If you’ve been reading my blog, you’ll note a lot of things that come up over and over. This includes being behind on retirement and needing to catch up, as its a common theme throughout the Finance Fridays section of my site. The major problem is finding the best way to maximize the money you save toward retirement to “catch up”. Well, the cornerstone is still 401k/403b and 457 (if available). However, now I’m going to talk about Backdoor Roth IRA and Why You Need One.
What is a Backdoor Roth IRA?
Well, it is way for people who don’t technically meet the requirements for the Roth IRA to make one. If you haven’t already, please read this post where I talk about Traditional IRA versus Roth IRA.
Is it really necessary?
Yes, after maximizing your 403b/401k and 457 options (if available), then you really need to take advantage of a Roth IRA. $5500 doesn’t seem like that much, but if you do it for 20 years, and then $6500 for 10 more years, then you have a good amount of post-tax retirement money. This helps you significantly in retirement by allowing you flexibility in withdrawing some money from your pre-tax accounts (401k/403b and 457) and some from your post-tax accounts (Roth IRA) to be tax-efficient.
Here are the numbers: Compound Interest Calculator
Put away $5500 from 30 years old to 50 years old
1, $458.33 ($5500/year), 20 years, 6% = $202,322.49 then
Put away $6500 from 50 years old to 60 years old
$202,322.49, $541.67 ($6500/year), 10 years = $448,004.46
So basically, depending on when you retire after age 60, you should have around half a million dollars in post-tax money to use.
Half a million? Ok, I see what you mean. How do I do it?
First things first, before we do anything else, you need to make sure you don’t have any money in a conflicting account. This is called the pro-rata rule, which is kind of confusing as are most things that are Latin. However, it’s better to illustrate an example rather than explain the rule.
Dr. Mistakes has $20000 in a Traditional IRA. He/she wants to do the Backdoor Roth IRA, so he puts $5000 of post-tax money into a Traditional IRA and then converts it into a Roth IRA.
(Note: I’m using round numbers to try to make the math easy to follow)
No problem right?
Wrong… here’s the problem. The problem was this traditional IRA was rolled over from a prior 401k which as you know is a pre-tax account. So instead of of just rolling over $5000 of post-tax money from a Traditional IRA, he/she has to account for the $20000 in the Traditional IRA (which was pre-tax from the 401k).
You owe tax on the conversion of ALL ASSETS in an IRA. Here is the formula (from Bogleheads):
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 my numbers:
100 * [ 5,000 / (5,000 + 20,000) ]
Which is 20%
So you can only convert 20% of your $5000 IRA into a Roth IRA, or $1000… which sucks.
Can I fix this?
Yes. This only applies to IRAs. So if you ruled over a 401k into an IRA (pre-tax money), then you can roll it back into another 401k (this can be a new employer OR a Solo 401k).
If the $20,000 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.
Long story short:
Before we move forward, make sure you don’t have any pre-tax IRAs. (This includes SEP-IRA and SIMPLE IRAs as well, if they were pre-tax).
Sensei, I messed up. I did the conversion forgetting I had a pre-tax IRA… can I fix it?
Yes. It’s kind of outside the scope of this post, but there is something called IRA recharacterization. Essentially, you convert your Roth IRA back into a Traditional IRA.
This Boglehead post explains it better than I ever could. IRA recharacterization
I may do a more in-depth post on this later if needed. However, I hope it isn’t needed.
What else do I need to know before moving on?
Well, this is kind of just a cautionary tale… but remember you want to convert $5500 (the max). So don’t put $5500 into something volatile for a month (like Stocks) and let it sit there. If it goes down a little, you won’t have maximized your $5500. However, if it goes up, the taxes you pay may increase because of the gains you made.
You don’t want to be taxed at a higher rate than needed… do you?
Ok, ok, ok. I’ve made sure I don’t have any pre-tax IRAs. And I know not to put the money into some volatile.
How do I do it?
Set up a Traditional IRA account under whatever broker you want. Vanguard, Fidelity, whatever.
Make a nondeductible contribution of $5500 with 100% into a non-volatile account, such as Vanguard Prime Money Market Fund (VMMXX)
Then (someday) convert the $5500 contribution into a Roth IRA. (it should still be exactly $5500)
How long you wait is up to you. Some say you can convert the next day, some say wait 30-60 days.
There is no rule in place, and there has been no audit over the length of time waited before conversion.
For simplicity, I think I would make the IRA contribution on a Monday and then convert on a Wednesday.
Do nothing until tax time ~ February/March of the next year.
Ok, then what?
In February/March you will fill out this form:
Here is my hypothetical example for a first time conversion:
For every year following you will need to report the previous years Roth IRA on lines 8, 11, and 13. So it would look like this:
The 2nd page stays the same.
Not too daunting right?
This is actually a lot more tedious on TurboTax or some other tax software, however, there are tutorials to help you with that:
However, I think it’s a good idea to not do your own taxes as a physician, unless you are confident. Some may disagree with me, but I think it is worthwhile to have a 3rd party do your taxes for you. Just by being a physician, you will be in a pretty high tax bracket, which I think increases your chances of being audited. To me, I think it’s worth it to have a CPA look at my taxes so I can rest easier. For those who like statistics here ya go:
The take home point is that for the Adjusted Gross Incomes of:
$200,000-$500,000, the audit rate is 2.66%
$500,000-$1,000,000, the audit rate is 5.32%
Less than that, it’s 1%, except for those with No Adjusted Gross Income.
Overall, I think what scared me the most about the Backdoor Roth IRA was messing up and getting audited or paying taxes twice or some other error. However, I have described all the major errors that can occur, the most important of which is making sure you don’t have any other pre-tax IRA accounts.
This reminds me that I need to take another look at my wife’s retirement accounts to make sure none of them are “pre-tax IRAs” before I do our Backdoor Roth IRAs.
I dunno Sensei. Isn’t this cheating?
I understand how you feel. I’m a straight-shooter too, especially when it comes to taxes.
However, please rest easy that although it’s called “Backdoor Roth IRA” it’s really just your “allowed annual Roth IRA conversion”. It just sounds way better to call it a “Backdoor Roth IRA” or “Stealth Roth IRA” or whatever the new name is. If it was me, I would have called it the “Ninja Roth IRA” because that seems the sneakiest.
It’s completely legal, and well known. Will Congress prevent this someday? Maybe… but I kind of doubt it.
What do you think about the “wait time” to convert?
Here is a good article which quote various tax specialists and CPAs about Backdoor Roth IRAs and conversion timing.
An excerpt from that article is:
“Many planners say they’ve done immediate backdoor conversions without fear of repercussions ever since the tax law changed in 2010 to allow them.”
Now, I don’t think the timing matters so much. However, I think waiting a day or two is reasonable rather than doing a same day conversion.
I think this time you should read the whole article. So pour some coffee and take a read.
The actual instructions and tax forms aren’t that difficult. However, please make sure you don’t have any other pre-tax IRAs.
What do you think? Will you be doing a Backdoor Roth IRA this year?
Shouldn’t we just call it a Ninja Roth IRA instead?
Let me know.
Questions, Comments and Suggestions are welcome.
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