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The American retirement system is confusing to say the least. 401(k)’s, Traditional IRA’s, Roth IRA’s. It can be pretty annoying to keep track of it all. Here’s a primer on how it all works if you’re a little rusty.
Today we’re going to focus on the humble IRA. To recap, an IRA can be opened up as two versions: the Traditional IRA and the Roth IRA.
| Traditional IRA | Roth IRA | |
|---|---|---|
| Contributions are… | Pre-tax Dollars | Post-tax Dollars |
| Deductible | Yes | No |
| Investments Grow Tax-Free | Yes | Yes |
| Withdrawals are… | Taxed | Not Taxed |
Between the two accounts, you are limited to contributing a maximum of $5,500 per year.
These are similar to Canada’s RRSP and TFSA accounts, except Canada’s versions are a lot less restrictive (no goofy age restriction, for example).
The problem with the Roth is that the IRS actually limits your ability to contribute if you make too much money. Here are the 2018 Roth IRA contribution tables.
So if you’re married and together you make over $199,000, it looks like you’re outta luck. No Roth IRA contribution for you. Boo.
Actually, no. I’m just joshing ya. There’s a loophole. There’s always a loophole.
While there’s an income limit for direct Roth IRA contributions, the limit doesn’t apply for money transferred over from a Traditional IRA to a Roth IRA. This is known as a Roth IRA conversion. Hence, the ability to make a sneaky-but-still-totally-legal contribution commonly called a Backdoor Roth IRA contribution.
Here’s how it works.
First, you open up a Traditional IRA.
Then you make a $5,500 ($6,500 if you’re older than 49) contribution and you elect NOT to take the $5,500 deduction on your income taxes. Why would you do this? Because if you deduct the contribution you will have converted post-tax money into pre-tax money, and when you covert it in the next step, you’ll be hit with a tax bill.
Finally, you perform a Roth IRA conversion that converts your entire Traditional IRA into a Roth IRA.
Voila! You have just performed a Roth IRA conversion by…ahem…entering through the…back door.
Before you actually do this, there are a few caveats you should be aware of.
In order to report a non-deductible contribution to your IRA, as well as report the conversion to the Roth IRA, you have to file Form 8606 to the IRS when you submit your taxes. If you don’t, it’s generally not the end of the world since you can file it retroactively, but as with most things IRS-related, you generally don’t want them to be pissed off at you. So remember: Form 8606! File it!
Also, if you have an existing Traditional IRA this gets somewhat more complicated due to something called the IRA Attribution Rules.
Here’s how it works.
If you had no existing IRA, making a non-deductible $5,500 contribution to an empty account sets the “basis” for that account to $5,500, meaning the amount of post-tax money that’s in there. When you do the conversion, your conversion amount would be $5,500, which is the same as your basis, so that gets calculated into a $0 taxable income and you’re set.
But if you already had an existing Traditional IRA that had, say $11,000 in it and you open a new one with a non-deductible $5,500 contribution, the IRS would treat it as one big IRA where 2/3’s of the account was deductible and 1/3 was non-deductible. So if you were to try to perform the IRA conversion. Only 1/3 of that ($1,833) would be non-taxable while the other 2/3’s ($3,667) would be added to your taxable income. That’s probably not what you wanted.
However, money in a 401(k) or similar employer plan would NOT be counted as part of the IRA attribution rules, so in the common scenario of having most of your retirement savings in a 401(k) and a Roth IRA outside, you could do this backdoor Roth IRA conversion without running afoul of the attribution rules.
If you have a combination of 401(k)’s, Traditional IRA’s, and a Roth IRA and want to make a backdoor Roth IRA contribution, you could theoretically still do it. Let’s say you wanted to make a $5,500 backdoor Roth IRA contribution and you had $100k in a 401(k) and $50k in a deductible Traditional IRA. You could consolidate the $50k Traditional IRA into your $100k 401(k) resulting in a 401(k) worth $150k. Then you open up a new Traditional IRA account and make a $5,500 non-deductible contribution. Then finally you convert THAT into the Roth IRA.
That may be a level of complication that may not be worth it though.
Remember, Backdoor Roth IRA contributions are only necessary if you make too much money to do a normal contribution. Unless, you know, you…like…going in through the back door…
Regardless, always consult a tax professional before you do anything to make sure everything’s done, filed, and documented properly. Laws change all the time, so double check!
So that’s how you do a Backdoor Roth IRA contribution. Has anyone ever done this? Was the process easy for you or were there headaches? Let us know in the comments!
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Then you make a $5,500 ($6,500 if you’re older than 49) contribution and you elect NOT to take the $5,500 deduction on your income taxes. Why would you do this? Because if you deduct the contribution you will have converted post-tax money into pre-tax money, and when you covert it in the next step, you’ll be hit with a tax bill.
———
Hmmm. You will be paying taxes on that $5500 no matter what: EITHER by not taking the $5500 deduction when you first contribute to the traditional ira OR when you do the conversion from traditional to Roth.
So why does it matter which one you choose?
Because there are no required minimum distributions (RMDs) for Roth accounts. This means that you will not be forced to withdraw any money if you don’t want to under current rules.
Also there is a provision for Roth IRAs that permits withdrawing contributions (not any investment gains) without penalty at any age as long as the money has been in the account for 5 full years.
This leads to strategies like bootstrapping a “Roth IRA conversion later”.
It also makes sense if you’re a high earner and make over the current IRA thresholds that Wanderer listed. I’m in that boat, so for me it’s a no brainer – either do this and shield the future growth from taxes, or invest in taxable and take the capital gains tax hit later on down the road.
I suppose that if you make less than the threshold levels, it’s probably not as easy of a choice though…
If you make less than the threshold levels, just do a regular Roth IRA contribute. No need to jump through hoops.
A nondeductible contribution to a Traditional IRA would be taxable when you withdraw it. For a Roth IRA, it’s not taxable. So leaving it in the Traditional IRA would give you the worst of both world: no tax deduction when you put it in and taxable when you take it out.
For early “retirees” be aware of a couple of things when contributing to IRA and using back-door Roth: you can only contribute earned income to traditional IRA. Any conversion $$ to Roth account is not deductible and therefore is part of your AGI for ObamaCare subsidy purposes so your healthcare cost will be higher. Would love to hear any expert opinion of this and/or some math whiz to explain pros and cons. Cheers to all.
I’m not sure what you mean. You’re not deducting anything anyway, so why would it matter whether it’s earned income or not?
Nicely written article. I’ve been doing this exact method for the last few years and it will be one of my draw down strategies. In the future, will you write about how an American can early withdraw from a 401k?
Sure. I can do that next week.
We just did this for the first time in 10 years.
https://nicoleandmaggie.wordpress.com/2017/12/25/so-we-opened-traditional-iras-and-roth-converted-them/
Did you find the process simple?
So much simpler than we had anticipated– if you read the post you can see lots of gushing about how with Vanguard you literally just push a button.
We did this once before back when the Backdoor Roth first became an option, and converted all of our traditional IRAs, at a loss(!) because markets were down, so we got an actual tax advantage. This time we just did it as soon as the money transferred. But it was also more complicated partly because it was etrade and partially because nobody was really sure what the conversion rules were or if you had to hold onto the IRA for a set amount of time etc.
Disgusting. Goddamnit. Face hidden in shame.
Hilarious “back door” humor!!!
But it’s only money right? Uh, right??
Uh…sure.
We did this for the first time this year. I had a rollover IRA into which I had moved all of the 401k funds from my prior employers, so I had to roll that amount into my current employer’s 401k plan as they accept rollovers like this. (No all of them do.)
The process was pretty easy. I opened a traditional IRA and Roth IRA account, made a $5500 transfer from my checking account to the traditional IRA, and then moved it all over to the Roth IRA. I used Fidelity, and the only issue is that they wouldn’t let me roll over the traditional IRA to the Roth IRA until the money sat in the traditional IRA for about a week. Not sure why – but I read multiple internet forum posts that this is actually pretty normal. May have had something to do with the fact that it was a new account – maybe it’s like they need to “hold” the funds for awhile to make sure everything clears?
One important thing is to make sure you fill out the 8606 correctly, else you’ll get hate mail from the IRS in a few years when they finally get around to reviewing your forms. There were a number of posters in the Bogleheads.com forum that got caught in this. This can be tricky in tax software – best bet is to google “backdoor Roth” and your tax software name for instructions on how to answer the prompts. Also look for posts on the various FI forums (WCI / PoF have good examples) on what a correctly completed 8606 looks like. Also, remember that you need one from each spouse if you’re married.
Also a minor point – you actually can contribute more than $5500 to a Roth IRA, via the so-called “mega backdoor Roth” process. My employer allows this, which is awesome! The Mad Fientist is a good source for how this works in case anyone’s interested.
Oh, and yeah – US tax law is waaaaay more confusing than it needs to be!!
Shit yeah, no kidding. For Canadians it’s just like “transfer. done.” into our TFSAs each year. For you guys it’s like a small novel of all the rules and forms you have to know about. Yeesh.
This year our income (pre-tax) from our jobs will be 225K. We’ve always contributed to Roth IRAs before but we may not be able to this year because of the higher income. How do we calculate our modified AGI for 2018 now? Because I’m thinking we may still be under the 189K limit if MAGI is used. I don’t want to wait until tax time April 2019 to find out. I’d rather contribute to the roth asap (or tIRA if that’s what we end up having to use because of too high an income). We’re Americans, married filing jointly, and have one kid. Any one have tips or been in a similar situation before? Thanks!
Check this article out: https://www.thebalance.com/how-to-calculate-your-modified-adjusted-gross-income-4047216
thanks!
I’ve been doing mega-backdoor Roth conversions since 2012. For the past 20 years (more aging boomer that FIRE millennial, but I love your blog), I ran my consulting firm as a sole proprietor and filed a schedule C for business expenses using TurboTax Home and Business. The SEP-IRA retirement deduction appears in the Schedule C section of TurboTax and TT will calculate how much you can contribute to your SEP depending on your net business income up to the ~$52,000 limit. It also fills out the Form 8606 for you as one of the TT forms.
The mega-backdoor Roth conversion is a boon to Schedule C filers because you can put ~19.8% of your net business income into a SEP-IRA (a pre-tax “traditional” IRA) up to the $52,000 a year and then convert the SEP IRA funds into a Roth via the backdoor. You put pre-tax funds into the SEP and then convert them into the Roth where you have to pay tax on them. So, it’s a wash tax-wise if the amounts are the same. I haven’t always converted all the money each year because sometimes it was going to be at a 33% or 38% tax rate on top on the year’s income, but would convert the higher yielding dividend stocks as much as I could take the pain. It’s also good to convert the stocks at the price (or a lower price) that you paid for them to help with the taxes because the tax is on the price when the conversion happens, not when you bought it. Plus you want to convert the funds as soon as it’s feasible because you want the dividends to occur in the Roth, not the SEP, because Roth dividends are never taxable.
The conventional wisdom has always been to go pre-tax because your tax bracket will be lower when you’re retired, but if you have sizable income in retirement, maybe not. And as I decided back in 2012, I don’t care if I’m paying more income tax now when I’m making big bucks when it doesn’t affect my life, if it means when I’m not working anymore I know how much income I have for the year. Plus with our government, who knows what’s going to happen to tax bracket rates.
Other benefits of the Roth over traditional IRAs are:
1) no required minimum distributions when you are 70 (I think Wanderer mentioned this)
2) your heirs can inherit your Roth intact, it doesn’t have to be dissolved like a traditional IRA upon your death, and
3) principal and dividend income from the Roth does NOT count as earned income (unlike traditional IRA distributions and dividends) when the IRS calculates the taxability of your social security. Probably not too important a point for younger people, but good for older people who plan on collecting a sizable SS check to know.
4) if you have earned income you can contribute to a Roth after 70, not so with a traditional IRA.
I stopped taking big consulting projects in 2017 so it was my last big income year and I guess I’m quasi-retired now. Due to my Roth dividend snowball, I’m also FI. I’m using 2018 as a transition year to convert the remaining SEP balance at a low tax bracket before I take social security and tap the Roth dividends in 2019.
I know Wanderer and Fire Cracker along with JL Collins and the Bogleheads are not focused on individual dividend growth stocks and that is my focus, so my experience may not be helpful for many readers. Mega-backdoor Roth conversions aren’t for everyone, but for a self-employed person like me, it was the road to peace of mind. Without the mega-backdoor conversions, I wouldn’t have my Roth dividend snowball.
Very interesting. I have zero experience with this stuff for self-employed/entrepeneurs, so this was very helpful.
This is probably the ONLY advice I haven’t taken from the FIRE community since I dove in head first about 8 months ago – it makes my brain hurt too much!! I’ve chosen to max out my 401k and HSA (with almost all of those investments in low-cost index funds) and then put the rest in VTSAX (which I know some would feel uncomfortable doing). I just like the idea of having the money available at any age without jumping through hoops, even though it’s riskier — and taxable. (I may still do the conversion ladder, though!)
My only realistic fear is that we’ll be in a recession when I retire, but I guess that’s what the emergency fund is for!
Keep up the great work (you’re so good to us Yanks) – this is one of my favorite FIRE blogs!
Thanks! And it’s not too hard to hedge for a recession in retirement. We wrote about it here: https://www.millennial-revolution.com/invest/workshop-invest/investment-workshop-18-manage-portfolio-retire/
Everyone always forgets the attribution laws. Thanks for mentioning them.
I’m glad we talked about this at Chautauqua as it produced an awesome post! You covered all of the important parts that others don’t seem to cover sometimes, especially the part about already having money in a traditional IRA. You Canadians understand American tax law better the most Americans! Matt and I did this for the first time this year and it was easy. I had to transfer money from my IRA to my 401k and it only required a 5 minute phone call and completing two forms. We are enjoying following your travels and reading your posts!!
YAY! It’s Beth! Thanks for the awesome chats at Chautauqua and giving us the inspiration for this post. You guys rock!
Investopedia says this: If you made nondeductible contributions, then any distribution contains both a taxable and a nontaxable portion. The nontaxable portion is based on your cumulative after-tax contributions and the taxable portion is based on the money those contributions earned over time. For example, over the years you contributed $50,000 to a nondeductible IRA, and by age 70½ the account grew to $75,000. Roughly 33% ($25,000) of the account value would be appreciation and taxable. (https://www.investopedia.com/retirement/should-you-contribute-nondeductible-ira/)
Is this correct? If so, it seems it would defeat the whole purpose of the exercise or am I missing something…