How To Do a Backdoor Roth IRA Conversion

I spend a lot of time and virtual real estate writing about personal finance and physician finance.  As a prelude to this article I recently published How Much Do Doctors Need to Retire? For all high-income earners (not just doctors), having avenues to allow your nest egg to grow with after-tax dollars is important.  There are various ways to grow your income. There are even more ways to house your income, but few are more daunting than the Backdoor Roth IRA.  In theory it is relatively straightforward, however understanding the nuances is critical.  Here we discuss what a Backdoor Roth IRA is exactly as well as how to perform one.  We will walk you through the perils and pitfalls of this conversion, as well as the benefits!  Here is how to do a Backdoor Roth IRA conversion! 

What is a backdoor Roth IRA?

Before we tackle how to do a backdoor Roth IRA, let’s first discuss what it is.  Well, for starters, an IRA stands for Individual Retirement Account (IRA).  There are many types of retirement accounts.  The Roth IRA is just one of these.  For the sake of this article, we will be discussing both Roth IRAs and Traditional IRAs.  Both are necessary to perform the backdoor Roth IRA conversation, and therefore I think it best we explain both. 

Traditional IRAs

Traditional IRAs are a type of retirement savings vehicle that is available to everyone.  The benefits are that no matter your income, you can contribute to them.  You can place either pre-tax or after-tax income into them.  The tax benefits that come from traditional IRAs are that you avoid taxation at the time of contribution.  However, this means that you are taxed at your effective tax bracket at the time of retirement withdrawal. 

This is important, especially for high income earners, so pay attention.  Anyone can contribute to traditional IRAs, even you!  What you need to understand is that by using a traditional IRA, you are opting to defer taxes now for later.  As such, individuals who will be (or expect to be) in a higher tax bracket at the time of retirement may lose a larger portion of their savings to taxation.  On the flip side however, if you are in the same or lower tax bracket at the time you start taking retirement distributions, then traditional IRAs may be the right savings vehicle for you.

Dr. Works-Hard uses a traditional IRA

Here is an example that might put this in better context.  Dr. Works-Hard is a 30-year-old with zero retirement savings.  She decides to put $1,000.00 in a traditional IRA monthly for 35 years ($420,000).   Assuming a real rate of return of 4%, then at the age of 65 (in 35 years) she would theoretically have $883,826.70!  She will have doubled her investment.  Now, if her annual income at the age of 65 (when Dr. Works-Hard plans to retire), places her in the 32% tax bracket, then her withdrawals are taxed at this rate annually.  If she decides to withdraw $100,000 each year to live off of, then effectively she pays $32,000 in federal taxes (not including state taxes) and lives off of $63,000. 

However, if Dr. Works-Hard creates a larger income for herself during those 35 years, and retires in the 37% tax bracket, then her withdrawals at retirement are taxed even further.  Thus, if she still plans to withdraw $100,000 annually, then she pays $37,000 in taxes.  She is effectively losing an extra $5,000 annually due to her higher tax bracket.  To some, $5,000 annually may not seem like a lot, but over the course of a 25-year retirement, that approaches $125,000 in losses (in this example). 

Roth IRAs

Roth IRAs, similar to traditional IRAs, are just another type of individual retirement account.  In contrast to traditional IRAs however, Roth IRAs tax your money at the time of contribution and thus are not taxed at the time of withdrawal.  In comparison to the above traditional IRAs, once your contributions are taxed, this money is allowed to grow without the penalty of taxation at the time of retirement withdrawal.  As you can see, this is a great savings vehicle for individuals who expect to be in a higher tax bracket at retirement.

Here is the catch… Roth IRA contributions are income capped.  Meaning, if your income is over a certain limit, then you are not allowed to contribute to a Roth IRA in the traditional sense.  For 2023, the income limits are as follows:

• Single filer: $153,000
• Couples married filing jointly: $228,000

As you can see, for the high-income earners looking for great investment vehicles, this excludes most. Especially if you plan to continue to optimize your income and earnings during the course of your career, you are limited in how you can allow your savings to grow post-tax.  Enter the backdoor Roth IRA…

Why do a backdoor Roth IRA?

So, as I have hopefully alluded to, it would be nice if individuals over the aforementioned income limits could pay taxes on their income now as to avoid higher taxation at the time of withdrawal.  Well, the backdoor Roth IRA is just that.  To clarify, a backdoor Roth IRA is not a separate type of individual retirement account.  The backdoor Roth IRA is just a strategy of using the legal transfer of money from one retirement account to another. This effectively allows higher income individuals to also utilize the benefits of a Roth IRA.  Consider it another entrance into the Roth IRA, a ‘backdoor’ if you will.

In simple terms, a backdoor Roth IRA is simply the conversion of non-deductible traditional IRA savings into a Roth IRA account.  Anyone is allowed to convert traditional IRA savings into a Roth IRA regardless of the income limits mentioned above.  There are some limits on the amount you can contribute and transfer annually (see below).  However, the takeaway is this, for high income earners who are above the income limitations for Roth IRA contributions, the backdoor Roth IRA is an avenue open to you, especially if you plan to be in a higher tax bracket at retirement.  However, before we dive into the step-by-step approach to performing a backdoor Roth IRA conversion, let’s make sure you understand all the considerations and pitfalls associated with this strategy. 

Important Considerations

Roth IRA contribution limits for 2023

As I mentioned earlier, there is a limit to how much you can convert into a Roth IRA.  These limits change each year, as such, I will make sure to update this post each year.  This information comes from irs.gov, and there is a lot more information to explore if you are interested.  For this year, the total contributions you make each year (to all of your traditional IRAs and Roth IRAs) cannot be more than $6,500 ($7,500 if you are age 50 or older).  However, you can also do a spousal backdoor Roth IRA that could house this limit as well, theoretically allowing you to contribute $13,000 annually ($15,000 for those age 50 and older).  This means that the maximum you can rollover into a backdoor Roth IRA would be $6,500 per person, no more.

Pro Rata rule

Understanding the Pro-Rata rule is incredibly important when it comes to successfully performing a backdoor Roth IRA conversion without bearing unexpected tax penalties.  So here is what you need to know.  When the Internal Revenue Service (IRS) reviews your IRA taxes, they view all IRA accounts in aggregate.  Meaning, if you have a traditional IRA and a Roth IRA, both of these IRAs are seen as one single entity (in aggregate). 

In simpler terms, the Pro Rata Rule applies when an investor (i.e. you) houses both before tax and after tax money in a traditional IRA.  For the sake of backdoor Roth IRA conversions, when you move money from a traditional IRA to a Roth IRA, if the money being converted has both pre- and post-tax contributions, then the Pro Rata Rule will apply.  The Pro Rata rule means the IRS will thus determine the ratio that should be used in determining how much of the conversion is pre-tax versus post-tax.  The formula looks something like this:

Calculating your non-taxable percentage

(Non-deductible contribution amount) / (Total of all non-Roth IRA balances) = Non-taxable percentage

Calculating the amount of after-tax funds converted to Roth IRA

Now that you have calculated your non-taxable percentage, you can now use that percentage to determine the amount of after-tax (post-tax) funds that will be converted to your Roth IRA.  That formula looks as follows:

(Amount of contributions to be converted to Roth IRA) x (Non-taxable percentage) = Amount of post-tax funds converted to Roth IRA

Dr. Works-Hard suffers the Pro Rata rule

Sorry for the math, but it is important.  However, maybe an example is better suited for explaining this.  Let’s say that Dr. Works-Hard has an income that is well above the Roth IRA income cap required to contribute (she makes $250,000 annually).  Therefore, she decides that she is going to perform a backdoor Roth IRA conversion as another strategy for saving as she expects to be in a higher tax bracket at retirement.  However, Dr. Works-Hard already has $100,000 housed in a traditional IRA.  For this fiscal year, she wants to contribute $6,500 (the contribution limit) to her Roth IRA to bring her total IRA savings (traditional IRA + Roth IRA) to $106,500. 

First, Dr. Works-Hard contributes $6,500 to her traditional IRA, totaling $106,500 in her traditional IRA account.  However, unfortunately she did not read this article first, nor understand the Pro Rata Rule… Thus, she converts that same $6,500 that she just contributed into her traditional IRA into Roth IRA hoping that this will suffice for her backdoor Roth IRA conversion.  However, since she already had traditional IRA savings (and remember the IRS views all IRAs in aggregate) the Pro Rata Rule now applies to her $6,500. 

The Pro Rata rule in action

The Pro Rata Rule would say that 93.8% ($100,000 pre-tax portion divided by $106,500 total) of the $6,500 being converted would actually be taxable.  Only 6.2% of the $6,500 being converted would be tax-free.  This means that $6,097 (93.8%) of the original $6,500 would be left in her traditional IRA as after-tax funds, while only $403 (6.2%) is converted to her Roth IRA as tax free…kind of defeats the purpose now doesn’t it…

There are other caveats and considerations that apply to the above scenario.  That was an over-simplification, but hopefully that demonstrates the importance of the Pro Rata Rule.  If your backdoor Roth IRA is performed following the steps below, then hopefully you can avoid the application of this rule altogether and transfer all funds into your Roth IRA without suffering Pro Rata penalties. 

Withdraw limitations

One important point to make is that all funds being converted to a Roth IRA are considered converted funds, not contributions.  As such, you must wait five years before you can withdraw money penalty-free if you are under the age of 59 1/2.  These converted funds (your backdoor Roth IRA conversions) are viewed as different than regular Roth IRA contributions which can be withdrawn anytime without taxes or early withdrawal penalties. 

State specific variations

I will not list them out here, but backdoor Roth IRA conversations can have some stipulations based on your individual state and local government regulations.  Be aware of this. 

Annual deadline

Lastly, it is important to know that backdoor Roth IRA conversions follow the fiscal year.  As such, IRA contributions for a particular tax year must be made between January 1^st of that same corresponding tax year and before April 15^th of the following year. 

How to do a backdoor Roth IRA conversion

Step 1: Confirm you have no other IRA accounts subjecting you to the Pro Rata rule

Before you move any money around, it is important to first make sure you do not have any other qualifying retirement accounts that would subject you to the Pro Rata Rule.  Other qualifying accounts include outstanding traditional IRAs, SEP IRAs, and SIMPLE IRAs.  Remember, all of these accounts are seen in aggregate by the IRS and may make you subject to the Pro Rata Rule. 

Step 2: Choose a platform for your savings

To begin to perform a backdoor Roth IRA conversion, you first need to choose a platform.  I personally use Vanguard, but there are loads of other investing platforms you can use.  Each of these platforms may have nuances on how to perform a backdoor Roth IRA exactly, thus contacting a professional or representative from your chosen platform if you have any questions or concerns.  Now that you have a platform, lets create an account. 

P.S. for those using Vanguard specifically, here is a great step-by-step guide from Physician on FIRE.

Step 3: Create a traditional IRA account

Now that you have opened a traditional IRA account with zero dollars in it, contribute the maximum amount allowed for this fiscal year.  For 2023, that amount is $6,500 per individual.  Remember, if you are 50 years or older, you can contribute an extra $1,000 totaling $7,500.  Once you have authorized this money to be moved into your traditional IRA account, watch it like a hawk!

Step 4: Create a Roth IRA account

Now immediately /open a Roth IRA account using the same platform you used to open your traditional IRA.  At this point you should have both a traditional IRA and Roth IRA with the same platform.  Once your money has been successfully placed into your traditional IRA account, immediately convert all $6,500 into your Roth IRA account.  Why do you have to do it immediately? 

Step 5: Immediately convert your traditional IRA contributions into your Roth IRA

If you leave money in your traditional IRA and do not convert it immediately, it could accumulate earnings (interest).  If you accumulate earnings on your traditional IRA contributions before converting it to your Roth IRA, then you have to pay taxes on these earnings when you perform your conversion.  Therefore, if you accumulate earnings and later decide to convert your money to a Roth IRA, you will then have more than $6,500 in your account (greater than the current contribution limit) and you will have to correct this by paying taxes.  Any untaxed amount left over in the traditional IRA will result in taxation after you complete your conversion.  This defeats the purpose, don’t delay, just immediately convert the $6,500 from your traditional IRA into your Roth IRA before it has time to accumulate any earnings. 

Step 6: Fill out tax form 8606

After you have successfully converted your $6,500 immediately from your traditional IRA to your Roth IRA, you now need to correctly fill out tax form 8606.  This does not need to be done immediately, this can be done closer to tax season for that year.  This can also be completed by your accountant if you choose to employ one.  If you forget this step, there is generally a $50 penalty come tax time. 

If you are choosing to do this for both your Roth IRA as well as your spouse (Spousal Roth IRA), then a separate Form 8606 is needed for your spouse as well.  IRAs are individual, and thus a form is needed for each conversion (one for you, one for your spouse).  I do not wish to instruct you on how to fill this out, there are better educated professionals on this matter.  Thus, I have provided a few links below that outline this.  For me I found this article on The White Coat Investor quite helpful!

Step 7: Rinse and repeat every year

Here is the kicker…you can do this every year!  Personally, I choose to do this on January 1^st of each year.  This way I get it out of the way and don’t have to worry about it.  Further, our family personally employs an accountant who we trust and completes our Form 8606 for us.  This keeps the process simple and offers an extra layer of oversight. Having an extra set of eyes helps me feel confident that I didn’t screw anything up. 

Hire a professional

Before we wrap things up, I will just add this disclaimer.  As I always include at the end of an article, I am not a professional, nor do I claim to be.  This article is written in its entirety to provide insight, information, and entertainment.  The backdoor Roth IRA conversion can be an immensely useful tool when it comes to high-income earner savings.  However, if performed incorrectly, it can be costly.  Thus, before you do anything, I always recommend you discuss this strategy with a professional. 

Take home points

Saving for retirement can be a daunting task.  Knowing if you are doing it correctly can be the cause of significant anxiety.  Further, for physicians, being in a high tax bracket comes with its own set of challenges.  The backdoor Roth IRA conversion allows high income earners a legal way to grow retirement savings after-taxes. This helps individuals avoid large taxation penalties at the time of withdrawal.  The backdoor Roth IRA can seem daunting, but there are multiple tools online that can help individuals learn to navigate this helpful but intricate conversation.  If you have any questions, comments, or concerns, please do not hesitate to consult a professional.  As always…

Stay motivated!

The Motivated M.D.

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