How To Setup a Backdoor Roth IRA
So you want to contribute to a Roth IRA but you’re above the income limit? Sounds like a good problem to have if you ask me (insert hair flip). Let me entertain you with a Backdoor Roth IRA.
First of all, what is a Backdoor Roth IRA? It’s a legal loophole for high-income earners to fund a Roth IRA if your income exceeds the limit that the IRS allows for Roth contributions. Bless the IRS.
If you’re single (what’s up 😏) and your modified adjusted gross income (MAGI) is more than $125,000 per year or you’re married filing jointly and your MAGI is more than $198,000 per year, then a Backdoor Roth IRA is for you. The Backdoor Roth IRA allows high income earners to get around these income limits.
Alexa, play Rich Girl by Gwen Stefani.
Why would you want to do a Backdoor Roth IRA? Well because most people are horny for a Roth IRA over a traditional IRA since you get tax-free growth and tax-free withdrawals within a Roth IRA.
Let me back up for a second. What’s your modified adjusted gross income (MAGI)? This is your adjusted gross income after taking into account allowable deductions and any tax penalties.
How to calculate your MAGI:
Calculate your gross income: Wages, salary, dividends, capital gains, unemployment, alimony, business income, tips, retirement income, interest, etc.
Calculate your adjusted gross income (AGI): Moving expenses, alimony paid, student loan interest, self-employment taxes, some contributions to IRAs.
Calculate your modified adjusted gross income.
Roth IRA Income Limits
Below is a chart showing the income limits based on your filing status, from yours truly, the IRS.
Fairly straight forward but, look at your filing status, choose your modified adjusted gross income, and then you’ll know how much you can contribute.
So what are the limits for an IRA? If you are under the age of 50, you can contribute up to $6,000 max per year in an IRA. If you are 50+. You can contribute $7,000 max per year in an IRA as long as you are within these income limits.
bUt LeAnDrA, wHaT aBoUt tHe pHaSe oUtS?
I got you.
A Roth IRA phase out is the range in which the government phases out your ability to contribute to a Roth IRA. For example: If you are single, and earn above $125,000 but less than $140,000, you can still contribute to a Roth IRA, but not the full $6,000 limit.
If you are married filing jointly and earn above $198,000 but less than $208,000, you can still contribute to a Roth IRA, but not the full $12,000 ($6k each between you and your spouse). You can contribute a reduced amount.
Let me show you a chart to help you identify how much you can contribute based on your filing status and your revolutions around the sun (your age).
For example, if you are married filing jointly, your MAGI is $205,000, and you are 45 years old, you could contribute $1,800 into your Roth IRA.
Another example: If you are single, your MAGI is $131,000, and you are 55 years old, you could contribute $4,200 into your Roth IRA.
Alright, so now that I’ve gotten you all hot and heavy about a Backdoor Roth IRA, how do you do it?
How to complete a Backdoor Roth IRA step-by-step:
In order to complete a backdoor Roth IRA you need these simple steps (to the left), some WiFi, and 10 minutes of elementary administrative work. Maybe a snack.
Side note: I wish they wouldn’t name the button on step 4 “Convert to Roth IRA,” as this implies that the traditional IRA is literally turning into a Roth IRA, but it’s not.
Your Roth IRA and Traditional IRA will both remain open, and the funds simply roll over from the traditional IRA to the Roth IRA.
Once the funds transfer to your Roth IRA, for the love of GOD please INVEST THE MONEY.
You need to buy funds within the account. If you don’t your money is sitting their like cash. This is a very common mistake that I often see, and it makes doing a Backdoor Roth IRA completely pointless because your money is NOT invested if you don’t buy funds.
A few things to keep in mind…
By doing a Backdoor Roth IRA, you are not dodging taxes. By converting the money from a traditional IRA to a Roth IRA, you will owe the taxes on the amount transferred for that tax year. Your money will simply grow tax free and be withdrawn tax free in retirement.
You can withdraw from your Roth IRA once you are 59.5. By withdrawing before age 59.5 you will be subject to a 10% penalty.
Typically, if you were contributing to a Roth IRA without this loophole, you would be able to withdraw CONTRIBUTIONS only, penalty free.
However, when doing a Backdoor Roth IRA, the funds you convert from a traditional IRA to a Roth IRA are considered converted funds, NOT contributions. Therefore, you will need to wait five years to have penalty-free access to these funds, should you need them.
How do you know when to do a Backdoor Roth IRA?
If you are single and earning more than $125,000 per year, or married filing jointly and earning more than $198,000 per year, and you have maxed out your traditional 401(k) of $19,500 for the year, then you’re ready to do a Backdoor Roth IRA.
By contributing to your traditional 401(k) first, you are deferring $4,680 in tax liability. What does this mean? Well, by contributing the maximum limit to a traditional 401(k) you are lowering your taxable income by $19,500 per year. Considering you would be in the 24% tax bracket, you would be deferring 24% of $19,500 which equals $4,680 per year.
Talking about saving money on taxes makes me hot and sweaty, in a good way.
Answers to some questions you may have:
When I have conversations about Backdoor Roth IRAs, people start playing 20 questions with me. And although I like to save 20 questions for a first date, I’m going to address some of the common questions I get about IRAs in general.
Can I contribute to an IRA for my spouse?
First of all, how nice of you. Secondly, yes. You may contribute to an IRA for your spouse if they are unemployed and you file jointly. Your total combined contribution cannot exceed your joint taxable income or $12,000, whichever is less.
What is the deadline to contribute to an IRA?
April 15 of the following tax year. My expert recommendation? Contribute to an IRA earlier in the year to take advantage of your money being invested for a longer period of time.
Can a minor have an IRA?
Yes, as long as they have earned income that is being reported to the IRS. Selling lemonade with your friend Johnny doesn’t count. If you are a parent, you cannot contribute to your child’s IRA.
Why wouldn’t I contribute to a standard, taxable brokerage account instead of an IRA?
IRA contributions have tax benefits unlike a taxable brokerage account. With a Roth IRA, your money grows tax-free and can be withdrawn tax-free (damn, do I sound like broken record or what?).
With a taxable brokerage account you would be paying capital gains tax and dividend taxes.
When completing a Backdoor Roth IRA, will I have two IRAs open?
Yes, you will be opening BOTH a traditional IRA and a Roth IRA to complete a Backdoor Roth IRA. Many people make the mistake of just opening a traditional IRA thinking the account literally CONVERTS to a Roth IRA, but it’s more like a roll over of the funds. You won’t see the “Convert to Roth IRA” button if you don’t have a Roth IRA open.
What if I already have a traditional IRA?
If you currently have a Traditional IRA balance BEFORE doing this you may owe some taxes thanks to the pro-rata rule. If you are opening the traditional IRA for this purpose then you are good to go. Talk with your CPA.
Want some hand holding?
I’ve helped plenty of clients complete a Backdoor Roth IRA in less than 30 minutes, and I like holding hands. If you want to hop on a call with me, I can help you with this in no time. Here’s the link to my calendar to sign up for a Zoom call with me.
What you’ll need: Your employer’s name and full address, your routing and account number, and the amount of money you want to invest.
