How to Set Up a Backdoor Roth IRA

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If you make too much to directly contribute to a Roth IRA, you may be able to set up a backdoor Roth IRA in order to get money working on your behalf in a Roth IRA type account. Roth IRAs can be incredibly powerful retirement investing and estate planning tools, as the money in Roth IRA accounts can be withdrawn tax free in retirement or by your heirs after you pass.

Setting up a backdoor Roth IRA is simply a matter of contributing to a traditional IRA, then converting the money in the account into a Roth IRA and paying any taxes due on the conversion. You'll also get some forms from your broker at tax time that you'll have to file along with your taxes. It's a fairly straightforward process, but it only makes sense in a handful of circumstances, and you need to keep careful track of the steps you take to remain within the rules.

Who would want to set up a backdoor Roth IRA?

You might be interested in setting up a backdoor Roth IRA if you:

Are under age 70 and 1/2,
Earn income through work, either as an employee or self-employed (or are married to someone who does and file your taxes jointly),
Have too high an income to contribute directly to a Roth IRA, and
Either you have no money in Traditional IRAs or are eligible to deduct your Traditional IRA contributions.

Age 70 and 1/2 matters because you are no longer eligible to contribute to a Traditional IRA in the year you reach age 70 and 1/2 or older. Since the first step of setting up a backdoor Roth IRA involves contributing to a Traditional IRA, you must meet the age requirement to contribute.

Earning income through work matters because you can only contribute to an IRA if you've earned 'taxable compensation' or are married to a person that earns taxable compensation and file your taxes jointly. The contribution limits for 2016 are $5,500 for a person under age 50 or $6,500 for a person age 50 and up, but you need to have at least as much taxable compensation as your IRA contribution.

Having too high an income to contribute directly to a Roth IRAmatters because if you aren't over the income limit, it's easier to simply contribute directly to a Roth IRA and cut out the "backdoor" part. Your income limit for Roth IRA contributions is based on your modified adjusted gross income and your tax filing status. If you're:

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Married filing jointly or a qualifying widow(er): You reach the phase out range when your Modified Adjusted Gross Income reaches $184,000 and lose your ability to contribute to a Roth IRA when it passes $194,000.
Married filing separately and you did live with your spouse at any point in the year: You reach the phase out range when your Modified Adjusted Gross Income is above $0 and lose your ability to contribute to a Roth IRA when it passes $10,000.
Single, head of household, or married filing separately and you did not live with your spouse at any time during the year: You reach the phase out range when your Modified Adjusted Gross income is above $117,000 and lose your ability to contribute to a Roth IRA when it passes $132,000.

If your income is close to that level but you're not 100% sure you'll pass the eligibility limits, you can still follow the backdoor Roth IRA approach and be OK no matter which side of the limits you wind up on.

Having no money in Traditional IRAs or being eligible to deduct your Traditional IRA contributions matters because of the way Roth IRA conversions are taxed. When you convert a Traditional IRA to a Roth IRA -- such as for creating a backdoor Roth IRA -- you pay taxes on the conversion based on the proportion of your Traditional IRA value that is not included in your post-tax basis.

It's not mandatory to meet this particular test, but it likely makes strong financial sense. If you have a substantial Traditional IRA balance and can't deduct your contributions, you might find that the tax impact of contributing, then converting would be heavier than the benefits you get from the move. For instance, imagine a case where you start the year with a $45,000 Traditional IRA balance with no basis, then make a $5,000 non-deductible contribution to your Traditional IRA.

As the $5,000 contribution was non-deductible, you're paying income tax on that money you contributed. If you were to then convert $5,000 of your now $50,000 Traditional IRA to a Roth IRA as if it were a backdoor Roth IRA, you'd then pay taxes on 90% of the conversion amount -- or $4,500. That's because 10% of the value of your IRA is the non-deductible basis from your recent contribution and thus isn't taxed again on conversion, but the rest would be taxable as ordinary income.

With that kind of tax burden -- tax on $5,000 contributed plus tax on $4,500 of the converted amount -- you might very well be better off avoiding the IRA entirely. Instead, consider investing the $5,000 in stocks you intend to hold for a long time or a low-cost, low-churn index-type mutual fund. With that strategy, you'd pay taxes on your original $5,000 income and likely very little further tax on your investments over time.

Your backdoor Roth IRA can be worth it

Once your money is in your Roth IRA, it can grow tax deferred in that account for the rest of your life, and if you need to spend it in retirement, your qualifying withdrawals can be completely tax free. If using the "backdoor" approach is the only way you have to get your money into your Roth IRA, then it can be an incredibly powerful tool in your retirement planning arsenal.

The article How to Set Up a Backdoor Roth IRA originally appeared on Fool.com.

Chuck Saletta has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.