A backdoor Roth conversion helps higher-income earners cut down on their tax burden when their income exceeds the limits of a traditional Roth. In a Roth, your money grows tax-free and you won’t pay taxes when you withdraw from your account later on. The backdoor conversion is a way to take advantage of the tax benefits of a Roth even if you didn’t qualify.
This process has been around since 2010 when the tax code changed and created a loophole. Basically, you put money into a traditional IRA, and then convert that account to a Roth IRA.
Sounds simple enough, but Roth conversions can be tricky – and it’s important to communicate with your accountant and make sure all the proper forms are filed. But first, here is what a backdoor Roth conversion looks like step-by-step:
How to do a Backdoor Roth Conversion
Step one: Put tax-deferred, deductible money in your traditional IRA. You want after-tax money for this step. That’s because you’ll be taxed according to the ratio of IRA assets that have been taxed versus those that haven’t been.
Step two: Make a non-deductible contribution to the traditional IRA. There are no income limits for the traditional IRA, but there are contribution limits. For 2019, they are $6,000, or $7,000 if you’re age 50 or older.
Step three: Keep money in cash. You will be taxed on any earnings from your money, so keep it in a money market or cash fund to avoid that.
Step four: Wait about a month, until you receive a statement from your IRA provider.
Step five: Roll your funds from the traditional IRA to the Roth IRA. Make sure this step is done before the end of the year.
Step six: Report the conversion on your taxes. For this step, you will need to include form 8606. Remember to file one form for each spouse.
Step seven: Repeat. If you do one conversion, you’re only contributing $6,000. Repeat the backdoor Roth conversion every year to build that money up and take advantage of the Roth tax benefits.
Communicating with your Accountant
One of the most important parts of a backdoor Roth conversion, as I mentioned in step six, is to file Form 8606 with your tax return.
It’s very important to make sure your accountant has filed that form. If they don’t, you could end up paying taxes twice on your backdoor Roth conversion.
If you’re concerned about getting the process right, work with a financial advisor you trust to help it go smoothly. Financial advisors and accountants often work together on your behalf to make sure everything is being carried out as it should.
A backdoor Roth conversion is a useful tool for minimizing your tax burden as your investments grow. Done correctly, it can help high-income earners use the tax benefits of a Roth IRA even if their income does not qualify.
Do you need help getting your finances organized? Contact me today to set up a meeting to talk about your goals. You can also download my free ebook for physicians for tips and information about getting your finances on track.