A backdoor Roth IRA allows people with high income to fund a Roth IRA despite the IRS income limits. This backdoor method involves the conversion of a traditional IRA to a Roth IRA.

The basic steps require you to first contribute your money into a traditional IRA, and then convert those contributed funds into a Roth IRA. Even though you did not qualify to directly contribute to a Roth IRA because of the IRS income limit, you can use this backdoor method to indirectly contribute to a Roth IRA.

Roth IRA Income Limits

For 2022, the income limit to qualify for Roth IRA contributions increased to $144,000 for single filers and $214,000 for married individuals filing jointly. For 2021, only people with modified adjusted gross incomes below $208,000 (married filing jointly) or $140,000 (single) may contribute to a Roth IRA.

If your income is above the limit, a backdoor Roth might be a good solution for you.

How to Perform Backdoor Roth IRA

A backdoor Roth IRA is a way for high-income individuals to contribute to a Roth IRA, even if their income exceeds the contribution limit. Here’s a step-by-step guide on how to set up a backdoor Roth IRA with Vanguard.

Step 1: Open a Traditional IRA

The first step in the backdoor Roth IRA process is to open a traditional IRA. This can be done through a brokerage firm such as Vanguard. You’ll need to provide some personal information and funding information to open the account.

Step 2: Make a Non-Deductible Contribution to Your Traditional IRA

Once you have your traditional IRA set up, make a non-deductible contribution to the account. This means that you won’t receive a tax deduction for the contribution, but the funds will grow tax-free in the account. You can contribute up to $6,000 per year ($7,000 if you’re 50 or older) to your traditional IRA.

Step 3: Convert Your Traditional IRA to a Roth IRA

After you’ve made your non-deductible contribution to your traditional IRA, the next step is to convert it to a Roth IRA. You can do this by contacting Vanguard and filling out the necessary paperwork. Your IRA administrator will provide you the instructions and paperwork for the conversion. If you don’t already have a Roth IRA, you will open a new account during the conversion process.

When you convert your traditional IRA to a Roth IRA, you’ll need to pay taxes on any pre-tax contributions and earnings in the account. However, since you made a non-deductible contribution, the conversion will be tax-free.

Step 4: Monitor Your Conversions

It’s important to monitor your Roth IRA conversions, especially if you have multiple traditional IRAs. The IRS has a rule known as the pro-rata rule, which requires you to pay taxes on a pro-rata basis on any pre-tax contributions and earnings in all of your traditional IRAs when you convert to a Roth IRA. To avoid paying taxes on your backdoor Roth IRA conversion, make sure to keep track of your contributions and conversions.

Only post-tax dollars may go into a Roth IRA. That means if you deducted your traditional IRA contributions and then decide to convert your traditional IRA to a backdoor Roth, you will need to repay that tax deduction when you file your tax return. See below for details on the pro rata rule and other information to determine your tax bill.

Step 5: Enjoy Your Tax-Free Roth IRA

Once you’ve completed the backdoor Roth IRA process, you can enjoy the benefits of a Roth IRA. Your investments will grow tax-free and you’ll be able to withdraw your contributions and earnings tax-free in retirement.

Rules and Restrictions

Types of transfers

The conversion of your traditional IRA needs to be one of the following:

• A rollover, where you receive the money from your traditional IRA and deposit it into the Roth IRA within 60 days.
• A trustee-to-trustee transfer, where the traditional IRA provider sends the money directly to your Roth IRA provider.
• A “same trustee transfer,” where your money goes from the traditional IRA to the Roth at the same financial institution.

Pro Rata Rule

The IRS requires rollovers from a traditional IRA to a Roth IRA to be done pro rata. When determining your tax bill on a conversion from a traditional IRA to a Roth IRA, the IRS is going to look at all of your traditional IRA accounts combined.

If all of your traditional IRAs combined consist of, say, 70% pre-tax money and 30% after-tax money, that ratio determines what percentage of the money you convert to a Roth is going to be taxable. In this example, no matter how much money you convert or which IRA account you pull the money from, 70% of the amount you convert to the Roth will be taxable. You can’t choose to convert only after-tax money; the IRS won’t allow it.

The IRS applies the pro-rata rule to your total IRA balance at year-end, not at the time of conversion.

Conclusion

A backdoor Roth IRA can be a great way for high-income individuals to take advantage of the benefits of a Roth IRA. By following these steps, you can set up a backdoor Roth IRA with Vanguard and enjoy tax-free growth and withdrawals in retirement.