Many tutorials will instruct you on how to perform a Backdoor Roth Conversion, discuss the necessary items (step transaction doctrine, etc). However, very few of them go through a step by step process for the very first time you ever set up a Backdoor Roth IRA. Most of them start with the assumption that you have something already set up. I, unfortunately, ran into several snags because of this. It was not straightforward at all, but utilizing a backdoor Roth conversion is vital to building wealth for high-income earners.
After you have maxed out your employer 403B/401K for you and your spouse and any governmental 457s, a backdoor Roth should be your next step!
Today, we will discuss exactly how to set up your first Vanguard Backdoor Roth. If it’s your first time performing a Backdoor Roth, you may want more information after reading through this post on how to perform $22,000 in one year (if married) or $11,000 (if single). If that’s you, read my post on breaking the $11,000 contribution rule.
Necessary items to note prior to starting tutorial
For starters, check to see if you make too much to contribute straight into a Roth IRA. This is straight from the IRS for the 2018 tax year (publication 2017-177):
The income phase-out range for taxpayers making contributions to a Roth IRA is $120,000 to $135,000 for singles and heads of household, up from $118,000 to $133,000. For married couples filing jointly, the income phase-out range is $189,000 to $199,000, up from $186,000 to $196,000.
A few other things:
1) You do have to pay tax on any money you make while your money sits in the traditional IRA account prior to conversion. Unfortunately, I was paid a dividend from the settlement fund because it took me too long to figure it out. Hopefully, this tutorial will prevent this for you.
2) Do NOT elect to withhold taxes when you make your conversions. Vanguard defaults to this, but some other websites do not and suggest you withhold 10%. Don’t do it.
3) Wherever it is an option you should likely choose to reinvest the dividends earned from the account.
Step 1. Navigate to Vanguard Website
The first step is the most intuitive. Head on over to the Vanguard personal investor website.
Step 2A. Open an Account
Locate the “Open Account” at the top of the screen (Red Arrow).
Step 2B. Click “Open a New Account”
Step 2C. Choose Funding Source
Most people will choose to wire money from their bank (Red/Black Arrow show in image below). However, select the appropriate option for you.
Step 3. Fund your Vanguard account
The next few steps after this are very intuitive. You can either 1) send vanguard a check or 2) give them your financial information.
Fill out the remaining appropriate information. When you type in (and select) your bank. Then select “individual” and it will look like the image below. Fill out this screen and the next four screens thereafter. Again, this part is intuitive. It also involves personal information, which is why you won’t see a screen shot from me!
Step 4. Review and Sign & Wire the Money
Use your banking account and routing numbers from a check to wire money to Vanguard. You will have selected a traditional IRA during the process. Go over everything one last time (Review) and then sign the documents.
Step 5. Register for an account
This part is intuitive. Make a username and password, etc. This gives you web access to your Vanguard account.
This is where is starts to gets confusing.
- Your money gets transferred to a “settlement fund” inside of your traditional IRA. The settlement fund is in the Vanguard Federal Money Market Fund.
- This settlement fund will hold your money (i.e. prevent you from using it) that you wired from your bank account for up to 7 days. You cannot do anything with your money until it clears. You simply have to wait. Sorry. If you try before it has cleared it will tell you that you have “no available shares.”
- This settlement account is a Brokerage account. This is a controversial topic on the Bogleheads forums. Some say that it may be a good thing because it simplifies the amount of tax paperwork you receive. Others say it has made the process unnecessarily complicated. As far as I am concerned, it is what it is.
- At this point, you have NOT opened a Roth IRA account into which you can convert your traditional IRA funds.
Step 6. Wait. How long? Who knows.
This is the mandatory part of any post on backdoor roth conversions where people talk about the Step Transaction Doctrine and how you should wait some amount of time before you convert your traditional IRA money to Roth IRA money because this was not a foregone conclusion and you need to show that this as not the intentional plan (to convert to a Roth). Waiting longer than a day or so (how long it takes for money to clear at Vanguard) makes little sense to me and here is why:
- No matter how long you wait the Step Transaction Doctrine says that multiple steps taken in a financial decision can be viewed as a single step. Therefore, if you don’t qualify via the rules above, then you shouldn’t qualify even via a Backdoor method regardless of how long you wait.
- This has been occurring since the rules changed around 2011. It is widely publicized and no one has ever mentioned or publicized being audited or fined by the IRS for completing this widely known mechanism for funding a Roth IRA.
- If you are deciding to do a backdoor Roth conversion this year, you are likely going to do it next year. And the next year. And so on. So, how can you justify in court that you “didn’t plan” to perform the Roth conversion in the first place when you have done it for multiple consecutive years. Clearly, this has become a pattern for you. Again, even if it was for one year, the step transaction does not protect you.
So, I would wait as little time as possible, because you want to avoid your traditional IRA from making money (which apparently includes dividends… don’t ask me how I know). If you make more than $1, your 8606 tax form becomes less clean. [Though I’ve been informed recently that you actually need to earn more than $2 for it to matter because of some complicated math]
Step 7. Open a Roth IRA
This is the key part that is not intuitive on Vanguard. If you click the “convert to Roth” button (red/black arrow shown below) and have not opened a Roth IRA account at Vanguard it will tell you that you have “no account” available to make this transaction. It doesn’t tell you why. It just tells you that you can’t convert to Roth because you have no available account.
[Note my traditional IRA shows zero funds because I have already performed the conversion at this point, prior to this it had $5500 in it]
In order to avoid this very annoying screen, you need to do the following:
- Click “Open an Account” under “My Accounts” as shown in the image below (red/black arrow)
- You will go through a similar process (select that you are already registered at Vanguard) that you went through above to set up another account, except it will be a Roth IRA this time and will be a lot faster this time because Vanguard already has most of your information.
- The key to this step is to NOT fund the Roth IRA. Make the selection to “add money later.” In other words, open a Roth IRA account with $0 (Zero dollars) in it.
Step 8. Now convert to Roth
After you have both a traditional IRA account (with hopefully $5500 in it), you can now convert to your open (but not funded) Roth IRA account. This will transfer the money into an identical Vanguard Federal Money Market Settlement Fund. In other words from your traditional IRA Settlement Fund to your Roth IRA Settlement Fund.
Step 9. Exchange the funds to a Mutual Fund
Now, you can finally select the “Exchange” function and choose the fund of your heart’s desire once it is in the Roth IRA account settlement fund. This can be done through either of the red/black arrow functions (Buy/Sell or Exchange). They both accomplish the same exchange function. Once you have selected this the next screen is intuitive. Transfer “all shares” to your chosen fund. In my case, I chose the Total Stock Market Index.
[Unfortunately I made $1.68 on dividends because it took me 10 days to figure out this process because of its non-straightforward process. Hence, writing this lengthy post].
[Another note, I plan to transfer all of my money into the Total Stock Market Admiral Shares once I have >$10,000, which is the minimum, when I make this conversion next time. The Admiral shares fund’s expense ratio if 0.04% compared to the 0.15% in the investor’s total stock market index fund, but the investor shares version has a lower minimum contribution of $3,000]
Step 10. Download a Net Worth Tracking Program
I think that following your networth is really helpful. It provides encouragement for you to stick to the plan. The one that I use and like the best is Personal Capital.
You can add all of your assets (retirement accounts including backdoor Roth, 401K/403B, cash/savings, etc) as well as any debts you may have (like your mortgage or car loans….oops).
Either way, find a program that works for you. I think it really does help.
(Optional) Step 11. Rinse and Repeat if married
If you are married, now repeat this process for your spousal Roth IRA conversion.
I hope that this was helpful! I had quite the hard time figuring this out on my own and ended up making money prior to my conversion because it took too long. Don’t forget to report your contributions on tax form 8606 (tax form in April for tax year for contributions) and your conversions on your 8606 (in actual calendar year conversion was performed)! Any accidental gains (>$2 gain) are reported on your 1040 for the appropriate tax year.
A new post coming later in January 2018 will go cover how first time backdoor Roth’ers can contribute and convert $11,000 per tax person ($22,000 for a married couple) in one calendar year.
Was this helpful? Anything I left out? Leave a comment or question below!