The Backdoor Roth IRA for High Income Earners: A Step-by-Step How To Guide

Door

Greetings.

I normally contribute to Roth IRA lump sum of $5K for previous year before April 15th of this year. While filling taxes (married jointly) for 2012, I realized that my wife’s and mine combined salary is at $185K which is above the limit of $183K. Could you please advise on what options I have to invest in Roth IRA. I have been doing this diligently for last 5 years and so far my returns have been at 47%. I really don’t want to miss out on the contribution.

Thanks!

Abhay K.

Hi Abhay,

Thanks for your question.   You are correct that your income exceeds the Roth limit.  The limit for single filers is $127k (phase out starts at $112k) and for married filers is $188k (phase out starts at $178k).  See the full Roth contribution Income Limits Table.

The Backdoor Roth IRA

Despite exceeding the limit, you can still contribute to a Roth IRA due to a loophole.  High earners cannot contribute directly to a Roth IRA, but they can contribute to a Traditional IRA and they can convert a Traditional to a Roth, which accomplishes the same thing as opening a Roth directly.

 

Traditional contribution + Traditional-to-Roth Conversion = Roth (Backdoor) Contribution

 

It may seem like a hassle, but it actually only takes a few minutes and the tax savings over the years can really add up.  Here’s the step by step process.

Step 1.  Contribute to a Traditional IRA (non-deductible)

  • Open a Traditional IRA (suggested account providers)
  • Contribute up to the contribution limit ($5,500 this year for those under 50)
  • Your contribution will probably not be tax deductible (However, Roth IRA contributions are not tax deductible)
  • This creates a “cost basis” of the contributed amount

Step 2.  Convert your Traditional IRA to a Roth IRA

  • There used to be income limits blocking high earners from doing these conversions, but the limits expired in 2010.  Now anyone can convert.

Step 3.  Pay any taxes on the conversion (probably close to zero)

  • Converting from Traditional to Roth is a taxable event
  • Since you already paid taxes on the money contributed (it wasn’t deductible), you now only owe taxes on any gains that you earned before the conversion
  • Taxes Owed = Tax Rate x (Conversion Value – Contribution Value)
  • If Conversion Value = Contribution Value, Taxes Owed = ZERO

Result:

  • Full contribution amount in a Roth IRA using post-tax dollars

An example:

  • Amy and her spouse earn $200k per year, making her ineligible to contribute to a Roth IRA
  • Amy contributes $5,500 to a Traditional IRA
  • The contribution is NOT tax-deductible because of her high income
  • The “cost basis” on her investment is $5,500
  • Amy contacts her IRA administrator (i.e. TD Ameritrade, E*trade, etc.) and tells them she wants to “convert” her Traditional IRA to a Roth IRA
  • In the few days between contribution to the Traditional IRA and converting to a Roth IRA, Amy’s account value has grown to $5,525.
  • Amy owes taxes on the $25 gain ($5,525 account value at conversion minus $5,500 cost basis).
  • Amy reports the $25 taxable gain on her taxes the following April.
  • Since Amy already had a Roth IRA with this IRA administrator, her “converted” amount was simply put into her existing Roth IRA.  If she hadn’t already had a Roth IRA, a new account would have been opened during the conversion process.

The Pro-Rata Rule

All rollovers from Traditional to Roth IRAs must be done on a pro-rata basis.  So if you have existing Traditional assets (pre-tax) and you try to do a Backdoor Roth IRA by contributing to a non-deductible Traditional IRA (post-tax), you cannot choose to only rollover the non-deductible Traditional assets.  Instead, any amount you rollover will be taken proportionally from across all of your Traditional assets.  For example, if you have $90k in deductible contributions and you make $10k in non-deductible contributions, intending to immediately roll it over to a Roth, when you do the $10k Traditional to Roth conversion (10% of your total Traditional assets) you will actually be converting $9k from your deductible contributions (10% of $90k) and $1k from your non-deductible contributions (10% of $10k).

Learn more about the pros and cons of various IRA contribution options for high income earners.

Choosing the Right Roth IRA

Before you open an account, be sure to think carefully about how you plan to invest.  If you are a long-term passive mutual fund investor, choose an account like Scottrade with 3,000+ no transaction fee funds and super low expense ratios on index funds (as low as 0.095%).  If you prefer to trade stocks in your Roth IRA, look for an account with easy access to company research and analysis software, like TD Ameritrade.  Learn more about Roth IRA account options here.

Other Articles by Joanna on Backdoor Roth IRA Conversions and the Pro Rate Rule:

 

About the Author

Joanna D. Pratt, CFA is an experienced institutional investor.  She holds a bachelor’s degree in economics and certificate in finance from Princeton and an MBA from Stanford.

Have a question?

Visit the “Ask Joanna” homepage or submit a question by emailing it to markets@nerdwallet.com.

 

Photo Credit:  Man entering door from Shutterstock.

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  • stringer

    For the last two years I have put the max into a non deductable IRA and immediately converted it to a ROTH. My taxes show that $5500 at a taxable event. Since I roll it over right away I usually don’t have any gains. I use H&R Block, are they doing it wrong.

    • Joanna Pratt

      It sounds like your tax basis is not being recognized. In order to get tax software to treat the situation properly you need to be really careful about entering your nondeductible tax basis (of $5500). Most tax software will have you enter the Traditional contributions (and will declare them non-deductible and increase your basis) separately from entering the Traditional to Roth conversion. Is it possible your contributions actually are deductible? Is it possible you entered $0 somewhere you should have entered $5500 or vice versa? These are the most typical causes of this issue.

      Rest assured it is possible to use H&R Block. I’ve used them several times myself and the $5500 was not considered a taxable event. It’s also possible in TurboTax: http://thefinancebuff.com/how-to-report-backdoor-roth-in-turbotax.html

  • Danny

    Question, I contribute 6500 each year to a Roth IRA, I am now over 55. Could I also contribute to a traditional IRA up to the limit and then convert ?

    • Joanna Pratt

      No, the $6500 limit applies to total IRA contributions you make to Roth plus Traditional accounts in a single year.

  • C in FL

    I have both a traditional and a ROTH IRA account. Next year I will be over the income limit to be able to contribute to my ROTH. If I roll over my traditional IRA into my employer’s 401k plan in April, can I then contribute to the traditional IRA (now at zero balance after being rolled into the 401k) and do a backdoor ROTH conversion later in the same calendar year without having to worry about the prorata rule?

  • EP

    I have a 401k offered through my employer with deductable assets, but no ira accounts. Am I able to complete the backdoor roth ira without converting my 401k? Does a 401k have anything to do with all of this?

  • Maxim

    One thing to also mention is.. what if you already have a traditional IRA account?

    For e.g., you already have $50,000 in a TIRA. For 2013, you want to contribute $5000 and convert that to a Roth IRA. You get taxed on 90% of the entire conversion (45/50) and the 5000 is taxed

  • John B

    Help! Hey Joanna, thank you so much for this page. I followed the instructions and everything went great except now I’m doing my 2013 taxes. Fidelity sent me a 1099-R that shows 5500 for gross distribution and 5500 for taxable amount. It also has a check in 2b for taxable amount not determined. When I entered this information into taxact.com where I do my taxes, it shot my taxes up by $1925! Is the problem that the tax software isn’t sophisticated enough?

  • Ming Hsueh

    Joanna,

    I have money currently residing in a Traditional IRA, but my company will allow me to roll this money into my companies 401K plan. If I roll the money into a 401K plan, do I still need to include it as part of the basis in the Pro-Rata Rule?

    Thank You.

  • AT401k

    I have been contributing the max on both a pre-tax and after tax basis to my 401k for many years. This enables me to receive my company match and is a forced savings plan. For the after tax portion I know the earnings will be taxed at ordinary tax rates, likely higher than if I had contributed, instead over the years to a taxable account, where earnings would have been taxed at long- term capital gains rates. How can I minimize the tax impact when it comes time to roll over and tap into these funds, which are now considerable? I realize now the error of my ways. How can I dig out?

  • Matt from Austin

    Technicality question: I contributed the full amount to the Roth IRA in 2013 and my income phased me out completely. To solve the excess contribution, I recharacterized it as a traditional IRA (funded with post-tax money).

    It’s now 2014 and I’m reading this article. Can I convert this account to a Roth IRA now given the initial recharacterization?

    Anyone can answer :) Thanks!