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Backdoor Roth IRA (HOW TO DO IT IN 3 STEPS)

November 6, 2019

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Roth IRAs are the BEST. They’re the single most powerful wealth-building tool that most anyone can take advantage of. However, it’s not available to everyone. If you make too much money, you probably don’t qualify for a Roth IRA. As of 2019, Roth IRA contribution limits start getting phased out when you make more than $122k single, or $193k married filing jointly.

Boohoo…. I know… first world problems. But just because you make a lot of money, doesn’t mean you enjoy paying taxes any more than the next person.

Luckily, there’s a workaround! And it’s called the backdoor Roth IRA. The backdoor Roth IRA is 100% legal, and it takes advantage of a little-known tax loophole. With a backdoor Roth IRA, it doesn’t matter how much money you make – anyone at any income level can qualify!

In this blog post:

  • I’ll explain how the backdoor Roth IRA works
  • Show you how to do it, step by step
  • And finally, I’ll talk about some of the common pitfalls that a lot of people miss when doing a backdoor Roth IRA

If all this sounds good to you, watch the video below or keep reading!

How the backdoor Roth IRA works

Although high-income earners can’t directly contribute to a Roth IRA, the IRS tax law has a quirky exception, that allows high-income earners to INDIRECTLY contribute to a Roth IRA.

In other words, high-income earners can contribute to a Traditional IRA, and then convert that Traditional IRA into a Roth IRA. This is perfectly legal, because while Roth IRA contributions are subject to income limits, Roth IRA conversions are not! It’s a weird little quirk in the tax law, and many high-income earners take advantage of this loophole every single year.

Step-by-step tutorial

  1. Open a Traditional IRA and a Roth IRA. These should be at the same company. My preferred brokerage is Fidelity. So for this backdoor Roth IRA tutorial, I’ll use Fidelity to show you the steps.
  2. Make a contribution to your Traditional IRA. (This is going to be a non-deductible contribution, which you’d later report on IRS Form 8606). When the money lands – this takes about 4 business days – transfer the money from your Traditional IRA to your Roth IRA. This can be done online, or just call Fidelity and have them walk you through the process.
  3. When it’s time to file your taxes for the year, the final step to the backdoor Roth IRA process is to fill out Form 8606. This is a special tax form that lets the IRS know that you made a non-deductible contribution to your Traditional IRA and that you’re converting it to a Roth IRA.

You can repeat this process every year. Except next year, you can skip the step where you open a new Traditional IRA and Roth IRA account. You can just use the same accounts every year, and the Traditional IRA would just spend most of the time with $0 in it, since it’s essentially just a pass-through account.

So that’s really it! The actual process is quite simple, especially if you use a platform like Fidelity. They make it really easy. However, please please please be sure to fill out Form 8606 correctly! If you make a mistake filling it out or worse, you don’t fill it out at all – you could end up paying way more in taxes than you were trying to save in the first place. Have an accountant look over it if you need to, but whatever you do, don’t mess up Form 8606.

Common pitfalls

And now for some common pitfalls to look out for:

  • The first one to look out for is not remembering the pro-rata rule, which basically means you must NOT have any money sitting in a traditional IRA, rollover IRA, SIMPLE IRA, or SEP IRA when you do the backdoor Roth conversion. If you do, you’ll trigger a “pro-rata” tax calculation that basically defeats the purpose of the backdoor Roth. I don’t understand the intricate details – and you don’t need to either. Just make sure you don’t have money in the aforementioned accounts! Close them down, convert them, withdraw from them – whatever you do, get rid of them if you the backdoor Roth is your top priority.
  • The second pitfall is making things more complicated than it needs to be by leaving a lot of time between the date of your initial non deductible Traditional IRA contribution and the date you do the conversion. The more time passes, the higher the chance that: 1) you forget to do the Roth conversion at all, or 2) the money accrues some interest so that you have additional (i.e. more complicated) things to report on your tax return
  • The third pitfall is filling out Form 8606 incorrectly. I know it’s not exactly the funnest thing to learn how to fill out an IRS tax form correctly, but many of you will be doing the backdoor Roth IRA every year for many years here on out, and your form is going to look pretty much exactly the same every year. So it’s worth the effort upfront! There are many great tutorials on YouTube about how to do this. You can run it by your accountant as well.

Final thoughts

Sure, the backdoor Roth involves some additional steps and can be a pain to learn how to do (at first). But it’s worth it!

To put it into perspective, if you invested $10k in Apple stock over 30 years ago, you’d have $13 MILLION today. If you had it in a backdoor Roth IRA, ALL $13 million would be for you! But in a regular IRA or any other type of account, you’d owe about $4 MILLION in taxes! Ouch.

Just goes to show… there are definitely some things in life that are worth making an effort for. A tax-free retirement is one of those things!

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YouTuber, Money Expert, Educator, Traveler, Rebel, and #1 Book Nerd. My mission is to empower you with the mindset and financial know-how to create a life of TOTAL freedom.

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Rose

YouTuber, Money Expert, Educator, Traveler, Rebel, and #1 Book Nerd. My mission is to empower you with the mindset and financial know-how to get more of what you want out of life.