Backdoor Roth

A Backdoor Roth IRA is a technique for contributing to a Roth IRA when your income exceeds the contribution limit. There is no income limit on contributing to a nondeductible Traditional IRA, nor on converting a Traditional IRA to a Roth IRA.

Overview
When you make a Backdoor Roth IRA contribution, you are making a nondeductible contribution (i.e., already taxed) to a Traditional IRA before making a Roth conversion. However, your pre-existing (non-Roth) IRA funds in Traditional, SEP, and SIMPLE IRAs will likely all be deductible contributions and their pre-tax earnings. When you make a Roth conversion, you cannot limit your conversion to just your nondeductible contribution.

When filing your income taxes, the money you convert will be representative of all the money in all of your Traditional, SEP, and SIMPLE IRA accounts, regardless of which account the Roth conversion money comes from.

For example: If your nondeductible contribution is only 25% of all the money in your Traditional, SEP, and SIMPLE IRA accounts, then only 25% of your Roth conversion amount will be tax-free. The remaining 75% of your Roth conversion amount will represent the deductible (pre-tax) money across all of your Traditional, SEP, and SIMPLE IRAs.

Consequently, you will owe tax (at your current income tax rate) on 75% of your Roth conversion amount (see example below). If you can transfer your pre-tax IRA funds to a solo 401k, employer-sponsored 401k, or 403b, then they will no longer be subject to taxation during the Roth conversion process.

Mechanics
To make a backdoor contribution, first make a regular contribution to a Traditional IRA with your IRA custodian. You do not specify to the custodian whether the IRA is deductible or not; it is just treated as an IRA.

As soon as the contribution posts, convert to a Roth IRA. To do this with Vanguard, you buy shares (or open a new account) in a Roth IRA, and fund it by "selling" shares in your Traditional IRA. Since your initial contribution was non-deductible, you pay tax only on the difference between the converted value and the amount contributed, and since you held the Traditional IRA for only a few days, the tax should be trivial. Thus, even though you are over the limit, you are in essentially the same situation as if you had made a contribution to the Roth IRA.

Caution
If you have any other (non-Roth) IRAs, the taxable portion of any conversion you make is prorated over all your IRAs; you cannot convert just the non-deductible amount. In order to benefit from the backdoor, you must either convert your other IRAs as well (which may not be a good idea, as you are usually in a high tax bracket if you need to use the backdoor), or else transfer your deductible IRA contributions to an employer plan such as a 401(k) (which may cost you if the 401(k) has poor investment options).

For example, suppose you have just created a new traditional IRA, and you add $5,000 of non-deductible contributions to it. You'd like to convert this IRA to a Roth IRA via the backdoor.

Suppose you also have another traditional IRA with $15,000 in deductible pre-tax contributions. These contributions may have come from a 401(k) rollover, or from standard deductible traditional IRA contributions from earlier years when you were eligible to make deductible contributions to a traditional IRA.

To compute the tax due, you would need to take $5,000 and divide it by $20,000 (the total value of all your traditional IRAs), to get the percentage of the conversion that will be tax-free. In this case, it is 25%. Therefore, the other 75% of your conversion--in this case, $3,750--would be taxable.

This can be viewed with the following formula:

Variables:

C = Amount to Convert to Roth

B = Balances of all pre-tax IRAs

TF = The percentage of the amount you're computing this would be tax-free

TF = 100 * [ C / (C + B)]

Using the numbers from the case study above results in:

100 * [ 5,000 / (5,000 + 15,000) ]

which is 25%.

If the $15,000 traditional IRA could be transferred into a 401(k), then the formula becomes:

100 * [ 5,000 / (5,000 + 0) ]

which is 100%, meaning that 100% of the conversion amount ($5,000) is tax-free.