How to Set Up a Backdoor Roth IRA

You may think a high income will shut you out of Roth IRA eligibility, but there’s another way in: a backdoor Roth IRA. And it can save you thousands of dollars in taxes.

Roth IRAs are retirement accounts that allow you to sock away money you’ve already paid taxes on. One of their big selling points is that you get to withdraw that money — and any investment gains — tax-free when you retire. So if you’re in, say, the 15% tax bracket now but expect to be in the 28% tax bracket when you retire, a Roth IRA can save you a ton of money later in life.

Here’s the thing, though: High earners can’t contribute to Roth IRAs. The government allows only those people with adjusted gross incomes below $194,000 (married filing jointly) or $132,000 (single) in the front door. (Find out how much you can contribute to Roth and traditional IRAs.)

The rules are different for traditional IRAs: Anybody can contribute, regardless of income. If you’re also covered by an employer retirement plan, however, your ability to deduct your contribution begins to phase out at a certain income level. NerdWallet has a quick calculator to show you how much of your traditional IRA contribution is deductible.

So why not just put the money in a traditional IRA and leave it at that? One word: taxes. Remember, withdrawals from a Roth IRA in retirement are tax-free. If you were shut out of a Roth IRA and still want your tax break in retirement, a backdoor Roth gives you that chance.

How the backdoor Roth IRA works

A backdoor Roth IRA boils down to some fancy administrative work: You put money in a traditional IRA, convert the account into a Roth IRA, pay some taxes and, lo and behold, you’ve got tax-free income in retirement. Even though you didn’t qualify for a Roth IRA to start, you get to sneak in the back door anyway.

It all works because in 2010 the federal government removed the income limits for IRA conversions, creating a Roth IRA loophole. Of course, you’ll need to get the mechanics right. Here’s a step-by-step guide on how to make a backdoor Roth IRA conversion.

1. Put money in a traditional IRA account. You might already have an account, or you might need to open one and fund it. If you’re opening an account specifically to do a backdoor IRA, you can fund your account with post-tax dollars and not have to worry about paying taxes on that money, and what it earns, in retirement. (See our picks for the best traditional IRA providers.)
2. Convert the account to a Roth IRA. Your IRA administrator will give you the instructions and paperwork. If you already have a Roth IRA with the IRA administrator, your “converted” balance will probably go right into your existing Roth IRA. If you don’t already have a Roth IRA, you’ll open a new account during the conversion process. (See our list of the best Roth IRA accounts.)
3. Pay taxes on the contributions to your traditional IRA. Remember, only post-tax dollars get to go into Roth IRAs. So if you deducted your traditional IRA contributions and then decide to convert your traditional IRA to a backdoor Roth, you’ll need to give that tax deduction back. In other words, you’ll need to pay taxes on the money you contributed, just like everyone else who invests in a Roth IRA.
4. Pay taxes on the gains in your traditional IRA. If the money in that traditional IRA has been sitting there awhile and there are investment gains, you’ll need to pay taxes on the gains as well as when you convert to a Roth IRA. You will report this on your federal income tax return in April.

One side note: If you have a traditional IRA and you’ve been able to deduct the contributions, you may be tempted to throw in some extra cash over and above the amount you’re allowed to deduct. The strategy here is to then convert just that extra, nondeductible portion into the Roth IRA. Think again. The IRS requires rollovers from traditional IRAs to Roth IRAs to be done pro rata. That means if you convert, say, 20% to a Roth IRA, the IRS requires you to convert 20% of the contributions that were deductible and 20% of the contributions that weren’t. You can’t cherry-pick.

Now that you know how to open a backdoor IRA, take a look at our guide to how and where you can open a Roth IRA.

Tina Orem is a staff writer at NerdWallet, a personal finance website. Email: torem@nerdwallet.com.

This post was updated June 23, 2016. It was originally published March 14, 2013.

from NerdWallet
https://www.nerdwallet.com/blog/investing/backdoor-roth-ira-high-income-how-to-guide/