[Editor’s Note 9/18/2018: We’ve updated and republished this popular post to include a new infographic and tutorial video to help make the steps to contributing to a Backdoor Roth IRA and filling out IRS Form 8606 even easier to understand and execute. This guide will show you how to get it done right and avoid/identify mistakes that can cost you time and money — even if the mistake was made by your financial advisor. We also cover how to handle late contributions to the backdoor Roth IRA (if you contribute in the following calendar year). If you’ve hesitated to make a Backdoor contribution on your own in the past, this post will give you the confidence to finally go ahead and get it done.]
I’m still getting frequent questions on how to do a Backdoor Roth IRA. So I thought I’d put together a basic, step by step, tutorial people can refer to when they do this. Most physicians should be using a personal and spousal Backdoor Roth IRA. Not only does this provide an additional $5,500 each ($6,500 each if you and your spouse are over 50) of tax-protected and (in most states) asset protected space, but it allows for more tax diversification in retirement. That allows you to determine your own tax rate as a retiree by deciding how much to take from tax-deferred accounts and how much from Roth accounts.
5 Steps to Making the Backdoor Roth IRA Contribution
Step 1 Contribute to Your Traditional IRA
Make a $5500 ($6500 if over 50) non-deductible traditional IRA contribution for yourself, and one for your spouse. You can use the same traditional IRA accounts every year, they just spend most of the time with $0 in it. Most fund companies, including Vanguard, don’t close the account just because there is nothing in it. I do this every January 2nd. I just place it into the Prime Money Market Fund to keep the math simple. Since it yields something like 0.04% and doesn’t go down in value, the sum when you convert will be exactly the same as when you contribute. No gains, no losses.
Convert the non-deductible traditional IRA to a Roth IRA by transferring the money from your traditional IRA into your Roth IRA at the same fund company. If you don’t already have a Roth IRA there, you’ll need to open one. This can be done in a minute or two online at Vanguard and is essentially the same process as opening the traditional IRA. I do this the very next day after I make the contribution. It is very straightforward. When you transfer the money, the website will throw up a scary banner saying something like “THIS IS A TAXABLE EVENT.” That’s true. It is taxable. It is just that the tax bill is zero for it since you’ve already paid taxes on the $5500 and couldn’t claim it as a deduction because you make too much money. You can now invest the money as per your investing plan.
Step 3 Beware of the Pro-Rata Rule
Get rid of any SEP-IRA, SIMPLE IRA, traditional IRA, or rollover IRA money.The total sum of these accounts on December 31st of the year in which you do Step 3 must be zero to avoid a “pro-rata” calculation (see line 6 on Form 8606) that can eliminate most of the benefit of a Backdoor Roth IRA.
You can get rid of these accounts in 3 ways:
- Withdraw the money (not recommended, as the money would be subject to tax and/or penalties, not to mention DECREASING your tax-advantaged/asset-protected investment space.)
- Convert the entire sum to a Roth IRA. Only recommended if it is a relatively small amount and you can afford to pay the taxes out of current earnings or taxable investments with relatively high basis.)
- Roll the money over into a 401K, 403B, or Individual 401K. 401Ks don’t count in the aforementioned pro-rata calculation. Some physicians have even opened an Individual 401K at Fidelity or eTrade (the Vanguard Individual 401K doesn’t accept IRA rollovers) in order to facilitate a Backdoor Roth IRA.
Step 4 Fill Out IRS Form 8606 Correctly
The second part of The Backdoor Roth IRA is done 15 months later when you (or your accountant) fill out your IRS Form 8606 on your taxes. Remember that you need one form for each spouse. You need to double check this to make sure it is done right, even if you hire a pro. Advisors have told me that they have had to help clients fix dozens of these that tax preparers had done improperly. If you don’t do it right, you’ll pay taxes twice on your Backdoor Roth IRA contribution.
[Update 2018: To get this step right, I’ve put together a Form 8606 tutorial video AND a correctly filled out 2017 form. Both show in detail how Form 8606 should be completed in a typical year. Yours will look different if you did your conversion in a different year from your contribution, or if you had an additional Roth conversion this year.]
Page 1 (below) shows a “distribution” from your non-deductible IRA. Since the money was already taxed, the taxable amount on your distribution is zero. Line 1 is your non-deductible contribution. On Line 2, your basis is zero because you had no money in a traditional IRA on December 31 of last year (if you’ve been carrying a non-deductible IRA for years this may not be zero.) Line 6 is zero in a typical year. Note that Turbotax may fill this out a little differently (may leave lines 6-12 blank) but you end up with the same thing. Line 13 is the same as line 3, so tax due is zero.
On page 2 (below), you are showing the Roth conversion. I’m not really sure why you have to do this twice (since you’re just transferring the amounts from lines 8 and 11 and then subtracting them), but that’s what the form calls for. As you can see, a Roth conversion of a non-deductible traditional IRA contribution without any gains is a taxable event, it’s just that the tax bill is zero for it.
When double-checking your tax-preparer’s work, you want to concentrate on lines 2, 14, 15c, and 18, and make sure they’re a very small amount, like zero, and not a very large amount, like $5500.
Notice how there is no place on the form to put the date when you made the contribution or the date when you made the conversion. It isn’t on the form your IRA custodian sends to the IRS (1099-R) either.
Harry Sit’s blog, The Finance Buff, has a nice tutorial showing how to fill out form 8606 using Turbotax, which, believe it or not, is trickier than doing it by hand.
Step 5 Repeat Next Year
Contribute and Convert Each Year
You do not have to wait any period of time between the contribution and conversion. Each year, I make my Traditional IRA contribution on January 2, then convert to a Roth IRA the next day. That gets my investment money working as soon as possible and simplifies the record keeping. Vanguard won’t let you do it the same day, so I have to wait one day anyway.
The Step Transaction Doctrinegiven its blessing on the whole process. Waiting just makes things more complicated on the 8606, as discussed in Pennies and the Backdoor Roth IRA.
Late Contributions to the Backdoor Roth IRA
While it is “cleaner” to make your contribution and your conversion all in the same calendar tax year, you can make your contribution up until your tax filing date of the next year. Late Contributions to the Backdoor Roth IRA has more details about doing this but hasn’t been updated in a while, so let’s do it now. The key to filling out the 8606 correctly when you make a contribution after the calendar year is to recognize that the contribution step is reported for the tax year and the conversion step is reported for the calendar year. So imagine you did the following during the calendar year 2018:
- Made a 2017 IRA contribution (reported on 2017 8606)
- Did a Roth conversion of that contribution (reported on 2018 8606)
- Made a 2018 IRA contribution (reported on 2018 8606)
- Did a Roth conversion of that contribution (reported on 2018 8606)
Your forms would look like this:
2017 Form 8606 (only have to fill out part I)
2018 Form 8606 (must fill out parts I and II)
Notice a couple things here. First, you’ve got to do all of Part I plus Part II for this year because you did the conversion step, unlike last year. Second, don’t get confused by the fact that this form says “2017” and line 4 asks about 2018. This is the 2017 form and you would actually be filling out the 2018 form. But since the 2018 form doesn’t exist yet, I had to use the 2017 form for this demonstration. So add one year to anything you see here. But let’s go through this line by line.
- Line 1 – That’s the money you contributed for 2018
- Line 2 – This is your basis. Since you made a contribution for 2017 but didn’t do a conversion during 2017, your basis is $5,500
- Line 3 – $5,500 + $5,500 = $11,000
- Line 4 – Remember this is asking about 2019, not 2018 and since you didn’t make the mistake of doing your contribution late again, this will be zero.
- Line 5 – $11,000 – $0 = $11,000
- Line 6 – This is the line that triggers the pro-rata issue. Even though you made a 2017 contribution, you did so AFTER December 31st, so this line would still be zero if had to fill it out for 2017, which you didn’t because you didn’t do a conversion in 2017 and got to skip lines 4-13. But this is the 2018 form and since you converted your entire traditional IRA, this will be $0.
- Line 7 – This doesn’t include conversions. Since you didn’t take any money out of your traditional IRA this year except the conversion, this is $0
- Line 8 – You converted a total of $11,000 this year to a Roth IRA, so $11,000.
- Line 9 – $0 + $0 + $11,000 = $11,000
- Line 10 – $11,000/$11,000 = 1
- Line 11 – $11,000 * 1 = $11,000
- Line 12 – $0 * 1 = $0
- Line 13 – $11,000 + $0 = $11,000
- Line 14 – $11,000 – $11,000 = $0 Note that when you do this form for 2019, line 2 will be $0. (Line 14 on 2018 form = Line 2 of 2019 form)
Line 15a – $0 – $0 = $0
- Line 15b – You didn’t take money out of an IRA to help you survive a disaster, so $0
- Line 15c – $0 – $0 = $0
- Line 16 – Line 8 is $11,000 so $11,000
- Line 17 – Line 11 is $11,000 so $11,000
- Line 18 – $11,000 – $11,000 = $0
As simple as this all seems, there are a few ways to screw up the process. Read 17 Ways to Screw Up A Backdoor Roth IRA to see them.
What do you think? Are you doing Backdoor Roths? Why or why not? Any questions about it? Comment below!