How to do a backdoor Roth IRA – Whiteboard Wealth #14
I get asked once in a while “what can I do to invest when I’ve maxed out my 401k plan?” Because the options are so limited for most of them the next question is “how do I do a backdoor Roth IRA?”. This topic is far from simple, and it can be debated as well. Don’t take this as gospel, always consult your accountant!
How to do a backdoor Roth IRA
A backdoor roth IRA is nothing more than a process to fund a Roth IRA when you normally could not. While MOST investors can fund a Roth IRA there are some who are over the income limits. For these investors, a non-deductible IRA may be the only option.
A non-deductible IRA is simply an IRA which you don’t take a current tax deduction for. These are fairly rare, but they do exist. For IRA contributions which you don’t get a deduction, you do still enjoy tax-deferred investment growth and tax-free withdrawals of principal. The investment growth however is taxed at ordinary income tax rates when withdrawn in retirement (and a 10% penalty if taken prior to 59 and 1/2 years old).
First step in doing a backdoor Roth IRA
All of your IRA’s – whether pre-tax or non-deductible – are treated as one for IRS purposes. This means if you have any pre-tax IRA’s this process won’t really work so well for you because you’ll potentially have a lot of taxes due.
Step one in the backdoor Roth is to make sure you have no pre-tax IRA’s anywhere. If you do and they’re from a prior 401k for example, can you roll those into a new 401k plan? Make sure it’s a good plan first. Rolling IRA money into an overly expensive 401k doesn’t make much sense.
Second step in doing a backdoor Roth IRA
The second step of a backdoor Roth IRA is to fund a NON-deductible IRA. Again, this is assuming you can’t already fund an IRA or a Roth IRA because your income is too high. But if you have no other pre-tax IRA’s lying around and are over the income limit, go ahead and fund a non-deductible IRA.
Third step in doing a backdoor Roth IRA
The third step is to wait a year, then convert the non-deductible IRA into a Roth IRA. I say wait one year because after all, you can’t do a Roth IRA contribution for a reason – you make too much money! So you don’t want to fund the non-deductible IRA and convert it right away – that will look like you’re just funding a Roth in the first place.
Some professionals think waiting a month or so is fine. I’m not one of them. I’m a bit more conservative I suppose. I also don’t see the harm in waiting a year. Worst case scenario is you make some money on the non-deductible IRA and pay income tax on only the growth when you convert it to a Roth IRA. All things considered, to stay in the good graces of the IRS I’ll take that!
Whiteboard Wealth #14 – How to do a backdoor Roth IRA