In this episode of Friends Talk Financial Planning, John and Bridget reveal the secrets to the backdoor Roth IRA strategy. If you think you make too much money to contribute to a Roth IRA, think again! They discuss how to navigate the income limits and take advantage of this little-known strategy to maximize your retirement savings. Join them as they break down the steps and provide valuable insights on tax planning. Don't miss out on this valuable financial strategy, and make sure to hit that subscribe button for more helpful content!
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TRANSCRIPT:
Bridget: Do you think that you make too much money to put money into a Roth IRA? Maybe not, and almost always you don't. In this episode of Friends Talk Financial Planning, we're going to discover the secrets to how to do a backdoor Roth, which lets you put money into a Roth IRA when you're a high earner. Hi, I'm Bridget Sullivan Mermel, and I've got a fee-only financial planning practice in Chicago, Illinois.
John: And I'm John Scherer. I've got a fee-only financial planning practice in Middleton, Wisconsin. And before we get into Roth IRA secrets, I just want to remind everybody to hit that subscribe button. That helps other people find this on YouTube. Go ahead and punch that like button as well. And then let's get into backdoor Roths. I'm really excited about this. And we often talk to people who think they make too much money to do a Roth. They will say, “I'd love to do a Roth, but I just can't do it because our income is up high.” It's a good problem to have; you have too much income. And what's the limits? If you're single, it's around $140,000.
Bridget: $138,000.
John: If you’re married…
Bridget: $218,000.
John: So you go, “Hey, listen, I got income over that.” The letter of the law says, well, you make too much money to contribute to a Roth IRA. But as you mentioned it in the intro, there's a way to get into this thing.
Bridget: Exactly. This has been going on for years, and now the IRS has pretty much said this is fine, and so this is not a risky strategy. I would take it out of the “this is a risky strategy” category. This is just a strategy that isn't well known.
John: Back in the old days, people would argue, “They didn't say we can't do this, so let's do it.” Now the IRA has said, “Yes, this is kosher to do.”
Bridget: So how do we do this? First, who is this for? So you're maxing out your 401K. Usually we recommend maxing out your 401K before you do a backdoor Roth. Another thing is that I see people with a decent amount of an emergency fund, but then they've got some more money in a taxable account on top of that, because they're good savers. And so, they might not be making out the 401K, but they have a bunch of money, or maybe they inherited some money. So we just move it to the Roth and then it's not taxable. That's nice.
Those are the big situations where I really recommend these. So the first step in this is the hardest. And that is make sure you don't have any IRA accounts around. So if you have IRA accounts, then it deletes the benefit of doing backdoor Roths. And your IRA has to be cleared by December 31. So they look at what was your IRA balance on December 31, so a lot of people have put money into IRAs as rollovers.
So you had an old 401K and you made a rollover, and you have this IRA sitting there. So what you can do is transfer back to your 401K wherever you've got a 401K. And I've seen about 99% of the time they take transfers. The ones that I haven't seen take transfers from an IRA back into a 401K, or that at least might cause a hiccup, are government agencies, but you work with the state government. Do you have any problems with backdoor Roth there?
John: We haven't seen anything. Technically those aren't 401Ks. They are 457s or 403Bs, and most of the time those are good. One of the other things you made me think of is for people who have a small business; maybe they sell things on Etsy, or they do something on the side, some consulting work. Those small business can set up a solo 401K plan, and it really is very similar to an IRA, but technically a business plan, that can be another great way to handle that.
Bridget: So you can just put the money into that 401K, and I think you'll probably need an EIN to start one, and you'll want to save your paperwork.
John: There’s a little bit more hassle, so it depends on your hassle factor, but that can be a way to do it.
Bridget: Yeah, and we encourage people to do it. So there's some hassle factors that we don't encourage people to take, but then this is a hassle factor worth taking. I think of it as a traditional great tax strategy. And John and I were just at a conference with presenter Steve Jarvis, and he was talking about how tax saving is generally small moves made consistently over time.
I thought there was a really great way to describe it, and that's the heart of backdoor Roths. Okay, back to more details about backdoor Roths. So first, make sure you're clear on IRA. Second, contribute money. For 2023, you can contribute $6,500 if you're under 50 and $7,500 if you're over 50. In 2024, it's $7,000 to $8,000.
John: When you say contribute money, Bridget, where are we contributing that money to? Not to a Roth IRA, right?
Bridget: No, you don't contribute it to a Roth IRA. You put it in a non-deductible IRA account. So you have to have an IRA account. Calling it a non-deductible is more for your convenience. It's not an official category of your custodian or of the IRS. So if you open an account that says IRA account, non-deductible, then you'll know, this is the one I'm using for the strategy, but you can use any old IRA account. But again, it needs to be clear when you start.
John: Yup.
Bridget: Okay, so step one, contribute money. Step two, convert the money to the Roth. Okay, so you need to have a Roth account at the same custodian, and then you can do this transfer. But make sure you note on the transfer that it is a Roth conversion. So that means that you might have to call the custodian. You just want to make sure that it's coded correctly. Because then what you're going to get at the end of the year is called a 1099R, and that's going to be from your custodian, and it's going to say you converted money from your IRA to your Roth.
And it'll say $7,000 on it, or $7,500, or however much you put in, and then it's done. There's a tax situation also. You have to report this on your taxes. So you'll have your 1099R that you're going to report on your taxes, and then you need to fill out an 8606 as well. And the 8606 shows the basis that it was a non-deductible contribution, that you didn't get a deduction for it, and that these zero out, and that you don't owe any tax for this conversion. So you can do the Roth contribution up until April 15 of the year following the tax year.
John: Yup.
Bridget: So right now, it's 2023. You have until April 15. My big caution is to do the contribution and the conversion in the same year. Because the IRS has given it their okay, they know you can do it within a day or two. If you can, do it right away. This helps limit the number of notices you might get from the IRS because it is fine for you to put the money in, and then technically, it's fine for you to put the money in any time before that date and convert it at any time in the future you want and just pay the tax.
However, from a pragmatic level, if you don't like getting notices from the IRS, they like it if they have the 1099R and the 8606 in the same year. This is all pretty complicated. It sounds complicated, but it's not that hard. Now, when I started this strategy, it was even before I had my financial planning practice. And so, the resource I used is called White Coat Investor. It's a blog by a doctor who started blogging on finances way back in the dawn of the Internet.
And they're very detailed about how to fill out the 8606 if you've got questions on that. And again, your tax planner should be able to do it. Or if you're doing your own taxes, make sure you show that you made a non-deductible IRA contribution. Make sure the 1099R is on there, and then make sure the 8606 is filled out. And then you should be notice free.
John: I was going to try to call you out on the jargon police, but unfortunately, the IRS gives us these forms, so these are the names of the forms.
Bridget: Right.
John: There's no other place to do this. And it's not simple, but it's also not that complicated. It just sounds that way when you have to know these inner workings.
Bridget: Yeah. And if you have a list of this is how you do it, it's fine. If you're playing baseball, it's like getting a single.
John: Yeah.
Bridget: You can just build this up over time, and then at the end, you can say, “Oh, this is kind of nice. I got some actual money in here.”
John: So to circle back on the sort of 30,000 foot view right. What we need to do is we need to put money into put money into a regular IRA that you don't get to take a tax deduction for, then take that regular IRA, because anybody can make a contribution to an IRA, then anybody can convert an IRA to a Roth IRA. So it's a regular IRA contribution. That's no tax deduction. A conversion then to Roth IRA.
Now you've got money that instead of just putting it into the Roth as a contribution, we've got this sort of circular route through the regular IRA. And then make sure that you file the right tax forms and that they get reported in the right spots, otherwise, the IRS is going to send you a love letter saying, “Hey, what's going on here?” And then you have to explain yourself in a little more detail than is necessary. Is that a good summary of things?
Bridget: I think that's a good summary. That's great. Now, I do want to get into polemic about why nobody knows about this. Maybe polemics are only in writing. I don't know. But it frustrates me that more people don't know about this, and I think the financial industry does a disservice. Why is that? I think it's because there's a lot of paperwork involved, and advisors don't really care that much about taxes. Or at least a lot of advisors don’t. John and I do.
Advisors don't care that much about taxes and tax strategy; they just want to work on your investments. And doing a lot of shuffling around with this kind of paperwork, even though in the long term it's great, in the short term, it doesn't really do anything for them. And if they're moving money from one account that they have to another account that they have, they don't make any money. That's a neutral to them. For me, it's what I live for.
John: Great. The other thing that for me is frustrating is on the other side of it is why the rules are written the way they are, so that if you make too much money, you can't just make a contribution. As a result, you have to do these shenanigans to basically do the same thing. Why not just make it legal? But that's a different discussion for a different day.
Bridget: Yeah. And the other thing is that it is on the radar of Congress. So during the most recent Secure Act negotiations, getting rid of backdoor Roths was on the table, but they didn't do it. So it's not necessarily going to last forever, but it is a great strategy. I wish they would just get rid of the income limits for it.
John: Yeah, that's right. Well, I think that's a great place to wrap things up here. Again, I'm John Scherer, and I run a fee-only financial planning practice in Middleton, Wisconsin.
Bridget: And I’m Bridget Sullivan Mermel. I've got a fee-only financial planning practice in Chicago, Illinois. We're both taking clients, but we're also members of ACP or the Alliance of Comprehensive Planners, which is a group of planners that think a lot like we do with tax-focused comprehensive financial planning all throughout the country. And you can check that out at acplanners.org.
John: And don't forget to hit that subscribe button.
At Sullivan Mermel, Inc., we are fee-only financial planners located in Chicago, Illinois serving clients in Chicago and throughout the nation. We meet both in-person in our Chicago office and virtually through video conferencing and secure file transfer.