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5 Steps to Create a Backdoor Roth IRA

If you make too much to be eligible to contribute to a Roth IRA, Money Girl explains how to create a backdoor Roth - and whether doing so is a smart move for your situation, and your financial needs.

By
Laura Adams, MBA
6-minute read
Episode #394

What Is a Backdoor Roth IRA?

Creating a backdoor Roth IRA is a completely legal strategy that begins with opening up a nondeductible traditional IRA. This after-tax account can be converted into a Roth IRA regardless of your income.

Since contributions to both a nondeductible traditional IRA and a Roth IRA are made on an after-tax basis, making a conversion doesn’t require you to pay any additional tax on contributions.

Let’s say you’re single and earn $135,000. That makes you ineligible to contribute directly to an existing Roth IRA. But you are eligible to convert a traditional IRA into a Roth IRA. See the difference? There’s an income limit on contributions, but not on conversions.

See also: 10 IRA Facts Everyone Should Know

5 Steps to Create a Backdoor Roth IRA

Here are 5 steps for creating a backdoor Roth IRA for people who earn too much to make contributions directly to one:

Step #1: Open Up a Nondeductible (Taxable) Traditional IRA

Some of the best places to open up your IRA or get retirement account advice include:

Step #2: Make Your Contribution

Contribute up to $5,500 (or $6,500, if you’re over age 50) to a nondeductible traditional IRA. That’s the contribution limit for 2015, but it’s likely to increase in future years.

Step #3: Convert the Account to a Roth IRA

Ask your account custodian or adminstrator to immediately convert the account to a Roth IRA. If you already have a Roth, the converted amount can be put there. If not, the custodian will open a new Roth IRA for you.

By the way, there used to be an annual income limit on Roth conversions, but that’s no longer the case - and anyone can convert.

Step #4: Pay Tax on Any Earnings

You can repeat this backdoor Roth IRA process every year that you earn more than the income limit. Unless the IRS tightens down on this loophole, it’s a guarantee that money you convert into a Roth IRA will grow on a tax-free basis.

Since you already paid taxes on the money you put into your new nondeductible traditional IRA, there is no tax due on the contribution.

However, if there are earnings in the account from the time you opened it and converted, there may be a small amount of taxable gain. You’ll receive a statement at the end of the year to include when you file your income taxes.

Step #5: Repeat the Steps Above

Remember that even though you've created a backdoor Roth IRA, you still can’t contribute additional funds directly to it when you earn more than the income limits. Creating a backdoor Roth is a workaround strategy to have a Roth IRA, and basically accomplishes the same thing.

You can repeat this backdoor Roth IRA process every year that you earn more than the income limit. Unless the IRS tightens down on this loophole, it’s a guarantee that money you convert into a Roth IRA will grow on a tax-free basis.

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About the Author

Laura Adams, MBA

Laura Adams received an MBA from the University of Florida. She's an award-winning personal finance author, speaker, and consumer advocate who is a frequent, trusted source for the national media. Money-Smart Solopreneur: A Personal Finance System for Freelancers, Entrepreneurs, and Side-Hustlers is her newest title. Laura's previous book, Debt-Free Blueprint: How to Get Out of Debt and Build a Financial Life You Love, was an Amazon #1 New Release. Do you have a money question? Call the Money Girl listener line at 302-364-0308. Your question could be featured on the show.