Retirement Answers

Jacob: 00:01

It is a three step process to actually contribute money to a Roth IRA, and you're doing it through what we'll call it the Backdoor. That's why it's named that. Now, what you actually are gonna be doing is you're gonna be contributing money to a traditional IRA, and then you're going to convert it to a Roth pretty much immediately. Welcome to Retirement Answers, a podcast built to answer your most pressing retirement questions. If you're someone who's either thinking about retirement or already in retirement, well, you're in the right place.

Jacob: 00:31

Hey there. My name is Jacob Duke, each week I'll be walking through different tips and strategies to help you succeed in retirement. So let's go ahead and get started with today's show. Hey, friends. Welcome back to Retirement Answers.

Jacob: 00:47

As always, my name is Jacob Duke, and I'm excited that you're here. Thank you so much for tuning into the show. If you're enjoying it, go ahead and give us a rating and review there on the app that you are using to listen to podcasts. I see a lot of new listeners are tuning in and many of you are not subscribers. So if you're enjoying the show or you find this episode helpful, go ahead and subscribe that way you don't miss any future episodes.

Jacob: 01:09

So today I wanted to talk about the Backdoor Roth IRA. I wanted to talk about what it is and how to actually execute it correctly because I've said this many times, but having a Roth IRA in retirement is crucial and it comes down to a tax question, right? If we have more money in a tax free or after tax account, like a Roth IRA, your tax bill in retirement will be a lot lower because you will not have as much income, which means your social security taxation will be a lot lower as well. So getting as much money into a Roth IRA as you can throughout your working years is very important. Now, the issue that many people have is while they're working, perhaps they're making too much money to actually contribute to the Roth directly.

Jacob: 01:51

So that's where the Backdoor Roth option comes into play. But depending on your income level and your tax rate, it might not make sense to contribute to a Roth. But today, we're just gonna assume that getting money in a Roth IRA is helpful for you. So let's go ahead and dive into what a Backdoor Roth IRA or a Backdoor Roth contribution is, and then we're gonna walk through how to do it correctly. So what is it?

Jacob: 02:13

Well, number one, it is a three step process to actually contribute money to a Roth IRA and you're doing it through, we'll call it the backdoor. That's why it's named that. Now, what you actually are gonna be doing is you're gonna be contributing money to a traditional IRA, and then you're going to convert it to a Roth pretty much immediately. So this is a three step process and those two steps right there I mentioned are probably the most important. Be sure to stay at the end because there is one step that a lot of people miss or don't do correctly that actually ends up hurting them in terms of using that Roth to their advantage.

Jacob: 02:45

So, first of all, why would we even do a door Roth? Well, I alluded to it earlier, but many people are often over the income limits to contribute to a Roth IRA directly. So in 2023, the income limit to be able to contribute to a Roth IRA for a single person is 138,000. And if you're married filing jointly, it is 218,000. Now there are phase out ranges above those numbers, but typically I suggest that if you are above those income limits, I would say avoid messing with the phase out ranges because it kind of gets messy and there can be a lot of confusion there.

Jacob: 03:18

So in general, if you're under $138,000 or under $218,000 you can contribute directly to a Roth IRA. Now it's only whenever you are above those limits, whether you're single or married filing jointly, that you have to think about doing a Backdoor Roth. So the first thing is to understand whether or not you are above or below those income limits. If you're gonna be close to those limits throughout your income year, then I would typically say just wait until after the year end, because remember we have until April 15 or the tax filing deadline to actually contribute to your IRAs for the previous year. So if you're gonna be right on the edge or on the line of that income limit, go ahead and wait until the next year after you know what your income really is for 2023, then you can make that contribution at that point.

Jacob: 04:02

And then you'll know, Hey, can I directly contribute to a Roth or do I need to do the Backdoor contribution? So, and it's also important to remember that in 2023, your contribution limits in terms of to a Roth IRA or traditional IRA for that matter are gonna be $6,500 if you're under age 50. If you're 50 or older, is $7,500 And those limits are often increasing. And also the income limits, 138 and the $2.18, those are increasing each year as well. So that's why we would do a Backdoor Roth contribution in the first place is typically if you're above that income limit and you wanna get money into a Roth IRA, then you can do a Backdoor Roth contribution.

Jacob: 04:40

This is perfectly legal. The IRS allows it. I don't understand why they don't just say, hey, regardless of your income, you can put money into a Roth IRA directly. Instead, they make you do a two, three step process in order to get there. So now let's actually dive into how this truly works.

Jacob: 04:55

So number one, you have to have two account types open in order to do a Backdoor Roth. You don't need just a Roth IRA, you also need a Traditional IRA to contribute the money into originally. So you have to have both account types open. Now a lot of people have these already open, but if you don't, you do need to open a traditional IRA and a Roth IRA in order to do a Backdoor contribution. Once you have the accounts open, you would contribute your contribution to the traditional IRA, and then you would quote convert it over into the Roth.

Jacob: 05:25

Now, before we just kind of skip ahead, I wanna make sure we cover this contribution portion of the process correctly. It's important to know that if you have any money in a traditional IRA, a simple IRA or a SEP IRA, those are all tax deferred IRA account types. If you have any money in those accounts, I typically would recommend do not do a Backdoor Roth contribution because of what's called the pro rata rule. Whenever you have money in a traditional IRA, you can have either pre tax or after tax money in that account type. Now, what's interesting is whenever you do a conversion out of the IRA into a Roth IRA, you don't get to pick which money pre tax or post tax you would like to convert.

Jacob: 06:08

So what that means is, is there is a pro rata rule, which says you have to evenly distribute through the conversion. What is pre tax and post tax? So let's say that you have a $100,000 traditional IRA, for example, and 50,000 of that is pre tax and then 50,000 of that is post tax. Now that's a hard scenario to actually get into, but let's assume that is true. Whenever you do a $10,000 conversion out of that traditional IRA, for example, you would have to pay taxes on 5,000 of that because of the pro rata rule, which means 50% of the account is made up of pre tax money.

Jacob: 06:42

Therefore, any distributions that come out, 50% will also be pre tax, which means you owe the tax on 50% of the distributions. So the same rule applies whenever you're doing a Roth conversion or a Backdoor Roth contribution. Whenever we have money in this traditional IRA, a SEP IRA, or a Simple IRA, we have to be careful because we can't just contribute the $6,500 to a traditional IRA this year in order to do that Backdoor contribution, and then just convert the 6,500 we contributed after tax. We actually have to do pro rata, which means upwards of 90 plus percent of the actual conversion amount could be taxable to you and that is not what we want to happen. So the first step in all of this is to get all of your money, if you have any in an IRA, SEP or simple, try to get it out of that account type and back into your four zero one ks.

Jacob: 07:32

So this is what I might call a reverse rollover. So typically we think of a rollover as, hey, whenever we have an old four zero one k, we wanna roll that over into an IRA. Well, if you're trying to do backdoor contributions, number one, don't roll over your old four zero one k into an IRA just yet, wait until your backdoor contributions are done or you stop doing them entirely. And if you already have money in a traditional IRA from a previous rollover, and now you're having to do backdoor Roth contributions in order to get money into a Roth account, that's whenever you would wanna do this reverse rollover. And if you have a current 401 ks, then try to roll over your IRA money and back into the four zero one ks.

Jacob: 08:08

Now most four zero one ks allow this. I would definitely check with Extodion and your plan provider to make sure it's possible, but that is the best course of action. Get all the money out of your IRA, roll it over back into your four zero one ks. And then you can actually do the conversion without any issues with the pro rata rule. So that's the first step.

Jacob: 08:26

Get any money, if you have any, in a traditional IRA, SEP IRA, or simple IRA, get it out of that account type and into your four zero one ks if you can. If you can't, then you may not even think about doing Backdoor Roth contributions because of the pro rata rule I mentioned. Okay, so that's the first step. We wanna make sure if possible, there's no money in our IRA already. Once we have an IRA open, then we would contribute our money to it.

Jacob: 08:49

So I typically recommend not doing a dollar cost average or periodic savings into a traditional IRA and then converting it to a Roth. I typically recommend doing it all at once. So one time per year, you're if gonna contribute the maximum of $6,500 or $7,500 depending on your age, I would just recommend contributing that one time at whatever point throughout the year or after the year before the tax filing deadline, and then you can do a conversion immediately a couple days later, and then it's really clean and simple. There's no gains along the way potentially. There's no multiple cost basis because you've done multiple contributions throughout the year.

Jacob: 09:26

It just makes it a lot cleaner and simpler if you do it that way. So that's pretty much it for contributions. Make sure you don't have any money in the IRA already. And if once you do decide to do a contribution, I would recommend doing it all at once. That way the conversion is actually a lot cleaner.

Jacob: 09:40

Now, step number two is whenever you have the money in your traditional IRA, you technically can convert that money over to a Roth immediately. Now, based on my experience, whenever you contribute to a traditional IRA, you're actually gonna have to wait a couple days for that money to settle from your bank moving into your IRA before you can actually convert it to the Roth. So typically it takes a couple of days before you can really do the conversion, but technically you can do it immediately. Now I would say do it as soon as possible, that way you don't start accruing interest from cash that is in your IRA. So do it quickly, but you would have to fill out a form with your custodian, whether that's Fidelity, Schwab, TD Ameritrade, whoever it might be, you would fill out their paperwork and say, hey, I wanna convert this amount, most likely the full amount you contributed into your Roth IRA.

Jacob: 10:24

And then they will move your money from your traditional IRA over into your Roth. So you went from $6,500 in your traditional IRA after you contributed it, you had zero in your Roth. And now after this conversion paperwork is signed, filled out and sent back in, they flip that money over into your Roth IRA. So perfect, you did a Roth IRA conversion. And what's interesting about this word convert, and I like to say that in quotes is just think of that word meaning, hey, I have to pay tax on the money.

Jacob: 10:50

So if you have money in a traditional IRA and you convert it to Roth, most of the time the money in a traditional IRA is pre tax. So whenever you convert it to that Roth, which just means pay the tax on, you will have a $10.99 at the end of the year whenever you receive your tax documents and you will have to pay your income taxes on that conversion amount. Now, what's interesting about a Backdoor Roth is you technically are not putting pre tax money into your IRA. You're putting what's called after tax or post tax money into your IRA, and then you're converting it, which means to pay the tax on. But since you're putting after tax money into the IRA originally, you're not gonna pay any additional taxes to convert it over into your Roth.

Jacob: 11:30

And the reason for this, and this is one of the things that you should look out for to make sure you're doing it correctly, is any year that you contribute to do a Backdoor Roth contribution, you need to file form 8,606 along with your tax return to tell them that you actually contributed after tax money to your traditional IRA, and then you converted it to Roth. The reason for this is to make sure the IRS doesn't think that the money you put in is pre tax money, which means you technically have to pay the tax on the Roth conversion. Either way you get to the same spot. The difference is it's a lot cleaner whenever you do the form 8,606 and there's no additional tax payment that is due. And the final step, and I think this might be one of the most important steps is that whenever you actually get your money into your Roth IRA, you need to invest it.

Jacob: 12:16

I see a lot of times people end up doing the conversion and they think that the Roth IRA is some magical account that does something really cool for them. Well, it does over time if you invest it correctly. Now, this is not investment advice, but typically you want the Roth IRA to be your account that grows the most, which means you're taking a little bit more risk in that account versus others. Because you want that tax free growth over the amount of time that you're investing in. So typically you would want your Roth IRA to be invested a little bit more aggressively so that has the opportunity to grow tax free.

Jacob: 12:47

So a few things to look out for just as reminders. Number one, we don't wanna have any IRA money already in the accounts. And if we do, we wanna see if we can do a reverse rollover back into your employer four zero one ks plan. Number two, if you are doing a Backdoor Roth contribution, remember to file form 8,606 with your taxes each year. And that just tells the IRS that you have after tax money in your IRA that you then converted, which means no additional taxes will be paid.

Jacob: 13:14

Now you will receive a ten ninety nine no matter what, anytime you do a Backdoor Roth contribution from your IRA account. But remember, if you do form 8,606 correctly, your ten ninety nine will say that you owe taxes, but you technically don't because you did not put pre tax money in the account. You're not taking a deduction for the contribution. And one other final point before I let you go is that if you decide to do a Backdoor Roth contribution any given year, make sure that you do not do a rollover from an old four zero one ks or an old employer plan that same year, because what happens is, is on the pro rata rule, is that calculation in terms of what is in the account is based on what is in your account on twelvethirty one, so December 31 of each year. So let's say for example, you did a Backdoor Roth contribution in August, and then you decided to do a rollover out of your old four zero one ks from previous job in December.

Jacob: 14:07

Well, any money that is in your account on December 31 is technically included in your pro rata rule, which means now you kind of either have to undo the Backdoor Roth contribution you originally did, or the amount that you actually converted is gonna be taxable at least in part, because now you have co mingled dollars that I mentioned before, pre tax versus post tax in your IRA. Therefore you have the pro rata rule in terms of the conversion amount and the distribution. So if you're doing a Backdoor Roth contribution, make sure not to do a rollover in the same year that you're doing that Backdoor contribution. Okay, so hopefully this provided some clarity for you around how Backdoor Roth contributions work, what they are and why you would even need to do them. So next time you're doing one, remember these things, remember these things to look out for, and I hope this is helpful for you.

Jacob: 14:54

And if it is, go ahead and review the show and rate it there on the app you're listening, and share it with a friend if you think they might find it helpful. Other than that, thanks again for tuning in to this week's episode of Retirement Answers. I look forward to talking with you again next week. Hey, it's Jacob again, and I wanted to extend a quick offer to you. If you have a question and you would like to have it answered here on the show, please email me at Jacob@retirementanswers.net.

Jacob: 15:20

And I'd love to answer that question for you right here on the show. Also, wanted to remind you that nothing discussed in today's episode is meant to be financial, legal or tax advice. Retirement Answers is for educational purposes only. Thanks for tuning into this week's episode. I look forward to talking with you again next week.