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We know about the traditional IRA and Roth IRA. If you don’t I highly recommend you go check out the episode right before this.

We know that opening and having a Roth IRA comes with some income restrictions. If you make over a certain amount you can’t open and contribute to a Roth IRA.  Married filing jointly folks have to earn less than $189,000 and if you file single then it’s $135,000. For more on that you can refer to episode 9.

So it would seem that the tax-free growth a Roth IRA offers would only be a wish for you high income earners. Not so fast. This is where the backdoor Roth IRA comes in.

The concept is basic. You open a traditional IRA, make a non-deductible contribution, and then convert that contribution to a Roth IRA. This backdoor roth IRA makes most sense for those who can’t have a Roth IRA and are making non-deductible contributions to a Roth IRA. This is because you’re making contributions with money you’ve paid taxes on. Now you’re converting it within the limits of the IRS over to a Roth IRA. And because this is money you’ve already paid taxes on it will grow tax free!

This is what is called the Back Door Roth IRA. Remember maximum yearly limits of traditional IRA contributions are $5,500, $6,500 if you’re age 50 or older. Those 70 ½ can’t do this, because your making contributions to a Traditional IRA and law says those 70 ½ and older cannot contribute to a Traditional IRA.

So you make the contribution to your non-deductible traditional IRA all at once or a little at a time over the year. And the next day or so you call the IRA provider and request to convert it to a Roth IRA. As of now this is perfectly within the limits of the law, however there are tax implications and if you’re listening to this episode and it’s not 2018 then you’ll want to check the laws and a tax professional. As I’ve mentioned before I’m not a tax professional or financial professional. This is all for educational and entertainment purposes.

So this backdoor Roth IRA sounds pretty awesome. I do want to clarify that this isn’t a way to escape paying taxes. The government is smart. They know about this strategy obviously. I personally think our retirement system is so terrible they really hope high income citizens are doing this.

There is something important you’ll want to know when making the conversions. With pre-existing (non-Roth) IRA funds in Traditional, SEP, and SIMPLE IRAs they will likely have deductible contributions and pre-tax earnings. When you convert funds to a Roth IRA, you cannot limit your conversion to just your nondeductible contribution. When you make that conversion, the IRS takes into account other non-Roth IRA funds.

For example: If your nondeductible contribution is 50% of all the money in your Traditional, SEP, and SIMPLE IRA accounts, then only 50% of your Roth conversion amount will be tax-free. The remaining 50% of your Roth conversion amount will be from the deductible (pre-tax) money across all of your Traditional, SEP, and SIMPLE IRAs. And you will end up owing taxes on the 50% converted from pre-tax funds. So you see a back door roth IRA doesn’t let you escape paying taxes. “In this world nothing is certain but death and taxes.”

Here is a strategy to have 100% of the conversion come from the non-deductible contributions and that is to move your funds from the non-Roth IRAs to a solo 401k, an employer sponsored 401k or 403b. This way you won’t have to worry about converting pre-tax money. All your conversions will be straight from the non-deductible traditional IRA (thanks to the Bogleheads for explaining that one).

As I’ve explained before the money in a Roth IRA grows tax free. So instead of contributing to a Traditional IRA every year and watching the money grow knowing you’ll have to pay taxes on the growth, you can convert the money to a Roth IRA and watch it grow knowing you won’t have any taxes to pay on the growth. This is one of my favorite wealth building strategies for high income earners, because you now have access to that tax-free growth benefit. In addition to, leaving money behind for children, grandchildren or whoever just became easier thanks to Roth IRA perks.

So we’ve been talking about contributing the max limit of $5,500 or $6,500 depending on your age. Now there are other ways to pump more money into retirement. One way is called the mega-backdoor Roth IRA. Dr. Jim Dahle over at the White Coat Investor, one of my favorite podcasts to listen to even though I’m not a doctor. He’s very thorough with his information and help for high income professionals, but more specifically doctors in the medical field. Residents and practicing physicians go check him out at White Coat Investor.

In order to utilize the mega Backdoor Roth IRA strategy you have to have a special 401k/403b plan. You’ll want to check with your employer or 401k/403b custodian. Next you’ll want to see if your 401k plan is set up for after-tax contributions. My 401k is with Fidelity so I went to see my plan and options. And we do have a 401a after-tax sub-bucket in the plan I can make even more contributions to. Right now, I’m not ready for that, but once we’re out of debt I’m planning to increase my contributions and buckets I save and invest in and depending if I max out all other accounts then this mega-backdoor roth ira option would be really great!

If any of this is unclear feel free to leave a comment/question below or reach out to info@habeshafinance.com. This journey of financial independence only happens when the FI community helps each other out!