Charles Schwab Backdoor Roth IRA Tutorial

Backdoor Roth IRA Basics

Understanding a backdoor Roth IRA is fundamental for the high income parent.

Everyone with earned income is eligible to contribute to a traditional IRA. Unless your modified adjusted gross income is below $133,000 for a single filer of $196,000 for a couple filing jointly, you can’t contribute directly to a Roth IRA. If your income falls below those levels, then you can stop reading now and just put your $5,500 directly in your favorite Roth IRA. Then go enjoy a nice beverage.

If your income is above the limits then read on. Next, you need to assess if your income is above the deductible limits. This is where the backdoor Roth comes into play. Here are the income limits if you are covered by a workplace retirement plan straight from the IRS website.

 

And if you aren’t covered by a workplace retirement plan:

 

So why would you stache away $5,500 a year and pay taxes on the contribution, then get the “amazing” opportunity to pay your regular income tax rate on the withdrawals after age 59 1/2?

If you are going to pay taxes on a contribution and the profits from the investment, it would be a lot more intelligent to just put it in a taxable account so you only pay a capital gains rate. I don’t understand why a non-tax deductible traditional IRA exists but I’m not in charge of our tax code so I don’t make the rules.

Fortunately, we can “sneak in the backdoor.” In reality, this isn’t the case at all because nobody is sneaking anywhere. It’s all spelled out to the IRS when you file your taxes. There is even a tax form (Form 8606) to complete the conversion from a traditional IRA to a Roth IRA. If the IRS didn’t want us doing this, why would they have a tax form for it? So let’s do our patriotic duty and pay fewer taxes on our retirement account profits. 

My Roth IRA’s are with Charles Schwab. Many index investors use Vanguard but my employer retirement plan is with Schwab and I decided to keep everything together for simplicity. They offer excellent low-cost index ETFs I can purchase commission free.

I’ve never seen a step by step tutorial for Schwab and I think they have come a long way in catering to the low-cost index investor. I offer up this tutorial to help those of us who have an IRA with Charles Schwab.

1. Setting up the Accounts

In order to take full advantage of the backdoor Roth, you need to get all your pre-tax money out of IRA-related accounts. This includes:

  1. Traditional IRA
  2. SEP IRA
  3. SIMPLE IRA
  4. Rollover IRA
  5. Individual Retirement Annuity
  6. Employer and Employee Association Trust Account
  7. Spousal IRA

All of these different IRA’s fall into the tax deductible eligibility category and the IRS views all tax deductible IRA’s as one big IRA regardless of the number of accounts you have.

Places you can transfer these type of account include 401k, 457, 403(b) or Thrift Saving Plans. If you have one of these employer-sponsored retirement plans, and they allow direct rollover from a personal IRA, you could rollover the pretax money into these plans and you would not be subject to the pro rata rules.

If your employer doesn’t allow direct rollover you could always open a Solo 401K to accomplish this.

With a small amount in these tax-deferred accounts then you may just bite the bullet and pay the taxes. You’ll have to make that decision. When I rolled over my IRA to the Solo 401K, I had over $50,000 pretax in the Rollover IRA and didn’t want to pay the $17,000 tax bill.

 

2. Make a Pretax Nondeductible Contribution to Your Traditional IRA

If you haven’t opened a traditional (or contributory is how Schwab refers to it) IRA, you’ll need to do that first. Its pretty straight forward and I won’t go over the process here. You’ll also need a Roth IRA. Make sure both those accounts are opened before you start the next sequence.

Make a contribution up to $5,500 (or $6,500 if you are over 50 years of age) into your contributory (or Traditional) IRA.

  1. I navigate to the “Online Transfer” tab because I’ve linked my checking account to my Schwab account. You could also send them a check but everything is available electronically, so I use the electronic option (Don’t want to waste a stamp).
  2. Select the “transfer from” and “transfer to” accounts.
  3. Put in your contribution amount (in my case it’s $5,500) and click Continue.

3. Wait for the Funds to Clear

The funds will usually take a day or two before they become available for conversion to the Roth IRA account. Some people are worried about something called the “step transaction doctrine.” Here is another article (requires registration) about the step transaction doctrine and how it doesn’t really apply to the backdoor Roth IRA but you’ll have to make the decision yourself. I’ve never heard of, or read of anyone having to pay penalties for transgressing the step transaction doctrine in regard to Backdoor Roth IRA conversions and I’ve converted the first day I can for the last five years without any contact from the IRS.

4. Convert to Your Roth IRA

Login to your Schwab account online. If you have multiple accounts you will need to select your traditional (contributory) IRA in which you placed your contribution. Navigate to the “Service” tab in the topbar and then select “Forms” from the Account Servicing tab.

 

The form you need will be listed first. It is the “Convert Traditional IRA to Roth IRA” form.

 

Click “Convert Traditional IRA to Roth IRA” and this window will pop up.

You have the option to complete online or fill out a form and mail it in. I completed my conversion online.

 

This is the next window that comes up. Select your “From” and “To” accounts. The “From” account is your traditional IRA and the “To” account is your Roth IRA.

This is what it looks like with the accounts selected. It will have your account numbers after the names but I’ve deleted mine in this image. Click Continue.

Next, Schwab gives you the opportunity to withhold taxes. Since this was a conversion from a post-tax contribution, you don’t need to withhold taxes because you already paid them.

 

They want to make double super sure you know what you are getting into with the tax withholding options. They make a good point about withholding. If you elect to withhold taxes and it is characterized as a distribution, you could be subject to penalty if you are under 59 1/2 years old. If you’re converting some pretax funds, it is better to pay those yourself from a nonpenalized account (like a checking account) when you figure your taxes for the year.

 

They give you one last chance to review everything in the next window. Click “I agree” if you agree.

I agreed. 🙂

 

And that’s it! You’ve done it. No sweat. You just avoided a nice chunk of taxes on future investment profits and even Schwab wants to give “Acknowledgment” of your striking achievement.

 

5. Do the Same for Your Spouse

What is good for the goose is good for the gander. Even if your spouse doesn’t have earned income, you can still contribute the maximum each year for your spouse in a Spousal IRA. It isn’t tax deductible either. Then he/she can convert his/her Traditional Spousal IRA contribution to the Roth IRA as well.

6. Select your Investments

I initially keep the money in cash when I contribute the funds to the Traditional IRA. It would eventually get swept to a money market fund but I usually do the conversion so quickly there isn’t time. Even if you do earn some interest in the Traditional IRA and sweep all of it over, you will only have to pay a small additional tax.

For example, say you leave the money in the Traditional IRA for a while and earn $10 in interest. If you’re in the 33% tax bracket you’d pay an additional $3.33 of tax for the year. Nothing to sweat about.

Once I have my money in the Roth IRA, I buy higher volatility and hopefully higher returning investments (like Emerging Markets or Small Cap Value funds). Roth money is quite valuable and I hope to grow this account faster than others. When you look at your total portfolio, you should look at things from an after tax risk adjusted standpoint. This is a subject for another post, but when you’re a total return investor like myself, you can probably place investments in whichever account you choose as long as the taxation and asset allocation align with your investment goals and Investment Policy Statement.

7. Fill Out IRS Form 8606

You can find the information to fill out the form here through the IRS and download the form here.

You can also file this form through TaxAct, TurboTax and the other major tax software companies.

 

Other Resources

Here are several other resources.

  1. Physician on Fire  Step by Step Guide to the Backdoor IRA at Vanguard
  2. The WhiteCoat Investor  The Backdoor Roth IRA Tutorial
  3. The Finance Buff Backdoor Roth: A Complete How To
  4. Bogleheads has a complete guide on the Backdoor Roth IRA
  5. Michael Kitces  How To Do A Backdoor Roth IRA (Safely) And Avoid The IRA Aggregation Rule And Step Transaction Doctrine.
  6. Charles Schwab website The Backdoor Roth—Is It Right for You?
  7. Morning Star Backdoor Roth IRA? Avoid These 6 Mistakes
  8. Financial Samurai Is A Backdoor Roth IRA A Good Move For Higher Income Earners?
  9. BigLawInvestor Backdoor Roth IRA A Step by Step Guide

 

Diversify Accounts Along with Investments

This is another strategy to diversify out tax treatment with different accounts. Having a variety of buckets including tax-deferred, capital gains taxed, and tax-free growth will give us options to minimize taxes. Using the backdoor Roth IRA will give us an additional option when it comes to withdrawing funds for retirement, especially if you don’t have access to other Roth options.

 


If you need help tracking all your accounts, there is a great application and is completely free. It’s called Personal Capital. With Personal Capital you can track all your checking, saving, mortgage, investment and retirement account all in one place. I used Personal Capital and find it to be the best way to keep all my financial accounts straight. Try it our free today.


 

Do you have any other questions about the backdoor Roth IRA? Do you think it’s worth the hassle? 

Tom
Tom is a doctor, husband and father of five with a passion for parenting and finance. When he isn't skateboarding, riding BMX, or jumping on the trampoline with his kids, he is reading and writing about personal finance. He helps high income parents educate and mentor their kids to become financially, emotionally, and intellectually self sufficient.

6 Responses to “Charles Schwab Backdoor Roth IRA Tutorial

  • Great tutorial for the Schwab investors. I’ve got the Vanguard camp covered. Has anyone shown how to do it with Fidelity?

    It’s great to have the visual step-by-step guide. It’s one thing to understand the concept, and entirely another to actually execute the process.

    Cheers!
    -PoF

    • Thanks PoF. I looked and couldn’t find a Fidelity tutorial. I know WallStreetPhysician is a Fidelity guy. He would be a good one to draw it up.

      Tom @ HIP

  • Nice play-by-play for Schwab.

    We have a significant amount of $$$ in our Traditional IRA accounts. I should see if our work 401(k)s (both Fidelity) allow a rollover from an IRA. We’ve totally missed out on all this Roth IRA action.

  • Great post! Is there anything special to designate a spousal IRA? Previously used backdoor Roth for both wife and myself, but now she stays at home with the kids. Thanks!

    • As long as you file your taxes “married filing jointly” you can contribute your income to your wife’s traditional IRA up to the limits.
      Schwab didn’t have a specific spousal IRA. You just open a traditional IRA if you don’t have one set up already. That will count as the spousal IRA. The important part is filing your taxes appropriately.

      Tom @ HIP

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