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Backdoor Roth: How high-income earners can get tax free money

Summary

A backdoor Roth is a way for high-income earners to be able to contribute money into a tax-free Roth IRA account. It is a matter of contributing non-deductible money to a Traditional IRA and then converting that to a Roth IRA. The tricky part comes during the conversion: If you have any money in an IRA that has not yet been taxed, you're going to owe taxes on that.

In today's episode we discuss:

  • The difference between a Traditional IRA and Roth IRA
  • A simple example of a backdoor Roth when you have no other IRA accounts.
  • How taxes work on a conversion
  • How you can still do a backdoor Roth even if you have other IRA balances
  • A potential way to save on taxes if you can roll your existing Traditional IRA balance into your current 401k account.

Resources:

Photo by Gabrielle Henderson on Unsplash

Transcript

Mike: [00:00:00] Welcome to financial planning for entrepreneurs and tech professionals. I'm your host, Mike Morton chartered financial counselor and financial advisor. In today's episode, I'm joined by Matt on his on-air radio show where we discuss the backdoor Roth. This is a way for high-income earners to contribute to a tax-free account. 

We review the principles and go over a couple of examples to explain how it works. Enjoy the show.   

Matt: [00:00:28] Look when we do these conversations, sometimes in the past.

I know a little something about it. I've invested some money occasionally. I'm in the great position today of I know absolutely nothing about the topic that we're about to discuss. I think our audience may know more about this than I do, so I am really excited, both to welcome Mike, back and learn something today.

Mike, welcome back.

Mike: [00:00:51] Thanks, Matt. It's awesome to be here. I'm surprised there's a topic that you don't know something about.

Matt: [00:00:57] Well, That's because I give off an air at all times of knowing something about something it's an acquired, it's either a skill or a curse. So tell me, let's start here. Tell me what we're talking about today.

Mike: [00:01:10] Yep. Today, we are going to explore what is called the backdoor Roth. . And I use that term because that's how listeners can Google and find more about this articles and things around the backdoor Roth. It is a way for high income earners to contribute to a Roth IRA account because they are above the limit for doing direct contributions to a Roth IRA.

There are income limits for contributing to one of these types of accounts and so if you're above, if you make more than X number of dollars as income as a family or a single filer, you may not contribute directly to a Roth IRA. And so there's something called the backdoor Roth IRA, which is a way of sneaking in the back door to contribute money into a tax-free account.

Matt: [00:02:01] Got it. Okay. All right. That is a very helpful starting point. Let's break this down to an even simpler level for me. So an IRA, an individual retirement account. you want to just give us the thumbnail on that?

Mike: [00:02:17] Yeah, absolutely. So we, I think we talked about this at a previous podcast. Maybe there's two different types of individual retirement accounts, IRAs there's the traditional IRA and the Roth IRA. And they work in exact opposite ways. Not going to get into the details of kind of which one's better for you.

You can listen to the previous episode, but the traditional IRA, you deduct it off of your taxes. So the contributions are deducted from your taxes. You have not paid taxes on the money in that account yet you will pay them when you withdraw that money. The Roth is the exact opposite. It is tax-free forever because you already pay taxes.

When you do the contribution, you've already paid the taxes on that money grows tax-free and when you withdraw it, it's still tax-free. So in either situation, you pay taxes once it's just during the contribution phase or during the withdrawal phase.

Matt: [00:03:04] Got it. Okay. So now we've got IRA. We've got Roth IRA. And now maybe you can help us build up to conversion. What's a conversion.

Mike: [00:03:16] Yeah. So what you can do, you are allowed to convert from one type of account to the other from the traditional IRA to a Roth IRA. And so you can do a contribution to your traditional IRA and convert it, literally convert that money over to a Roth IRA. And that's how this backdoor Roth works very simple.

Okay. , it gets more complicated. We'll get that to later in the episode, but very simply   you open an account, a traditional IRA. You contribute money to that traditional IRA, you go in the dropdown and  , you transfer money from the traditional IRA to your Roth.

IRA. Just transfer that money. And now it is literally in the Roth IRA.

Matt: [00:03:55] Got it. Got it. And you mentioned at the top that you may be limited in contributing to a Roth IRA from the get-go. Based on income. So how does that work? What's that limitation

about? 

Yep. 

Mike: [00:04:11] So if you make too much money, if you have that problem where your income is high enough.

Matt: [00:04:16] I've been, I've been struggling that, there's a support group for that. And I'm working every day to get over it.

Mike: [00:04:21] Exactly. So for single filers, it's around 75 to a hundred thousand dollars. You can look it up. It changes each year. So if you're over that income limit or as a family, it's about $200,000. So as a family, if you make that more than $200,000, you can not contribute to a Roth IRA. Period. All right.

So the IRS doesn't allow it. You could do it, but you got to fix it later when your accountant tells you you weren't allowed to do that. So you can contribute to a traditional IRA.  .  There's no income limits to contribute to a traditional IRA. However, you can't take it off your taxes.

So there's certain limits around deductability depending on your income again. So I don't want to get into much of the weeds on those things. I do want to focus, just continue to focus on maybe some examples with the backdoor Roth IRA, because it will become more clear to the listeners, if this is something they can do, or if they need to research it some more and we'll get into where those gotchas might be.

Matt: [00:05:20] okay. All right. Why don't we break it down through an example? We can start there. All right. 

Mike: [00:05:24] Perfect. Matt, I'm going to use your family as an example. All right.

Matt: [00:05:27] all right. Now, is this my real family 

Mike: [00:05:29] This This is your real family. Real family.

Matt: [00:05:32] of my family?

Mike: [00:05:33] It's your real family, but it might not be a real income.  , we'll pretend on that front.

Matt: [00:05:37] We'll we'll call w let's keep this a little bit anonymous. We'll say that this is someone named Matt R no, that's too much.

Mike: [00:05:43] That's right. All right, Matt. So your family say you have an income of $250,000. All right. As a family and there's two married, couple. And you've got three kids and the kids aren't important, but I just love your kids. So I thought I'd mentioned, this is a family with three kids.

Matt: [00:06:06] agree. You're you know what, I, now that you're buttering me up. I feel like there's going to be bad news coming, but go on for your sketching out is amazing.

Mike: [00:06:15] All right. So Matt, you have income of 250,000 as a family, but between you and Emily now, Emily contributes to a 401k. She's working out of the house, for an employer, she contributes to a 401k. That's your retirement plans right now. And you have no other individual retirement accounts.

So Emily, Emily's got a 401k making contributions but no other individual retirement accounts. So here's what you do. . So each of you opens a traditional IRA. And a Roth IRA. So now you've between the two of you, you've opened four new accounts and you could do this at any other brokerage houses or wherever you have, your accounts, you open up four new accounts, they have to be in your name.

So Matt, you open up the traditional and the Roth and Emily does the same. You contribute $6,000 to your traditional IRA. You are the under the age of 50. So you can, Oh,

so you could contribute $6,000 and Emily does the same.  Just transfers from your checking, checking, or savings account into your new traditional IRA account. Just drop down, transfer money from one account to the other $6,000. Once it's there, you can transfer it from the traditional IRA to the Roth IRA again, just from the dropdowns transferring money from one account to another account.

Now, during that process, It's going to ask you, do you want to withhold taxes and you're not going to need to do that. And now you have $6,000 in your Roth IRA and Emily $6,000 in her Roth. IRA. Now the tax thing, the reason you don't have to withhold it during that transfer is because you've already paid taxes on that 6,000.

When you put it into the traditional IRA, you're going to tell your accountant or your tax software that I made a non deductible contribution to the traditional IRA. I can't take it off my taxes. So I've already paid taxes on that money. That 250,000 you made his income. It's still 250,000.

You're not deducting anything. And so you've already paid taxes once. So when you do the transfer from the Traditional to the Roth, you don't have to pay taxes again. Now you and Emily both have $6,000 in tax free account forever.

Matt: [00:08:22] Got it all right now, because you were buttering me up earlier with this. Lovely story. I was, as I said on the lookout for catches and I thought I detected one there. So tell me if I'm right to be suspicious. You said no other IRA accounts, is that a catch?

Mike: [00:08:43] Yeah, that's the, that's one of the big catches. Okay. So this very simple scenario laid out. Is if you have no other IRAs, now that includes traditional IRAs, rollover, IRAs, SEP IRAs, and simple IRAs. Notice they all have IRA in the name. Okay. But those are all accounts where you may not have paid taxes yet.

And that is the big. Gotcha. So again, simple example, if you don't have any of those types of accounts, this is a very easy process to get money in the back door, into a Roth IRA. Now , the dropdown from the traditional to the Roth, that's called the conversion.

You're converting money from a traditional IRA into a Roth IRA. Now, remember you pay taxes once. The government does want their money on this earned income. And so we're going to have to pay taxes at one point or another. Typically on the traditional you have not paid taxes yet. The money in that account.

So when you convert it to the Roth that dropped down, transferring it over to the Roth, that's when you pay the taxes. Now, in your case, , you didn't owe any other taxes cause you would have already paid taxes on that 6,000. Okay. . But if there's money, you have not yet paid taxes on that's the point at which you have to withhold and pay taxes during that conversion.

Matt: [00:10:04] Okay. So I already paid taxes. I don't owe anything. And if I don't. If I haven't then what happens?

Mike: [00:10:12] This is where it gets really tricky. If you haven't paid taxes on that money, you're going to owe taxes. All right. So let me give you an example. This is not a backdoor Roth example. We'll get to that in a minute. This is just a conversion example.  . , you're going to pay taxes during that conversion.

When you go from the traditional IRA to the Roth IRA, you can convert at any time. All right. Any calendar year, you can go in and convert money. So let's take a look at another example, John and Jane.  . So John and Jane have to say the same income, 250,000. John has a traditional IRA account. All right.

Just he's had it for a few years. He's contributed over the past few years, and it has a balance of $12,000 in it today. He can convert that money from a traditional account to a Roth. I should say he, when he contributed, when John contributed this money, he took it off his taxes. He has not yet paid taxes on this money.

All right. So it's sitting there at $12,000 and he decides for whatever reason, I'm going to convert this money this year. From a traditional, heard this, tax-free account Roth. I want to convert the money. So he does the dropdown 12,000 rolls it from traditional to the Roth IRA. At that point, when he goes to fill out his taxes for that calendar year, he's going to have an extra 12,000 of income that the government's going to want to.

Oh, pay the taxes. He's going to have to pay the government taxes on that 12,000. He converted 12,000. The way it works is that he had  , 250,000 of income with his family. It's now 262. So you add the 12,000 and then you're going to pay income taxes on 262 of income. It's going to be ordinary income when you do a conversion.

Matt: [00:11:54] Now it is this inevitable. He's going to pay those taxes no matter what,

Mike: [00:12:00] Yes. And no  , yes. And yes, I should say actually, you're going to pay the taxes no matter what

taxes. I almost caught myself, but even if you inherit the IRA. So he could have left the $12,000 in there and he had unfortunate demise and his kids inherited the IRA. They're still going to have to pay taxes on that money at some point.

So yeah,  , if it has not been taxed at some point in the future, you're going to pay taxes on it.

Matt: [00:12:26] I like the way you gave the unfortunate demise to John in this and not to Matt in your earlier example. That's I appreciate that. Let me back things up just for a second to a higher level. I feel a little bit like, how Steven Spielberg hid the shark in jaws for the first 45 minutes of the movie.

I feel like we're hiding the shark a little bit here. I know we didn't want to get into the wherefores of. The intricacies of Roth versus traditional at the same time, I am left with a shark here, which is why would you want to do this? What would motivate John or Matt to go in and say, I'd like to convert.

I have an inkling based on your previous guidance on this show. I have a guess,

but, 

Mike: [00:13:12] all right. What's all right. I want to hear, I want to hear your guess first on the, see if you're

Matt: [00:13:15] what I've learned from Mike Morton. Financial advisor is that your basic tax strategy should be: pay taxes when your tax burden, the amount of tax you would pay would be lower. Don't go out of your way to pay more taxes.

So if your marginal rate is going to be higher, maybe that's not the best time to pay more taxes. Am I on the right

Mike: [00:13:40] You got it, man. You nailed it on the head. All right. Good job. This time. Last time I asked you that you got to completely opposite, so it's good. You're coming along, Matt.

Matt: [00:13:48] this is why people come to you for advice that shouldn't just make this stuff up on their own.

Complete the thought.

Yeah.

Mike: [00:13:53] Yeah, exactly.

Matt: [00:13:54] do this

Mike: [00:13:55] So you want to do the conversion? It's cool. It's one of the only ways that you get to decide when to pay your taxes. So you've got a balance sitting in your traditional IRA, maybe a $50,000, that you've contributed over the last five or eight years, and so you have $50,000 balance.

At any point you're allowed to convert that. And at that point you will pay taxes. So you get to decide when to pay your taxes. Typically you're just paying them, off of that income every year, you have to pay taxes on your income year in and then year out. So it's the one option where you get to decide.

So when should you decide is your question and it's when you're in the lowest tax brackets. So there's a couple of things. One when you're young, I recommend contributing directly to a Roth. If you're under the income limits, or you can do a backdoor Roth, like we're talking about. Do that when you're young, you're probably in a lower tax bracket, hopefully your income and career is going to continue to grow.

And I know a lot of people in this situation will go all the way till they're about 35 or 40. Before switching over to the traditional, they now they've built up a lot in the tax-free and the Roth accounts. They've already paid taxes, but now their income is getting much higher. And so taking the deduction now they're in a 24% tax bracket or above now, it makes sense to start using the tax deductions at that point.

The other time, that's a really good time for doing this is right around retirement. Anytime you're in a low income year. You want to convert. There's a lot of people out there with a couple of million dollars in their tax deferred accounts, their 401ks and traditional IRAs, and hardly anything in a tax-free account.

So between those retirement, And taking your required minimum distribution. So ages 60 to 70 or 50 to 60 or whatever it is. That's a great time when you retire and you have almost no income that you can do conversions. And again, you can control how much income are to happen. Now you don't have to convert the whole thing at once to, you could just do a hundred thousand dollars at a time and you'll still be in pretty low income tax bracket.

Matt: [00:15:55] got it. All right. That actually makes some logical sense. Although I am guessing as with all things, I, this is a good general disclaimer here. You're not giving any individual financial advice to Matt or John or Jane or whoever people in terms of the exact timing and their exact tax situation.

They should really work with their own individual financial advisor tax advisor to make sure they get the details right on

Mike: [00:16:24] So there's a lot of moving parts trying to give a framework for that. But yes, disclaimer, this is not financial advice. This is general information.

Matt: [00:16:33] information. All right. So what else?

, I mean,

A lot in here. But what are some of those other considerations that people just generally might want to have in mind?

Mike: [00:16:41] So I thought what I'd do is just go back to that example, make it a little more complicated. So we started with your example, which is super straightforward, but now there's an example. Maybe you've already got some money in traditional IRAs that has not been taxed yet. So let's look at John and Jane, back to their example, they're having 250,000 of income.

Jane does not have any traditional IRAs. . So she's got her 401k at work, but she doesn't have any other individual retirement accounts. She could do the exact same thing that Emily was doing. She can contribute 6,000 to a traditional IRA, convert it and not owe any additional taxes. She's already paid the taxes on the 6,000 non-deductible and then transfers it over.

No problem. Remember these are individual retirement accounts. So Jane and John, even though they have combined income, their individual retirement accounts are treated separately. All right, but say John has that $12,000 balance in his traditional IRA. Now this could also be from a rollover IRA could have been in previous job that he had in a 401k and he rolled it over to a rollover IRA.

But the point is he has not paid taxes on this $12,000. It was deducted back when he made that money . And he got a tax break then. So he's got 12,000 in his traditional IRA account. And he's got no other IRAs just that one. If he contributes 6,000 to that same account, that traditional IRA. Now he's got 18,000 in there.

He can't deduct the six that he just put in. He's above the income limit. So now in his IRA, he's got $18,000, 12 that he has not paid taxes on six of it. He has, he's going to have to pay taxes on, he can convert the whole thing all 18,000, but he's going to have to pay taxes on the 12,000. All right, so you can convert, you can add the six convert all 18.

Now he's got 18,000 tax-free forever and he'll pay taxes. We'll add that 12,000 to his income taxes for that calendar year. Yeah.

Matt: [00:18:36] got it. I, I think what I take away from this and it's the , I'm following the numbers, but I could even see just from a high level, it sounds like what this all kind of boils down to at the end of the day is. You have a number of mechanisms to save for retirement that have been set up, you have the traditional and the Roth, and then you have the others that you threw out there.

It sounded like a Dr. Seuss sequence. It's it was like on Donner, on blitz it on SEP on simple. Anyway, so you've got all these mechanisms, but the point is , they give you a menu. Of ways to assert some control over your tax situation to minimize the amount you're paying in taxes, maximize the amount you're saving for retirement.

Mike: [00:19:21] Yeah, that's exactly right. There are a lot of different accounts and it becomes a little overwhelming to try to coordinate all those different options. The good news is though, for a lot of people out there, keep it simple, contribute to your 401k into your IRA is year in and year out. The savings is 90% of the game.

All right. The taxes is just, we're trying to save you thousands of dollars. Undoubtedly , it adds up to a lot of money, but you got to save the money first. 

.

Matt: [00:19:48] And of course, again,  it does get into the there's devil in the details. Are there any kind of deviled details that people should just bear in mind before barreling into this?

Mike: [00:20:00] absolutely. So a really good one is I said that John had 12,000 in his traditional IRA. What if he could get it out somehow if he didn't have that, man, he wouldn't have to pay taxes on it. A lot of employer accounts 401k is we'll allow roll-ins from your traditional IRAs. Into your current 401k.

So you can contact HR roll money from your IRA, into your current employer account. Once you do that, it is no longer in an IRA account. And now you can do the conversion in the very simple example. And so that's something always try to look for first. Is, are there ways of getting out, you could have one or 200,000 in these accounts are there ways of getting them into a 401k or a self-employed 401k?

Matt: [00:20:45] This is Mike Morton giving us a really fascinating look into a little niche,  in tax and personal financial planning.  

Mike: [00:20:54] Thanks for joining us on financial planning for entrepreneurs. If you like, what you heard, please subscribe to and rate the podcast on Apple iTunes, Google play Spotify, or wherever you get your podcasts. You can connect with me at linkedin or mortonfinancialadvice.com. I'd love to get your feedback. If you have a comment or question, please email me at financialplanningpod@gmail.com. Until next time thanks for tuning in