I’m a big fan of Roth IRAs: They offer the most flexibility and best future tax advantages for retirement money…

  • Earnings are never taxed
  • You can withdraw your contributions at any time without penalty
  • You don’t have to take the money out after you hit retirement age
  • As long as you’re working, you can keep contributing
  • Your heirs don’t have to pay taxes on withdrawals

Plus, qualified withdrawals (when the account is at least 5 years old and you’re at least 59½) from your Roth IRA won’t make your Social Security benefits taxable because they don’t count as income…but withdrawals from traditional IRAs do count, and could greatly increase your future tax bill.

On top of all that, Roth IRAs are super easy to set up and fund. The problem: If you’re a high-earner, you can get locked out of these beneficial accounts.

For tax year 2019, single and head-of-household filers start getting phased out for Roth contributions when MAGI hits $122,000 and are locked out completely at $137,000. People using the married filing joint status phase out between $193,000 and $203,000.

But there’s still a way for you to reap all of the advantages of a Roth IRA, no matter how high your MAGI is…

Use the backdoor

A backdoor Roth is really just a Roth conversion that helps you legally sidestep the maximum earnings rules.

Even if you earn too much to put money in a Roth IRA, you can still make a non-deductible contribution into a traditional IRA. Once you’ve done that, you can convert your traditional IRA to a Roth without taking another tax hit.

It’s a pretty simple strategy, and it makes a lot of sense for high earners because the future tax benefits are well worth it: Once you’re retirement money is in a Roth IRA, the earnings will never be taxed (as long as you follow the withdrawal rules).

And all it takes is about 30 minutes of your time.

A backdoor Roth IRA works best if you don’t already have money in traditional (pre-tax) IRA accounts, including SIMPLE and SEP plans.

4 easy steps to your backdoor Roth IRA

Once you’ve decided a backdoor Roth is right for you, setting it up is simple.

  1. Open a traditional IRA account and a Roth IRA account at the bank or brokerage of your choice.
  2. Make a non-deductible traditional IRA contribution: up to $6,000 if you’re under age 50, and up to $7,000 if you’re 50 or older.
  3. Ask your IRA trustee to transfer the funds directly to your Roth IRA account.
  4. Fill out IRS Form 8606 to report the transactions when you file your taxes.

Many advisors say you should wait several months between steps 2 and 3 to avoid any IRS scrutiny under the “step transaction doctrine” (when a series of steps changes the tax outcome). But waiting comes with a little catch: Since the earnings in the traditional IRA account haven’t been taxed yet, converting them into a Roth account will trigger a tax bite.

Tax year or calendar year?

IRA contributions can be made during the tax year, from January 1 of the current tax year through the tax return due date – usually April 15 – of the following year. For example, a 2019 IRA contribution could be made in March 2020.

IRA conversions go by calendar year, and must be done by December 31 to count for that tax year. For example, doing a conversion in March 2020 counts for tax year 2020, even if the related contribution is for tax year 2019.

To avoid dealing with the hassle of figuring out those taxes, keep the lag time to a minimum – a few days. If you plan to take advantage of this strategy every year anyway (which you should), there’ll be a pattern regardless of how long you waited to convert. Plus, people have been openly using (and writing about) this strategy for years without any IRS issues.

If you’d feel more comfortable with a little more lag time, keep your contributions in a slow-growing, low-earning account (like a savings account) until you make the conversion.

Don’t Forget Form 8606!

Form 8606 is a crucial part of this process – it’s where you report all nondeductible IRA contributions and Roth conversions to the IRS. That does two things:

  1. It establishes the tax basis of your IRA accounts. The basis is the total amount of IRA contributions that you’ve already paid taxes on.
  2. It notifies the IRS of the Roth status so they can’t come back later and try to tax the earnings in your account.

If you’ve already filed your tax return without including Form 8606, file it now (and that goes for previous years’ returns, too).

Avoid tax traps

If you already have a traditional IRA (or SIMPLE or SEP) account with pre-tax money in it, you’ll be subject to special IRS pro rata tax rules…and that could make the backdoor strategy much less attractive.

According to the IRS, all of your traditional IRAs count as one giant IRA, whether the original contributions were deductible or not. When you convert any or all of it to a Roth IRA, you have to pay tax on the portion that hasn’t been taxed yet.

This all gets calculated right on Form 8606.

Here’s an example of how the pro rata rule works:

Say you have $16,500 in an existing traditional IRA. Then you make a new $5,500 nondeductible contribution to a separate traditional IRA account this year. You convert that $5,500 to a Roth IRA. Based on the pro rata rule, $4,125 of that conversion would be taxable this year. See the full calculation here.

One way to avoid this issue: Consider rolling your pre-tax traditional IRA accounts into your 401(k), as long as your employer allows it. If you have self-employment income, even if it’s from a side gig, you can open a solo 401(k) and stash your IRA assets in there.

Bottom line: Roth IRAs offer too many benefits to miss – especially if you have a substantial retirement nest egg. Don’t let the income phase-out rules keep you from taking advantage of this wealth-building gift. Use the backdoor to contribute to a Roth IRA every year and never pay tax on those earnings.