all prior years, and the total balance of your traditional IRA is $120,000. Since 1/3 of your IRA consists of non-deductible contributions, when you convert a some or all of your IRA into a Roth IRA, 1/3 of the funds being converted will not be taxable, and the remainder will be taxable upon the conversion.
When I did my Backdoor Roth IRA last year, it was really simple. I didn’t have any tax-deductible traditional IRA contributions, so the math was easy, too. I opened a traditional IRA with Fidelity, and as soon as the account was opened and funded, I went online and selected the option to convert it to a Roth IRA. It was very quick and easy, and I opted to keep my traditional IRA account open, with a zero balance, so I could use it again the next year. The trickiest part was figuring out how to report it properly in TurboTax (but fortunately Google helped with that).
The Backdoor Roth IRA only became an option for higher earners starting in 2010. This is a “loophole” that may close at some point in the near future, so if you are a higher earner who has the ability to contribute to a Backdoor Roth, I strongly urge you to take advantage of it. In an upcoming blog post, I will go into detail explaining why highly compensated folks should contribute $5,500 each year to a Roth IRA, regardless of your current tax bracket. You may think that because you’re in a high tax bracket now, you are more likely to benefit from a traditional IRA, but in the next post, I will lay out some calculations that show that you can actually reap a very large benefit by making a Backdoor Roth contribution instead. Take advantage of this current tax scheme while you can!
* If You Have $8,000 Left Over, Put $5,500 in A Roth IRA, Regardless of Your Tax Bracket