The Backdoor Roth IRA: How High Earners Can Get Tax-Free Money in Retirement

If you’re a high earner, you may have heard that you’re not allowed to contribute to an IRA.

That’s because the IRS places limits on who can contribute to a Roth IRA and who can deduct their contributions to a Traditional IRA. If you make more than those limits, you’re supposedly out of luck.

And you’d be justified in feeling like that’s a pretty raw deal. After all, you work hard for your money and you want it to work hard for you.

And if you’re not allowed to contribute to an IRA, that’s up to $11,000 per year (for a married couple) that won’t get the special tax benefits an IRA offers.

Lucky for you, there’s a way around the rules.

Today we’re going to talk about the Backdoor Roth IRA, which is a process through which even high earners can contribute to a Roth IRA and get all the tax advantages that come with it.

Here’s what we’re going to cover:

1. Who should consider a Backdoor Roth IRA?
2. How to do the Backdoor Roth IRA
3. Pitfalls to avoid

If you’ve previously been told that you earn too much to contribute to an IRA, today is your lucky day.

Who should consider a Backdoor Roth IRA?

The only people who should consider a Backdoor Roth IRA are people who earn too much money to directly contribute to either a Traditional or Roth IRA.

Here are the income limits for these accounts as of 2015. These limits are actually based on Modified AGI, which is a slightly different number than your regular income (gotta love the IRS!).

For a Roth IRA (source):

• If you are single, your contribution is phased out from $116,000-$131,000.
• If you are married filing jointly, your contribution is phased out from $183,000-$193,000.
• If you are married filing separately, your contribution is phased out from $0-$10,000.

For a Traditional IRA, if you participate in a 401(k) or other employer plan (source):

• If you are single, your contribution is phased out from $61,000-$71,000.
• If you are married filing jointly, your contribution is phased out from $98,000-$118,000.
• If you are married filing separately, your contribution is phased out from $0-$10,000.

For a Traditional IRA, if you DON’T participate in a 401(k) or other employer plan but your spouse does (source):

• If you are married filing jointly, your contribution is phased out from $183,000-$193,000.
• If you are married filing separately, your contribution is phased out from $0-$10,000.

If you don’t participate in a 401(k) or other employer plan and your spouse doesn’t either (or you’re single), then you can contribute to a Traditional IRA regardless of income.

And if your income is lower than these amounts, you can contribute to an IRA the normal way so there’s no need to worry about the Backdoor Roth IRA.

How to do the Backdoor Roth IRA

Alright, so if you make too much money to contribute to an IRA the normal way, how do you get around it?

Here are the basic logistics of the Backdoor Roth IRA, though there are also some potential pitfalls you’ll want to avoid. We’ll get into those pitfalls just below.

Step 1: Open a Traditional IRA

There are many places you can do this, and two of my favorites are Vanguard and Betterment.

Whoever you use, just make sure they offer good, low-cost index funds.

Step 2: Contribute to the Traditional IRA

Technically, you’re allowed to contribute to a Traditional IRA no matter what your income is. It’s just that your contribution won’t be deductible if your income is higher than the limits above.

So in this case you’ll be making what’s called a non-deductible contribution, which simply means that there’s no tax break on your contribution.

You don’t need to do anything to mark your contribution as non-deductible. It will automatically be counted that way at tax time because of your income.

Step 3: Convert it to a Roth IRA

Regardless of income, you are allowed to convert money within a Traditional IRA to a Roth IRA at any time.

The only catch is that you’ll be taxed on the conversion. And in normal circumstances that’s a significant consideration, since your Traditional IRA money will typically have been contributed tax-free and therefore the entire conversion would be taxed.

But in this case, since you made a non-deductible contribution to your Traditional IRA, the money was already taxed.

So when you convert to a Roth IRA, there really won’t be much of a tax impact at all. The amount you contributed can be converted tax-free, and you will only be taxed on any money you earn between the time you contribute and the time you convert.

If you do the conversion soon after your contribution, you won’t have earned much, if anything, and therefore your tax bill will be minimal.

All of which means that you’ll end up with money in a Roth IRA, ready to be withdrawn completely tax-free in retirement, just like if you had contributed the normal way.

Now, every investment company will have a slightly different process for actually doing this conversion, so I would recommend reaching out to their customer service and having them walk you through the steps.

But in all cases it should be fairly simple.

And as long as you can avoid the pitfalls we’ll talk about next, you can do this for both spouses.

Pretty cool!

Pitfalls to avoid

Every time I explain this to someone, they always give me that look that says they’re not quite sure any of this is actually legal.

And trust me, I get it. It definitely sounds a little sketchy.

Actually, it’s great that your BS meter goes off like that! When it comes to money, and ESPECIALLY when it comes to the IRS, it’s better to be safe than sorry.

But rest assured, the Backdoor Roth IRA is definitely legit. Many people do it every single year.

BUT there are some pitfalls to avoid to make sure it all works smoothly.

Pitfall #1: Other IRAs

In order for the Backdoor Roth IRA to work the way I described above, you CAN’T have ANY other Traditional IRA, SEP IRA, or SIMPLE IRA with money in it.

Here’s why:

When you convert to a Roth IRA, the IRS counts ALL of your IRAs as part of the conversion, even if you’re only doing it from one account.

And if you made deductible contributions to those other IRAs, then at least part of your conversion will be taxed.

As an example, let’s say you take the steps above to make a non-deductible $5,500 contribution. But let’s say you also have $25,000 in a different Traditional IRA, and that money was contributed tax-free in years past.

If you convert the $5,500 from your new account, the $25,000 will also be counted as part of the conversion. Which means that most of that conversion will be counted as money that has never been taxed, and therefore needs to be taxed now.

The calculation works like this:

• $30,500 total IRA money
• The $5,500 non-deductible portion is 18% of that
• The $25,000 deductible portion is 82% of that
• So 18%, or $992, of the conversion will NOT be taxed
• And 82%, or $4,508, of the conversion WILL be taxed

Not so great.

Luckily there’s a workaround.

If you have a 401(k), 403(b), or 457(b) retirement plan through work, or if you have a Solo 401(k) through your business, you may be able to rollover that deductible IRA money into one of those accounts before doing the Backdoor Roth IRA.

Doing so would remove all of the complications we just talked about. You would no longer have any other Traditional IRA money and would therefore avoid any unwanted tax consequences.

So, if you have any existing Traditional IRAs, SEP IRAs, or SIMPLE IRAs, make sure to handle this step before you do the Backdoor Roth IRA.

Pitfall #2: How long to wait

There’s a big question around how long you should wait between making your non-deductible IRA contribution and doing the Roth IRA conversion.

Some people feel like it’s fine to do it right away. Others recommend waiting until you have a statement showing the money in your Traditional IRA. And others recommend waiting an entire year. (Here’s an article with all you could ever want to know about this.)

There are two main reasons why there’s such wide disagreement:

1. The IRS has a rule called the step transaction doctrine, which essentially just means that they’re allowed to decide that a series of steps is illegal if the end result is against the spirit of IRS rules, even if each individual step is perfectly the legal. The people who recommend waiting feel like the longer you wait, the less likely it is that the IRS will be able to use this rule against you.
2. On the flip side, there isn’t a single case (as far as I know) of anyone getting into trouble for this, or even of the IRS mentioning that people might get in trouble for it. This is why some people say you can do the conversion immediately.

I don’t have a specific recommendation for you, simply because I don’t know any better than anyone else exactly what the IRS might decide to do.

So I would simply encourage you to use the information above to make whatever decision feels right to you.

Take advantage!

The Backdoor Roth IRA definitely takes more effort than a regular contribution, but it’s absolutely worth it if you make too much to contribute otherwise.

The alternative is likely investing the money in a regular old taxable account instead, which is still a good option. But it’s nowhere near as good as money that will be completely tax-free down the line.

So if you have the opportunity to use the Backdoor Roth IRA, I would definitely try to take advantage of it.

Have you ever done this yourself? What questions do you have about making it work?