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All About the Backdoor Roth

Introduction


Roth IRAs are powerful investment vehicles, as they allow you to contribute post-tax earnings that then grow completely tax free for life. If contributed to when in a lower tax bracket (such as in training or from a childhood or college job) than you anticipate being in during retirement, getting continued tax free returns for decades is pretty hard to beat. Additionally, unlike traditional IRAs, Roth IRAs do not have required minimum distributions (RMDs) as the government has already taken its cut for taxes.


Once you pass a certain income level, you are no longer eligible to contribute to a Roth IRA in the traditional way. This means many attending physicians working full time do not qualify.


Thankfully, there are completely legitimate tax loopholes which allow high-income earners such as physicians to get money into Roth accounts for that tax free growth.


The most ubiquitous of these is the ‘backdoor Roth,’ which is a completely legal strategy where contributions can be made to a Roth IRA via contribution to a traditional IRA and then converted to a Roth IRA.


There is also a second strategy called the “mega backdoor Roth” where some 401k plans allow you to make after tax contributions that are then automatically converted to Roth. Not every 401k plan has this, but if yours does, it’s worth looking into and seeing if it’s right for you.


Although these strategies are well known and accepted by the IRS, there are rules and processes that must be followed carefully. This article covers some of the major things to be aware of and walks you through the process.


As always, note that we are not accountants and you should consult appropriate expertise before taking action based on these ideas, which are not individualized to your personal situation. You should make sure this is accurate and up to date. This page contains affiliate links from our advertisers, which support the group at no cost to you. To learn more, visit our disclaimers and disclosures.


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Basics of Roth IRAs


Roth IRA Income Limits

For Roth IRA contributions, the government has a phase out limit on income where the amount you can invest in the year decreases. Once you hit the top end of the phase out range, you are no longer eligible for a regular Roth IRA. These limits are not based on your actual income, but rather your modified AGI income amount.


In 2023, to make a full contribution, this means your modified adjusted gross income should be below $138,000 if filing single and $218,000 if filing jointly.


An overview of the 2023 Roth IRA income limits for contributions

For additional guidance and more specifics, visit the IRS website.


Please note there are additional restrictions if you file your taxes as “married filing separately” but you lived with your spouse at any time during the year - often in this case you are not able to contribute to a Roth at all.


If you know your income will exceed the maximum income limit, you can proceed to considering a Backdoor Roth IRA.



FAQ: What Happens in a Year Where I Make Variable Amounts of Income?

This question comes up from time to time on our communities, particularly when somebody is graduating from training and starting their first job as an attending physician, or if somebody takes a few months off as a break between jobs or for a parental or sick leave.


One key warning: you can not put contributions directly into a Roth IRA and then try to pass them as a Backdoor Roth if it turns out you made more than the limit for Roth contributions. If you do, you’ll have to reverse it. Overfunding a Roth IRA can be a headache to unwind, especially if the amount invested has already grown since your contribution.


Rather, if you know your modified AGI will be close to the phase out range, it is a good idea to hold off on investing in a regular Roth IRA until the end of the year or the beginning of the next year when you have your final income amount.



How Much Can I Contribute (for both Roth IRA and Backdoor Roth)?


As of 2023, the total contributions guidelines for each year were:

  • $6,500 standard contribution limit

  • $7,500 allowed for individuals 50 and up under a catch-up rule

  • Total is added across all IRAs an individual owns (both traditional and Roth)

  • You have until tax day (or until you file your tax return, whichever is sooner) to make IRA contributions for the previous year

    • Extensions are excluded



Is a Backdoor Roth Right for me?


Whether you should do a Backdoor Roth IRA can depend on your situation and retirement goals. Generally, we love the concept for our physician community members, but here are some considerations to factor in. If after reading this you aren’t sure whether you want to do a Backdoor Roth IRA or if you need additional assistance beyond our step-by-step guide below, reach out to one of the financial advisors on our database.


When You Should NOT Do a Backdoor Roth

  • If you make below the income limitations to contribute to a regular Roth IRA contribution, keep it simple and do that.

  • If you have any non-Roth IRA (Sep IRA, SIMPLE IRA, Traditional IRA), pause and read below.

  • You’re not willing to do the paperwork for a backdoor Roth - there are tax forms you need to file for doing this. It’s not complicated, but does need to be done correctly and you may need to get your accountant involved if you are not comfortable. More about this here.

  • You are close to retirement and you are planning on withdrawing money within 5 years. Withdrawals from a Roth IRA are only tax free if you are>59.5 years old and have met a requirement for a 5 year holding period. Otherwise they may be subject to ordinary income tax or a 10% federal penalty tax, or both. The 5 years period applies for each conversion separately, and begins on the first day of the year in which the conversion contribution is made.


Estate Planning Considerations

  • If you plan on withdrawing from your IRA during retirement and think you will be in a lower tax bracket during retirement, it may be more beneficial to do a traditional IRA, defer taxes now, and pay taxes at a lower marginal tax rate in retirement.

    • However, the longer they are in a Roth, the more advantageous it can be to pay taxes as a high marginal tax bracket for tax-free growth, so factor in how long you plan on leaving your contributions invested.

  • If you likely won’t need to touch your IRA during retirement, a Roth IRA can be a great tax-advantaged strategy for estate planning and inheritances.


Do You Have Any Pre-Tax IRA Funds?

The IRS has a pro-rata rule for assessing additional tax considerations on a Backdoor Roth IRA. This applies to any pre-tax (tax deferred) funds in an IRA, such as:

  • SEP IRA

  • SIMPLE IRA

  • Traditional IRA

If you have money in these accounts, the pro rata rule will apply to you. Depending on how much you have in non-Roth IRAs, it could negate any tax benefit or actually penalize you for using this.


This rule basically necessitates that all of your IRAs be treated as a single account from a tax perspective. The intent here is to prevent you from getting out of taxes that would normally be involved in a conversion of the funds that you’ve contributed in pre-tax fashion.


Because of that, your Roth conversion will be taxed proportionate to your pre- and post-tax percentages of your total IRA holdings (see an example of this in the pro-rata section below).


Note the pro-rata rule only applies to IRAs, not to 401(k)s or other similar employer-sponsored retirement plans.


Pro-Rata Rule Example

The IRS takes the percentage of post-tax dollars against the total balance of all your IRAs and charges your marginal tax rate on the percentage of taxes on your Backdoor Roth IRA contributions using the following calculation:


(non-deductible amount)/(total of all non-Roth IRA balances) = non-taxable percentage


(amount of Backdoor Roth IRA conversion) x (non-taxable percentage) = taxable amount


For example, if you put $6,000 into a new traditional IRA but have $54,000 in a SEP IRA, the pro-rata rules dictates:


$54,000/($6,000+$54,000) = 0.90, or 90%


So the IRA will assess taxes at your marginal tax rate on the prorated amount of:


$6,000 x 0.90 = $5,400


Tracking the pre-tax versus post-tax amounts can be very complicated for future Backdoor Roth IRAs and when it comes time to assessing taxes for distributions, so we don’t recommend the Backdoor Roth IRA if you have this situation.



Options to Avoid the Pro-rata Rule

If you already have tax-deferred funds in IRA accounts, you may still have an option for a Backdoor Roth IRA that allows you to get around the pro-rata rule, depending on your current work situation.


Not all, but some 401(k)s/457(b)/403(b) plans offer the ability to roll funds into the plan. If you have one of these plans, check with your plan administrator to see your options. Rolling your IRA into an employer plan will remove the balance from counting against you in the pro-rata calculation, as discussed above. Just make sure you assess the different fees and fund options and balance it against the advantages of the Backdoor Roth IRA before rolling your IRA in.



Tax Reporting

In each tax year you do a Backdoor Roth IRA, you are required to file IRS Form 8606 as part of your income tax return to ensure it is accounted for properly. If you already hire an accountant to do your taxes, make sure you mention your contributions and Backdoor Roth IRA, then double check before signing and submitting your taxes that the Form 8606 is included. If you prepare your own taxes, find guidance on the IRS website here.



Summary of Pros and Cons


A summary of the pros and cons of Backdoor Roth IRAs from the sections above


Doing the Backdoor Roth IRA


If a Backdoor Roth IRA fits well with your situation, we suggest getting one setup and funded sooner rather than later. For one, the government has in recent years proposed to discontinue this tax loophole, but given how widespread its use is, it has been hard to pass. The other reason of course is that the longer it’s invested, the more growth you get tax free.


The first time you do a Backdoor Roth IRA, you might find the process overly complicated, so we’ll walk you through the process below.



A step-by-step guide for a Backdoor Roth IRA, covering the information included below

Open Your IRAs

If you don’t already have both a Roth IRA and traditional IRA set up, start by creating these accounts with the same institution. Vanguard and Fidelity are two popular choices.


Make a Contribution to Your Traditional IRA

Once the accounts are open, make a contribution to your traditional IRA. Remember, the IRS restricts how much you can contribute for each calendar year across all IRAs, so remember to take those guidelines into consideration when making the contribution.


Typically, when you make your contribution, your institution will ask how you want to invest your contributions. If you set up a new account, it should default to cash, typically a settlement fund. New account or old, leave it in the cash/settlement fund.


IRAs can let you contribute to the previous calendar year (up until the tax filing deadline) or the present year. Make sure you pay attention to which year you are funding so you don’t over fund the previous year by accident.


Convert Your Contribution

Once your contribution has transferred successfully into your traditional IRA (this can take a few business days), you are ready to begin your Backdoor Roth IRA conversion.


This process can differ depending on your institution. Vanguard, for example, has a “Convert to Roth IRA” button. With Fidelity, it’s treated as an account transfer, so you’ll use the Transfer function.


While moving your contribution from the traditional IRA to the Roth IRA, you will likely get an alert that this is a taxable event. Under normal circumstances, where you typically have tax-deferred contributions in a traditional IRA, the contribution you made was with after-tax dollars. So long as you’ve accounted for the pro-rate rule above and properly file your Form 8606 with your individual tax return, you won’t be assessed additional taxes on your contribution from the conversion.


Invest the Funds

While you wanted to leave the contribution in the cash account for its short stay in the traditional IRA, don’t repeat this on the Roth side. Make sure once you complete your Backdoor Roth IRA, you invest the funds. If you aren’t sure what to invest them in, we generally recommend a three-fund portfolio strategy. You can also explore our investing page if you are a more hands-on DIY investor.


If you’re a completely hands-off investor, you can usually open IRAs with the financial advisor who manages your portfolio. They will be able to help you complete the process, though they may not assist on the tax side, so make sure your accountant is aware. You can visit our database of financial advisors.


Don’t Forget Your Form 8606

While your conversion is done once you’ve invested your contribution in your Roth IRA, you haven’t completed your Backdoor Roth IRA until tax time comes around. Make sure you or your accountant completes the required Form 8606 and files it with your individual tax return, or the IRS will send you a nastygram.



Backdoor Roth IRA FAQs


We see a lot of great questions on Backdoor Roth IRAs within our physician communities. We’ve compiled some of the most commonly asked ones below to help guide you through the process.


What are the contribution deadlines?

You have until the tax filing deadline to make the contribution for a Backdoor Roth IRA, same as a traditional IRA or Roth IRA. So for a 2023 Backdoor Roth, you would have until April 15th, 2024 to make the contribution. Keep in mind that IRA contributions are included in your personal tax return, so you would want to make your contribution before you file your taxes, or you’ll have to file an amended return.


If you make your 2023 contribution in early 2024, you must reflect this on your IRS Form 8606. Make sure you include your contribution on both Line 1 and Line 4.


While you have until tax day to make your contribution, to simplify the Backdoor Roth IRA process and paperwork, we recommend contributing and converting your Backdoor Roth IRA before year end.



What accounts do I need to open? When I empty out the traditional and it goes to zero, will the account close? Do I need to do this every year?


If you don't have a traditional IRA or a Roth IRA, you will have to open both of those. If you have them, you can use the existing ones. You can use these same two accounts every year, and don't need to worry about the traditional IRA account closing with the zero balance.



When I contribute the money to the traditional IRA, what should I invest it in?


For simplicity, put it in a money market fund. That way it can't lose value. You're going to convert it as soon as you can anyways so you're not losing out on money. If you made a mistake and did invest it in something that lost money, you can't add more money in as you already made the max contribution for the year.



I made my contribution to the traditional IRA and am ready to convert to the Roth IRA on the next day. However, the traditional IRA accrued interest of $0.53 in the interim. Now what? Will I have to pay taxes?


You can go ahead and convert it all at once. The taxes on that accrual are negligible, if any. Don't worry about this, it will all be on your form (and if the tax is less than a dollar, it may not even show up).


If you already made the mistake of converting just your original contribution and there's now a minimal balance in the traditional IRA, just do the conversion again and pay the (again, likely negligible) tax.



What happens if the conversion doesn't happen until the next calendar year because I made the contribution late in the year and it took a few days before I can do the conversion?


There is often a few days’ wait period in between when you make a contribution and when that contribution is available for a conversion; for some it can take up to a week. Let’s say you made your after-tax contribution to your traditional IRA on December 29th, 2023 but weren’t able to complete the conversion until January 3rd, 2024. Your contribution will count for the 2023 annual contribution limit, but any taxes generated will count toward your 2024 tax return.


If you don’t have any pre-tax funds in your IRAs (see the pro-rata rule above), the only taxes you might have to pay would be on the gains earned during that short period between December 29th and January 3rd when the conversion completes.


To account for this, you would include your contribution on your 2023 IRS Form 8606 Line 1. You would then carry over the amount on Line 14 of your 2023 Form 8606 to Line 2 of your 2024 Form 8606.


It’s crucial you complete the Form 8606 properly and submit it with your tax return to make sure your contributions and conversion are properly taxed. When in doubt, we always recommend working with an accountant to guide you through the process, even if only for the first year.



Can I contribute to the traditional IRA over the course of the year and convert as I go?


This is not worth all the paperwork. Also, if you don't do the conversion immediately you have to worry about tax implications if it makes money (and conversely, you could lose money if you didn't choose the money market fund). Just save up the entire contribution and make the contribution at once and convert it immediately.



My spouse has money in another IRA; does this mean we both can't do the backdoor Roth because of the pro forma rule?


IRAs are individual retirement accounts so you can still do the backdoor Roth as long as the pro forma rule doesn't apply to you.



I'm going to be close to the limit for contributing to a Roth IRA; how do I know if I should do the Roth contribution the traditional way or the backdoor way until my taxes are calculated?


You could either wait until your numbers are calculated (you have until the tax filing deadline to do the Roth and backdoor Roth contributions/conversions if applicable), or you could just go ahead and do the backdoor Roth preemptively. You'll just have to do the extra steps and the paperwork, which are relatively simple, and easier than undoing the Roth as below.



What if I funded a Roth IRA and then found out I made too much?

If you contributed to a Roth IRA and your income ended up exceeding the limit to be eligible to contribute, you have to do what is called a recharacterization. This process takes your Roth IRA contribution and recharacterizes it as a traditional IRA contribution.


A recharacterization must be completed before your tax-filing deadline, though the IRS generally includes extensions when dealing with recharacterizations (so you may have up to October 15th) versus the April date for contributions.


The brokerage company your IRA is with can help you through the process with a simple phone call or by filling out a form on their website. Thankfully, it’s a pretty easy process.


From the IRS’s perspective, as long as this is done before filing your taxes, they’ll only see it as a traditional IRA contribution. It will be like you never put it into the Roth IRA in the first place. You won’t report the recharacterization, you will report on your taxes as if you made the contribution to the traditional IRA.


Presumably, at this point, you will want to take advantage of the backdoor Roth instead of leaving the money in the traditional IRA. Then the process is similar to the one highlighted above. To keep taxes minimal, we recommended converting it to a Backdoor Roth ASAP.





Roth IRA recharacterization to complete a Backdoor Roth IRA properly for high-income earners.


Mega Backdoor Roth


A Mega Backdoor Roth is different from a Backdoor Roth IRA. This is a strategy that allows for a much larger conversion than the annual contribution limits for Roth IRAs as the transaction occurs with an employer-sponsored plan - such as a 401(k) - instead of a traditional IRA.


Not all 401(k) plans offer the ability to do a Mega Backdoor Roth, so you would need to check with your plan administrator to see if this feature is available.


Mega Backdoor Roths are taxable events, unlike the Backdoor Roth IRA, regardless of the pro-rata rule, so it requires additional cash on hand at the time of the conversion.



Disclaimer: Please remember that while we attempt to keep this information current, all of this is subject to change and you should do your own research and consult with any relevant licensed expertise before making decisions on the basis of this tutorial. We are not licensed financial advisors and this is not individualized advice. This is purely for informational purposes only and should be verified with licensed expertise as you feel appropriate. We specifically disclaim any errors or omissions.



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