The Backdoor Roth: Investing in a Roth IRA for High Earners

I love my Roth IRA.

I was lucky in that my dad pushed me to open one the moment I started earning money that was reported on a W-2. The Roth IRA was created in 1998, the year I started college, so I got in as early as once possibly could have gotten a Roth IRA. Of my many investing mistakes, I'm glad this wasn't one of them!

Which is great because as I'd get older, this fantastic tax-free investment vehicle was no longer possible for us. There's an income phaseout.

But there's still a way to sneak money into a Roth IRA through the backdoor.

And for the full scoop on how this works, I enlisted the help of PoF, moniker for the brains behind Physician on FIRE, because he's been doing this for a while. One of the groups of people who very quickly become ineligible for the Roth IRA are physicians. Medical professionals are well compensated (oftentimes because they need to pay off massive student loans!) and so the only way they can get into the Roth game is through this backdoor method.

If you aren't in the phaseout yet, take it from one early retiree — keep contributing to your Roth IRA!

If you are in the phaseout, read on for PoF's explanation on how Backdoor Roth IRAs work.

Is a backdoor Roth legal? For years, it lived in a legal limbo period where people weren't sure. But in a recent Conference Report that accompanied the Tax Cuts and Jobs Act, Congress recognized the legitimacy of IRA conversions. If you are to read it, it's on page 289 under footnotes 268 and 269:

268 Although an individual with AGI exceeding certain limits is not permitted to make a contribution directly to a Roth IRA, the individual can make a contribution to a traditional IRA and convert the traditional IRA to a Roth IRA, as discussed below.

269 Although an individual with AGI exceeding certain limits is not permitted to make a contribution directly to a Roth IRA, the individual can make a contribution to a traditional IRA and convert the traditional IRA to a Roth IRA.

===========================================================

Roth money is some of the most valuable money there is. Secure in a tax-advantaged retirement account, it's money that will grow tax-free, and you won't pay a penny in taxes when you withdraw the money, either.

Roth is simply a designation for post-tax money that will never be taxed again. You can have Roth dollars in different types of accounts, like a 401(k) or 457(b), but the most common Roth account you'll encounter is a Roth IRA.

You may find yourself in the fortunate position of earning “too much money” to contribute directly to a Roth IRA. No one feels sorry for you, not only because you're earning a great living, but also because you're not actually unable to contribute to a Roth IRA. You just can't do so directly in a one-step fashion.

This is where the backdoor Roth, a two-step process, comes in handy.

What is the Backdoor Roth?

If you earn more than $122,000 in 2019 when filing single or $193,000 if married filing jointly, you're in the phaseout range or completely ineligible for a direct Roth IRA contribution.

If your income is unpredictable and there's even a small chance that you might end up in the phaseout range or above, you should make your Roth contributions via the back door, just in case. There's no penalty or downside for making your Roth contributions in two steps instead of one (other than the minor inconvenience of the extra step).

The process will look different depending on which brokerage you use but the steps are the same. If you use Vanguard, as I do, you can follow the screenshots in my step-by-step guide to a Vanguard backdoor Roth.

  • Step 1: Make a non-deductible IRA contribution to a traditional IRA.
  • Step 2: Convert the non-deductible contribution to a new or existing Roth IRA.
  • Step 3: Report the transaction with IRS Form 8606.

That's it.

Before Congress formally recognized backdoor Roths, folks suggested waiting for a statement cycle between contribution and conversion. This is no longer necessary.

What is crucial is remembering to report the transaction on IRS Form 8606 to ensure you don't pay taxes on the conversion. Since you're making a non-deductible IRA contribution, you're already using post-tax money. If you don't file this form, you could end up paying tax twice, and that would more than defeat the purpose of making this investment.

Backdoor Roth Caveats

Before you jump right into it, here are a few key things to know about the conversion:

Annual Maximum Contribution

The current maximum is $6,000 per person per year, up from $5,500 in 2018. As a couple, each individual can put away $6,000 a year, even if one spouse has no earned income because this is a benefit of a spousal IRA. (It's also $6,000 in 2020)

However, to contribute to an IRA either directly or indirectly via the backdoor, you must have earned income. A retiree with no earned income cannot do this.

The Pro-Rata Rule

To make the conversion tax-free, it's imperative that you do not have any tax-deferred IRA money in your name. That includes a traditional IRA with tax-deferred contributions, a SIMPLE IRA, or a SEP IRA. If you do, a portion of your conversion will be subject to income tax via the pro-rata rule.

The pro-what-now?

Let's say you have a total of $54,000 in tax-deferred dollars between a traditional IRA and a SEP IRA. You attempt the backdoor Roth and convert your new $6,000 non-deductible IRA contribution to Roth. Since your total IRA balance was $60,000, and 90% of those were tax-deferred dollars, you'll pay income tax on 90% of the conversion. In this case, $5,400 of the $6,000 will be reported as taxable income.

If you do have IRA dollars you need to deal with first, you can consider converting them all to Roth, which might make good sense if you're in the 24% federal income tax bracket or below.

Another option is to rollover your IRA dollars into either an employer's 401(k) or a solo 401(k) plan that accepts rollovers. This gets the IRA dollars out of an IRA, so you aren't affected by the pro-rata rule.

I've done both a large conversion and a large rollover in the past when I used to have a SEP IRA. I now recommend a solo 401(k), also known as an individual 401(k), over a SEP IRA, largely for this reason.

(if you do a rollover, you'll want to take advantage of some of these great rollover IRA promotions)

Timing and Deadlines

You have until Tax Day in April to complete step one, the non-deductible contribution, for the prior year. If you haven't done this for 2019, it's not too late!

The limit for 2019 was $6,000.

If you're married and have never made backdoor Roth contributions, you can now sock away $24,000 with a pair of 2019 and 2020 backdoor Roth contributions.

That's $6,000 per person in 2019 and $6,000 per person in 2020.

Backdoor Roth Best Practices

Here are some Backdoor Roth best practices to keep in mind too:

Max Out Other Tax-Advantaged Accounts

Max out all other tax-advantaged accounts available to you. If you have access to a 401(k), 403(b), 457(b), HSA, etc… you should also be taking full advantage of those. You're earning a healthy six-figure salary. You shouldn't have to pick and choose which accounts to max out if you're aiming to grow your wealth.

Consider the backdoor Roth as taking a portion of what you'd normally be investing in a non-qualified brokerage account, a.k.a. taxable account and making it Roth money, instead. You're basically taking $6,000 per year and protecting it from tax drag.

The backdoor Roth is not made in lieu of tax-deferred or otherwise tax-advantaged investments. It's a supplemental investment that replaces a portion of your non-tax-advantaged investing.

Invest Promptly and All at Once

Check this box off early in the year. Time is on your side, and the sooner you invest the money, the sooner you'll benefit from tax-free growth. I've now made seven pairs of backdoor Roth contributions for my wife and me, and I usually complete both steps in the first few days in January.

Wait until you can contribute the full $6,000. The paperwork gets messier when you make the non-deductible contributions a little bit at a time. You'll also have some gains or losses that can slightly complicate matters.

Avoid Volatile Investments

With the initial contribution, make your initial IRA investment in cash or a money market fund. You're converting it soon so you don't want it to move around too much. After the conversion, you can invest in the asset class of your liking. It's simpler to avoid volatility in the 1 to 7 days you might have the money in the traditional IRA account.

Don't Forget IRS Form 8606!

Make sure Form 8606 gets filled out and filled out properly.

I've heard of people being hounded by the IRS for back taxes when they did Step One and Two right but those steps weren't reported properly. I have shared links of examples on how to fill this out by hand or popular tax software here.

If you can't do it, don't sweat it. I've calculated the value of the Backdoor Roth. While the benefit really can add up to hundreds of thousands of dollars over many decades, the first year you do this, your benefit will be in the range of $20 to $40. If you have significant tax-deferred balances and no good way to move or convert them, it's not the end of the world.

The backdoor Roth is an optimization strategy, and it's a great way for high earners to add some tax diversification, but it's not the be-all-end-all.

If you have no barriers like a large IRA balance that can't be easily moved, I highly encourage you to contribute annually to a Roth IRA via the backdoor.

If you earn a high income and your financial advisor hasn't done this for you yet, or if your CPA hasn’t suggested it, I would ask them why not.

If you get a blank stare, you may want to consider finding a new financial advisor or CPA.

This has been an option since 2010, and it's one worth exploring.

Other Posts You May Enjoy:

Your Guide to the Ray Dalio All-Weather Portfolio

The All-Weather Portfolio won’t outperform a growth-oriented portfolio over the long term and will even trail well behind it during times of stability and growth. But the All-Weather Portfolio does something a growth-oriented portfolio won’t and probably can’t do; protect your portfolio during times of economic and financial crisis.

7 Best Stock Research Websites for 2021

If you've been investing for a while, you know that a good stock research website is one of the best investment tools you can have. But with so many to choose from, how does one decide. To help, we've created a list of what we believe to be seven of the best stock research websites.

Paper Trading – Learn to Trade Before Committing YOUR Money

Before you begin actively trading investments, start by using a paper trading account. It’ll give you an opportunity to test your current knowledge, gain experience, and learn how specific trading platforms work. All of that will make you better prepared to begin trading with real money, and minimize the risk when you do.

About PhysicianOnFIRE

PoF is an anesthesiologist, family man, and supposed outdoors enthusiast who spends way too much time indoors when not working on his website, Physician on FIRE.

PoF reached financial independence at the age of 39 after a 9-year career but continues to work because, mostly, he enjoys his job.

He created his blog to enlighten, educate, and entertain fellow physicians and other people who may have similar circumstances (high-income, late start, educational debt, etc…). His aim is to help those who want to help themselves and share some unique insights from the perspective of a practicing physician. He hopes to leave you informed and inspired to look at life a little differently than you might have before.

Reader Interactions

Leave a Comment:

Comments

About the comments on this site:

These responses are not provided or commissioned by the bank advertiser. Responses have not been reviewed, approved or otherwise endorsed by the bank advertiser. It is not the bank advertiser's responsibility to ensure all posts and/or questions are answered.

  1. Adam says

    Question – my accountant told me I can’t (or shouldn’t) do a Backdoor Roth IRA contribution because I have a SEP IRA and there’s some aggregator rule that takes into account all my pre-tax retirement money. I tried to Google but couldn’t find a great explanation of this works. My accountant seems to think I’m better off not doing the Backdoor Roth IRA contributions because of my setup. Right now I contribute to a Roth 401k through my company but I still have the SEP and then an older Roth IRA. Any thoughts for me?

  2. Physician on FIRE says

    This scenario is covered above under the Pro Rata Rule section. For you specifically, if you’re happy with the investment options in your company’s 401(k), you could roll the SEP IRA over to it.

    Alternatively, if you’re still earning 1099 income and contributing to the SEP IRA each year, open a solo 401(k) instead and contribute to that account instead. If you open with a brokerage that allows rollovers (I use eTrade), you could also roll the SEP IRA into it.

    It’s too late to do the backdoor Roth for 2018, but you’re good to go for 2019 as long as the balance of the SEP IRA and any other tax-deferred IRA money in your name is Zero on 12/31/2019.

    Cheers!
    -PoF

  3. Julie says

    Is eligibility to open either a regular ROTH IRA or Backdoor ROTH IRA go away if both individuals in a MFJ return are eligible (and do) contribute to a 401k at work?

  4. Mighty Investor says

    Great article, especially highlighting the need for the 8606 form and to not get tripped up by the pro rata rule. I have a feeling a ton of people are doing Backdoor Roths without being aware of the pro rata issue.

    Wallet Hacks consistently provides the best articles of any financial blog I know.

  5. FiPhysician says

    I love the suggestion “you may want to get a new Financial Advisor or CPA.”

    I have asked around and there actually ARE FAs and CPAs that suggest backdoor Roths for their clients, but too many are stuck doing business as usual (FA) or historians rather than proactive (CPA).

    The more you know the right questions to ask the better off you are going to be!

  6. Wealthy Doc says

    The pro-rata part is confusing but important to know about. A lot of physicians are just now finding out they can benefit from Roth IRA. They thought they made too much money. That was true prior to 2010, but that was over 8 year ago people! In the meantime, they have been adding to traditional retirement accounts. The benefit of annual new Roth IRA money is diminished because of their tax situation.

    I agree with converting existing retirement funds. Doing so up to the top of the 24% tax bracket makes sense. It should be an option for most physicians in the $200K – -$300K range. The top of that bracket increased from $315K to just over $321K in 2019 for married couples.

    The 24% marginal rate is low. So are all the rates below that. And the brackets are large so the effective federal tax rate ends up very low by historical comparisons. I remember 70% marginal rates. My father remembered 90% marginal rates. Above 24% the bracket jumps to 32%. Still not a terrible rate, but it is less clear whether that will be higher or lower in the future.

    And don’t forget about your elders, young man. I put $13K into our Roth IRAs this year. $7K for me (over age 50) and $6K for my young wife. You will be in that situation in the future!

As Seen In: