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.

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.