The Backdoor Roth IRA

Roth IRAs (individual retirement accounts) are a fantastic, tax-advantaged vehicle for saving and investing for retirement. However, not everyone can contribute to a Roth IRA because the IRS places limits on high income earners. That's right, if your modified adjusted gross income (MAGI) is above a certain amount, you might only be able to contribute a reduced amount or no money at all to a Roth IRA.

If your gross income is a bit more than the average US pharmacist, this might put you in a gray area where you might not be sure if you are allowed to contribute to a Roth IRA. Firstly - congratulations! This is a good problem to have. Secondly - thankfully, there is a solution to get around the income limits of a Roth IRA using a strategy called the backdoor Roth IRA.

So who are the income limits a problem for? The 2022 modified adjusted gross income (MAGI) phase-out limit for a single filer is $129,000 per year and $204,000 for married couples filing jointly. The phase-out limit is where lesser contributions are allowable until they are completely phased-out at a higher limit. For greater detail, please see the following: https://www.irs.gov/retirement-plans/plan-participant-employee/amount-of-roth-ira-contributions-that-you-can-make-for-2022. It's important to note that this is not the same as gross income, which is the agreed to salary/compensation in your offer letter/annual raise. MAGI, as the acronym suggests, is a modified version of adjusted gross income (AGI) with certain add-backs. AGI is generally a good estimation for MAGI, but for the sake of comprehensiveness, please see the following link: https://turbotax.intuit.com/tax-tips/irs-tax-return/what-is-the-difference-between-agi-and-magi-on-your-taxes/L7kHckNS3.

If you're a pharmacist that will make $130,000 this year, and you contribute in full to your 401(k) ($20,500) and HSA ($3,650), these contributions will lower your AGI to $105,850 ($130,000 - $20,500 - $3,650). This means that you do not have to worry about contributing to a Roth IRA directly (with the assumption that you are single), and you do not need to use the backdoor Roth IRA assuming you don't have other sources of income (and various other add-backs including student loan interest), which would put you in the danger zone (above the IRS phase-out limit). Now if you were a pharmacist making $160,000, and you contributed in full to 401(k) and HSA, you would need to utilize the backdoor Roth IRA to make a full contribution.

While I don't make enough money for me to worry about having to use a backdoor Roth IRA, I decided to do it anyway in 2022.

The following are the steps I took. The importance of Step 1 cannot be overstated. You want to ensure that you first clear out SEP, SIMPLE, traditional IRAs by rolling these over into a 401(k) or an individual 401(k). Technically, you don't have to do this step first, and you can complete this anytime in the year that you do the conversion. However, just to keep things simple and straightforward, I would first roll these over into a 401(k), 403(b), or Individual 401(k). There are additional options that can be found here: https://www.whitecoatinvestor.com/backdoor-roth-ira-tutorial/. The reason you want to do this is because of the pro rata rule, which can have tax implications if you don’t do a rollover. Remember, you can have these (SEP, SIMPLE, traditional IRAs) at any brokerage institution, so make sure that you don’t have dollars sitting in a traditional IRA (or the other IRAs mentioned) from a previous employer/self-employment at any brokerage house.

Since I don’t have any funds in these accounts, I moved onto the next step, which was to open a traditional IRA at Vanguard. I contributed $6,000 to the traditional IRA on 1/3/2022. Vanguard told me it would take one week for the funds to settle. This step took about 10 minutes.

Once the funds settled on 1/10/2022, I converted it over to a Roth IRA. Since these are taxed dollars that I contributed to a traditional IRA, when I convert these dollars from a traditional IRA to Roth IRA, I owe an additional $0 in taxes. When done correctly, there are no additional taxes owed. I used these $6,000 to purchase VTSAX the same day. This step took another 10 minutes.

Since this was my first time doing this, I found this guide to walk me through the process with Vanguard: https://www.physicianonfire.com/backdoor/. I also called Vanguard because I really didn't want to screw this up, and they also walked me through the process. This was a lot less scary that I anticipated. Please note that you will need to file IRS form 8606 when you file your taxes. I will be submitting this when I file my 2022 taxes in 2023.

All in all, 20 minutes to put another $6,000 in an account where my dollars will never be taxed ever again no matter what my MAGI is. I’d say that’s a pretty good deal.

There is one additional point to note. Congress made an attempt to kill the backdoor Roth in 2021 as a part of the Build Back Better (BBB) bill. Thankfully, Joe Manchin pulled support for the bill, so we will likely be okay for 2022 unless Congress tries to reintroduce it in a revised version of the bill. For some speculation around potential scenarios that may play out in the future, please see: https://fitaxguy.com/2022-backdoor-roth-ira/.

Summary

Pre-Work

1. Clear out SEP, SIMPLE, rollover, and traditional IRAs by rolling them over to another account (401k, individual 401k, etc.)

Week 1 of new year - 1/3/2022

1. Contribute full amount to traditional IRA (TIRA) on first business day of new year (1/3/2022)

2. Wait 1 week for funds to settle from bank to brokerage house (1/10/2022)

Week 2 of new year - 1/10/2022

1. Convert to Roth IRA and purchase index funds immediately (VTSAX).

Post-Work

1. Submit IRS form 8606 when 2022 taxes are filed in 2023.

If you are a new pharmacy graduate or would like to become more knowledgeable with regards to personal finance and do not understand the intricacies of investing, such as Roth and traditional IRAs, sequence of returns risk, and using market-cap weighted index funds to grow your net worth, I explain all of this and more in a concise booklet, which can be found here: https://amzn.to/32PLB3x or on the homepage.

If you have any questions/comments, please find a comment box below.

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Disclaimer: The article above is an opinion and is for informational/educational purposes only. It is not intended to be investment advice. Seek a duly licensed professional for investment advice. The author has taken care in writing this post but makes no expressed or implied warranty of any kind and assumes no responsibility for errors or omissions. No liability is assumed for incidental or consequential damages in connection with or arising out of the use of this information.