The Optometrist's Guide to Roth IRA and How to do a Backdoor Roth
Chapter 2: How to do a Backdoor Roth with Vanguard: Step by Step Instructions
Updated for 1/5/2021
In this chapter, we will show you a step-by-step guide (with screenshots) on how to do a Backdoor Roth for new investors. We will be using Vanguard as an example, but Fidelity and other major brokerages will have similar steps.
Before we get started, here are 4 requirements before attempting to do a backdoor Roth IRA
(1) You cannot have any tax-deferred money in any existing IRAs such as a traditional, SEP or SIMPLE.
- If you do, you need a strategy to move that money to a Roth-IRA (W2) or solo 401K (1099/SCorp) via IRA rollover and be aware that there might be a tax bill due on the conversion.
- Note: This applies to spousal IRAs as well
(2) Set up 2 Separate Accounts: Trad-IRA + Roth IRA
- We will use the same two accounts to do the backdoor Roth conversion each year.
(3) Have the full amount $6,000 (for 2021 Limit) to fund for the 2020 Contribution first
- If you have another $6,000 to contribute, then you can make a 2021 contribution as well, but again you have until 4/15/2022 the following year to do so.
(4) Repeat for your spouse if needed
Step 1: Open up an account with Vanguard
If you are new to Vanguard, it is pretty straight forward, so we won’t go through all the steps. Again, make sure you open both Trad-IRA and Roth IRA accounts.
Step 2: Contribute $6,000 to your Traditional IRA First
Once you open both your Trad + Roth IRA accounts, go into your Trad IRA FIRST, you should automatically have a Vanguard Federal Money Market Fund (Settlement Fund). This is basically cash, and where we can use to hold any money for transactions. Then click Contribute to the Trad-IRA account.
Tell Vanguard where your money is GOING TO for your 2021 Contribution (this amount would be $6,000), and it will automatically be placed in your Federal Money Market.
Note: I already contribute $6,000 for both 2020 and 2021, so that's why my "You can Contribute" is $0.00 but yours should say $6,000
Next, select where the Money is COMING FROM? In this case, we are going to transfer it from a personal checking account @ First Republic Bank. You can transfer it from other Vanguard accounts as well.
Next, consent to electronic delivery of the prospectus of the “Federal Money Market Fund”. This is basically telling you what the fund actually invests in, which in this case, is all cash.
Step 3: Wait 1-7 days before making the Roth Conversion
It usually takes a day or two for the $6,000 to transfer from your Checking account to your Vanguard Trad IRA.
Then wait another 1-7 days before making the conversation to Roth IRA. Why?
- Step Transaction Doctrine: Some people believe that it is best to wait to do nothing from 1-7 days, this will allow the IRS to “bless” the backdoor Roth convert.
- But In 2018, Congress officially blessed the step of the Backdoor Roth IRA under current law, so many people convert it the next day without any IRS red flags popping up.
Step 4: Convert your $6,000 to a Roth IRA via Backdoor
- Once your $6,000 Settles in your Trad-IRA (usually takes 1-2 days)
- Go to the top Menu "My Accounts"
- Within your Trad-IRA account, select "Convert to Roth IRA", once your $6,000 has settled in your available balance
Part 3: Choose the Roth IRA account to convert to. If you open up the Roth IRA during the initial set-up, it will show up here. If you haven't, well you didn't follow instructions very well, so stop and Open a Roth IRA first.
Part 4: Tax Holding
You will be given some information that the conversion is a taxable event that cannot be reversed. Well this isn’t exactly correct, because the final net contribution is a non-deductible $6,000 contribution.
- For 2020, there is a new tax reform that eliminates the ability to re-characterize (or undo) Roth Conversions.
Step 5: Select your investment funds within your Roth IRA
Remember to buy your funds once you have the $6,000 in the money market. Think of your Roth IRA as an additional retirement accounts, so choose your investments accordingly.
Step 6: Repeat for your Spouse (if applicable)
If you are married and file jointly, then your spouse can also do a backdoor Roth for an additional $6,000 even if he or she doesn't have an earned income.
Step 7: Fill out Form 86060 in your 1050 during your tax season
Here is what your IRS form 8606 should look like, but if you want additional instructions from IRS, find out more here.
Step 8: Repeat every year before April 15 (Tax Deadline)
I usually like to do my Roth IRA backdoor every year around January. I do the full $6,000 amount on the same month of every year. Remember this will go into your Money Market Fund, so you will have plenty of time to choose your investments.
I recommend selecting your investment funds as soon as possible, so your money can start working sooner.
In addition, if you have an extra $6,000 laying, and want to contribute for 2020, go for it!