Are you familiar with the concept of Roth IRA? If you have no idea what’s the difference between a Roth IRA and a traditional IRA, you should start with my previous posts here and here. In short, Roth IRAs allow you to invest your post-tax money and withdraw it and its interest earned tax free in retirement. You invest money in traditional IRAs before taxes and pay taxes on the capital and interest earned when you withdraw it in retirement.
I continue to be a proponent of maxing out your 401k first for almost everyone. For higher income earners, once you fully contribute to your 401K, HSA, and 529, your next best option is a Roth IRA. But there’s a problem. If you’re are able to max out 401K, HSA, 529 and still able to afford a normal living, you probably don’t have the option to directly contribute to your Roth IRA. You make too much money.
How much is too much? If you are a single filer, your contribution amount starts to phase out by $118,000 and you become ineligible if you make more than $133,000. If you are a married couple filing jointly, your phase out and ineligibility start at $186,000 and $196,000, respectively.
But there’s a solution. There is a loophole to allow you to contribute to your Roth: it’s called a backdoor Roth IRA.
The concept of backdoor Roth IRA is really a process of converting your traditional IRA (non-deductible because you make too much money to be eligible to make deductible contributions to a traditional IRA) to Roth IRA. How do you do that? You need to complete three steps:
1.Make a contribution to your traditional IRA account. What if you don’t have a traditional IRA account? Open one. It takes 5 minutes on Vanguard or Fidelity or whatever brokerage you use. I leave no money in this traditional IRA account almost all year (note, this is actually important. Any money you leave in your traditional IRA at the end of the year will trigger pro rata rule which will cost you money). In the first week of January, I make a $5,500 contribution to my traditional IRA. ($5,500 is my maximum. The max is $6,500 for individuals 50 or over).
2.Convert your traditional IRA contribution to Roth IRA. If you have your IRAs with Vanguard, it is literally clicking a button on your account page that says “convert your traditional IRA to Roth.” Note: Don’t choose rollover or recharacterization! Every January after I contribute to my traditional IRA I keep an eye on my account for my money to arrive. As soon as my money shows up on the traditional IRA account, I click “convert to Roth IRA.” When you click “convert”, you will get an warning that says, “Warning: this maneuver is a taxable event.” Ignore it. It’s telling your something you already know.
3.File a 8606 form with your tax returns before April 15 of the following year (tax day). You can find this form here. You will need to make sure this form is filed when you do your taxes. This form is how IRS keep a record of your post tax IRA contributions (i.e. Roth or non-deductible). I plan to write a separate post on this in the future.
That’s it. Now you have gotten around the Roth IRA contribution limit and contributed to your Roth IRA via a “backdoor” as a high income filer.
Wait minute: Why don’t you contribute to your traditional IRA if you can’t contribute directly to your Roth IRA? Does a traditional IRA provide you with the same tax advantages as your 401k? Great question, again, my friend. Unfortunately, if you make too much money to contribute to a Roth IRA, you also make too much money to contribute to a traditional IRA that can provide you with useful tax advantages. When you contribute to a traditional IRA, it’s now called a nondeductible traditional IRA. I will write a post on this nondeductible entity, but for now you just need to know that it’s not worth your money. But it is with the exception of it being the first step to investing in of a backdoor Roth IRA.
Are there reasons that you can’t contribute to your backdoor Roth IRA or are there any mistakes you should avoid? Yes, there are and you should really pay attention to my next financial posts. This seemingly simple maneuver can be trickier than you think when it comes tax season. Keep on following me! In my next post I will discuss some common pitfalls of contributing to a backdoor Roth IRA.