- The backdoor Roth is a strategy that allows
high income earners to bypass the income limits
that are set on traditional Roth IRAs.
So, if you love Roth IRAs,
but you make too much money,
then the backdoor Roth is a strategy for you.
Stick around I'm covering how you can do this
in just a few steps in this video.
(upbeat music)
Hey guys, this is Justine with The College Investor,
investing and personal finance for millennials.
So you guys know about Roth IRAs, right?
So Roth IRAs are a type of retirement account
in which you can contribute after tax dollars
up to $6,000 per year.
Then during retirement you can withdraw that money tax-free
and keep in mind,
that entire time that you have your money in a Roth IRA
your investment grows tax free as well.
Now these are great types of retirement accounts
because of the tax advantages,
however, there are some income limits.
For married couples filing jointly,
your adjusted gross income can be no more
than $206,000 per year.
For single income earners,
your adjusted gross income
can be no more than $139,000 per year.
So if you've seen your income
rise over the past couple of years,
and maybe your adjusted gross income
is over those thresholds
there is a way that you can still take advantage
of the tax benefits of a Roth IRA
by doing a backdoor Roth strategy.
So instead what you need to do is contribute
taxed money into a traditional IRA,
and then convert it into a Roth IRA,
and then you'll need to fill out some paperwork
during tax time.
Now there's a big note that you should keep in mind,
the IRS doesn't let you pick and choose
which money you can convert into a Roth IRA.
So this is called the rule of parody,
any money from a SEP, Simple or Traditional IRA
that is converted into a Roth IRA
will be taxed in proportion to how it came
into those accounts,
and that's why we recommend moving that money
into a 401(k) first.
Okay, so that's exactly step one
is to roll any pre-tax accounts into a 401(k),
or an individual 401(k) if you're self-employed.
Now step number two is to open a traditional IRA
and contribute up to $6,000 into that account.
It's best if you work with an investment company
that has both traditional and Roth IRA accounts available,
so that you can make that conversion
within one company very simply.
So step three is to convert the traditional IRA
into a Roth IRA.
Now, typically you can do this online.
You may have to make a few phone calls,
but I personally have a traditional IRA with Vanguard
and I saw that there was a quick option
to convert it into a Roth.
And then step number four is to fill out IRS form 8606
when it comes to tax season.
Now tax software like TurboTax
makes it really easy for you
to add that form into your overall tax return,
but you may wanna consult with a tax professional
to make sure that you are filling out that form correctly.
All right, so that's really it,
just those four simple steps
but you'll wanna make sure you avoid some pitfalls
when it comes to executing a backdoor Roth.
And the first pitfall is using a backdoor Roth
when you don't have to.
So this really is for high income earners
who have exceeded the income limits for a Roth IRA.
You'll also want to avoid the fact that
if you're not filling out
all of your retirement buckets first,
so if you haven't maxed out your 401(k),
go back and do that
before you attempt a strategy like this.
Next you'll want to avoid crossing calendar years
when you are doing your contribution and conversion.
Ideally you would be making the contribution
into that traditional IRA
and converting it into a Roth
all within the same calendar year.
It just keeps things very simple
when it comes to actually reporting this to the IRS.
You'll also want to avoid having funds
in a SEP, Simple, or Traditional IRA
that won't be used for the backdoor Roth.
And also, you wanna make sure
that you're not opening a SEP or Simple IRA
after you've executed the backdoor Roth.
Just makes things a little bit complicated
because then you end up having to pay taxes
at your ordinary tax rate,
and that's why we recommend moving that money
into a 401(k) first.
Plus you want to avoid forgetting that form 8606
when it comes to tax season,
and then you don't want to deal with too many transactions.
Ideally, all you're going to be doing
is moving that money from a Traditional IRA,
into a Roth IRA,
and then completing that tax form, and then you're done.
Now again the backdoor Roth strategy
is an excellent strategy to use
if you are a high income earner,
and you wanna take advantage of those tax benefits
that come with a Roth IRA.
It's an excellent strategy but remember
to fill out those other retirement buckets first,
before you execute this type of strategy.
Now for more information on how to invest wisely,
be sure to check out all of our free resources
at thecollegeinvestor.com.