Retirement Answers

Jacob: 00:00

The Backdoor Roth might be the greatest tax loophole for high income individuals, but 99% of people have no idea how to do it correctly. So in this episode, I'm going to tell you exactly how to do a Backdoor Roth contribution without messing it up. Hey, friends. My name is Jacob Duke, and I'm the host of the Retirement Answers podcast. As always, if you're a frequent listener and you're enjoying the show, please share with a friend and leave a rating and review there on Apple Podcasts and Spotify.

Jacob: 00:24

There have been a lot of new listeners lately, and I'm excited to continue sharing all this information with more and more people each week. Okay, let's jump into it. What is the Backdoor Roth IRA and why is it even necessary? Let's kind of start at the basic level here. A Roth IRA is a tax free account, meaning you are going to put after tax money into it, so you earn an income, you take that money after you pay taxes, then you put that money into a Roth IRA, and then it grows in a tax sheltered capacity, meaning it will not pay taxes all along the way, and then whenever you take that money out in the future, assuming two rules are met, I'm going share those with you in just a second, but assuming that those rules are met, you can take money out of your Roth IRA completely tax free.

Jacob: 01:02

Now, what are the two rules that have to be met in order for that to be possible? Well, the first one is that you have to be 59.5 years old whenever you take that money out and the account has to been open for five years. Now, whenever we're talking about taking money out of this account, there's a few extra things to know here because any dollars taken out before 59.5 or before that five year time window has passed, that does not mean that that is gonna be taxed. Only the portion of the account that is growth or what has accumulated in time after you've made contributions, that particular portion is what we're talking about here that is subject to that five year rule and the age requirement. Any money that you have put into the account, what's called principal or your contributions, that money can be withdrawn at any point regardless of your age, or regardless of how long the account has been open, and there's no tax implications or penalties on that.

Jacob: 01:50

So for example, if you put $10,000 into your Roth IRA over the years, you can take that $10,000 out at any point regardless of your age or how long the account has been open, no tax, no penalty. But if that $10,000 has grown to $15,000 meaning you now have $5,000 of growth in the account, that growth, that $5,000 that is what is subject to the fifty nine and a half year age requirement and that five year rule. So if you take your so if you take that $10,000 of your contributions out, there's no tax penalty, but as soon as you start taking money out of that $5,000 of growth, and you're not 59.5, and the account has not been open for five years, you would begin paying taxes and penalties on that distribution of the growth. So that's a few things to know like around Roth IRAs in general, and just to be clear here, whenever you take money out of a Roth IRA, you are always going to take your principal amount out first. So whatever you've contributed, always taking that amount out first, and then secondly, any growth in the account, that's what's gonna come out second.

Jacob: 02:48

So if you're under 50 nine and a half, and you've got that same scenario where you put $10,000 in and then you have grown the account by $5,000, so a total 15 is in the account right now today, and you need to take $5,000 out of the account for whatever reason, just know you're gonna be taking from the principal first, so you subtract 5,000 out of your 10,000 of original contributions, and that is not taxable, but you only have $5,000 left of potential contributions to pull from moving forward. So that's how a Roth IRAs work in practice. Now, again, the true benefit of a Roth IRA is the fact that you can have tax free income in retirement once you're 59.5 or older, you can have the full account, no tax, no penalty, and that's really the game changer here when it comes to Roth IRAs, and that's why everyone says, Hey, have Roth if you can get Roth, like do it, do it, do it, start at a young age and just pile money to Roth IRAs or Roth 401ks as much as you can. That's the true benefit is you get the compounding over time, and you have more tax free money in the future.

Jacob: 03:43

Now, catch is this, not everyone can contribute to a Roth IRA in a traditional fashion. And that's what brings up this Backdoor Roth contribution. So let's talk about why this Backdoor Roth thing is even necessary. The reason for this is because not everyone can put money into a Roth IRA directly, because there are income limits and requirements around who can contribute. So if you earn too much money as an income, you might not be able to put money directly into a Roth IRA, which brings up the need for having to do this Backdoor Roth IRA, and we're gonna walk through the process here in just a moment.

Jacob: 04:17

I'm gonna share some things to look out for as you're doing this, but what are the income limits? Well, in 2025, if you're single, there's a phase out range. So it's not just a hard stop limit, there's actually a range kind of phasing out over time over these levels, and then once you reach the top of that, you cannot make any Roth contribution. So the phase out range for a single filer in 2025 is a $150,000 of modified adjusted gross income, and then it goes up from 150 to a 165,000 of modified adjusted gross income. So that's for single filers.

Jacob: 04:46

So if you earn less than $150,000, then you can contribute to a Roth IRA, no questions, no problems. But as soon as you go above 150 and you fall into this phase out range of 150 to 165, you're not going to be able to contribute the full amount. You can contribute some, but the phase out range again, it starts at the full 7,000 or 8,000 if you are above age 50, you get that full contribution amount if you're under $150,000 but as soon as you go over, that total contribution max for the year starts going down as you get closer to 165, and then once you're at 165, that's whenever you cannot contribute any money to a Roth IRA directly. Now, when I say directly, that means like straight into the account. Again, we're going to talk about the other option you're going have here in just a moment.

Jacob: 05:30

Now, married filing jointly folks, the phase out range this year in 2025 is $236,000 up to $2.46. So if you're under $236,000 married filing jointly of total modified adjusted gross income, you have nothing to worry about, you can contribute to a Roth IRA directly. As soon as you enter that phase out range, again, a portion of your total maximums is what you're able to do all the way until you get to $2.46. And I'm not walking through the phase out ranges exactly, you just have to maybe look that up for yourself if you might fall into those ranges. But if you're above the total phase out range maximum, you're not able to contribute any dollars to a Roth IRA.

Jacob: 06:05

And that's where this Backdoor Roth contribution comes into play and even the need for it. So that's why anyone would need to use a Backdoor Roth contribution is because they earn too much money. That's really what it is. And don't ask me why there's actually income limits here. I don't know.

Jacob: 06:20

Maybe this is something that's outdated and maybe should be corrected or looked at because, again, the limit for a broth contribution in the first place is $7,000 if you're under age 50, and then it's $8,000 if you're above age 50. So that's per person. So for married filing jointly, it's just double. You could do that for each person have double going in total. But, you know, that's not a lot of money in today's world.

Jacob: 06:41

So it's not like people are able to really abuse the Roth IRA and use it more than what it's designed to be for. So, I think the income limits are perhaps just outdated and kind of like not necessary, especially given the fact that the Backdoor Roth IRA, which I'm about to explain how it works here in just a second, is a thing and the IRS knows about it and they say to do it. So, it's really interesting that it's even necessary, but that's why a Backdoor Roth contribution is necessary. Now, let's talk about what it actually is. So, whenever we're doing this, if you cannot contribute money directly to a Roth IRA, meaning you take it from your bank account and you put it straight into your Roth, you're gonna have to do it through the Backdoor.

Jacob: 07:19

Now, this is a two step process instead of just a direct one step process, and here's what's gonna happen. You've got to have a Roth IRA open, and you also have to have a traditional IRA open. Now, this is not a four zero one ks, so an IRA is different from a four zero one ks, just so we know. This is not through your employer or anything like that, this is you on your own at a custodian, Schwab, Fidelity, Vanguard, wherever, and you have to have both of those account types open, you got to have a traditional and a Roth IRA open. So what you're gonna do whenever you are making this contribution is you have to contribute your amount, whatever it is, let's call it $7,000 and let's say you're under age 50, you got to contribute your $7,000 to the traditional IRA, that's the first step.

Jacob: 07:57

The second step is to then convert the money that's now in the traditional IRA to your Roth. Now, when I say convert, that simply means to pay the tax. So if you can't move money from a traditional account to a Roth account, you can't do that without paying tax. Okay? So whenever I say convert here, just kind of follow me and just stick with me to the end so you'll see what really happens.

Jacob: 08:20

But you've got to put the money in traditional IRA, then you have to convert it to the Roth, and that's the two step process. You just went around the back of the house and went through the backdoor and then boom, you got your money into your Roth. That's what's happening here and that's really all that it is in terms of the actual process of doing it. Now, there's a few other things we got to know here, I'm gonna share some things to look out for in order for you to do this correctly, but that's really the base of what's happening here. And then the final step would be for you to invest the money that's in now in the Roth IRA.

Jacob: 08:46

So you think of the traditional IRA in the sense, it's almost like a pass through account. It's just kind of doing its part, and that's really it. So you have to put the money into the traditional IRA and then convert it immediately to the Roth, and then you invest the money once it's in the Roth. Again, a two step process here instead of just a direct Roth contribution. And again, this is only for people who are above those income limits, and you make too much money that this would be necessary.

Jacob: 09:08

Now, here's a few things to know, and these are the things that most people mess up on or miss out on. So going back to that word convert, okay? Whenever we make a contribution to a traditional IRA, normally, it's going to be a tax deferred contribution, meaning you're going to deduct that amount of money off of your income for the year so that you don't pay tax on it. So that's a tax deferred contribution, just like, you would have a tax deferred four zero one ks or traditional four zero one ks, technically, you're not deducting it out of your income because it's just not being reported on your income, but once you have taken the money into your hand at your bank account, and then you decide to contribute to traditional IRA, you would have to deduct that off your tax return. Well, in the backdoor world, what we're doing is we're not going to make that deduction on our tax return.

Jacob: 09:53

Okay, so we're not going to deduct the money that we have put into our traditional IRA in this instance. And so the question might be in your mind, Jacob, can I even do that? Is it possible to do a non deductible traditional IRA contribution? That's what we're doing here. And the answer is yes, as you absolutely can do a non deductible contribution to an IRA.

Jacob: 10:12

Now, I would say to only do that in this instance, although you can do this any other time, you can make a non deductible contribution to an IRA at any other point. The problem with doing that is you then have what's called basis in the account, and then you have pro rata issues moving forward. Again, I'm not going dive into pro rata in that instance here today, but I'm going to talk about pro rata here in just a moment and one of the big mistakes to avoid that a lot of people don't know about. So stick with me there on pro rata. But in this instance, we are going to make a non deductible contribution IRA.

Jacob: 10:44

So on our tax return, we're not going to deduct the $7,000 we put into our IRA. And normally, whenever your tax software sees that money went into an IRA, what's going to happen here is it's going to want to deduct that. So you have to tell it no, don't do that. And you also have to file form 8,606, okay? And that is what says, hey, this is a non deductible contribution to an IRA.

Jacob: 11:05

Anytime you make a non deductible contribution to an IRA, you have to file form 8,606. And since that's what we're doing here, you need to file form 8,606 with your tax return so that this is all reported correctly. So what's going to happen here is a few different things. Number one, again, you're going make a non deductible contribution to an IRA, you got to file form 8,606 with your tax return, so that's reported correctly. You're also going to get a 5,498, so form 5,498.

Jacob: 11:29

All that does is tell us what contributions we've made to IRAs throughout the year. You're going to get that because you're going to get that for your IRA, your traditional IRA, because you contributed money to it. Okay, and then you also get a form ten ninety nine that's going to show the amount that you distributed from your traditional IRA and move that into the Roth that's going to show up on a ten ninety nine. Now, here's the catch, that's telling you how much of your distribution is now taxable. But again, if we are filing Form 8,606, as we should, we will not be paying any additional taxes in this scenario because we're not deducting any income from our taxes either.

Jacob: 12:02

So it's kind of like a, if you had deducted it, you would then have this ten ninety nine, which would create taxes, but we're not going to deduct it. So the ten ninety nine is reportable, but not taxable. So I hope that makes sense. So again, you're gonna have a 5,498 for the contribution you made to your traditional IRA, but you're also going to get a 5,498 from your Roth IRA showing that the money was actually moved into that. So by doing a Backdoor Roth contribution, you should get three tax forms that year.

Jacob: 12:28

So you're gonna 5,498 from each account, traditional and Roth IRA, and you're also going to get a $10.99 from your traditional IRA showing you how much money was converted over. Now, those are the three tax forms, and again, remember to file Form 8,606. Filing Form 8,606, that's the part that gets missed a lot here, so it's not reported correctly most of the time by people doing themselves, understanding how this needs to be reported on their tax return. Hopefully a CPA or a tax repair, someone who's helping you on this is doing this correctly. I'm not sure if tax softwares or anything like that is able to follow this nowadays because it needs to be told what to do.

Jacob: 13:02

I'm not sure. Let me know if you have experience with that or knowing more about that. But that's one of the big mistakes a lot of people make is not filing Form 8,606. Now, another big mistake that you have to know about here is going back to the pro rata rule. Okay, so pro rata, let's see if I can explain this clearly for you.

Jacob: 13:20

In order for a Backdoor Roth contribution to be done correctly, or the way that you actually want to go, you need to have no money in your traditional IRA, and you need to have no money in your SEP IRA or simple IRA, anything that's an IRA that's tax deferred, this does not include 401Ks or 403Bs or TSPs, okay? So, don't think of those account. Those are all what's called ERISA plans, and they are not subject to this restriction. But any sort of individual retirement arrangement account, so IRA, simple SEP or traditional IRAs, those have to have no money in the account if you want to avoid the pro rata issue that I'm about to explain. Okay, so, and when I say no money in the account, that means no money in the account at the end of the calendar year in which you do a Backdoor Roth contribution.

Jacob: 14:07

So let's just say you did a Backdoor Roth contribution here in this is the recording in February. So February 2025, let's say you do a Backdoor Roth right now, if you then have money in a traditional IRA by the end of this calendar year, so 12/31/2025, there's a balance in that account, then you will have some sort of pro rata issue. And what does pro rata mean? It means that the type of money within the account is evenly distributed throughout the account. Okay, so let's break this down.

Jacob: 14:37

Let's say that you have $100,000 in your traditional IRA, alright, at the end of the calendar year, and you also did a Backdoor Roth of $7,000 into the traditional IRA, and then you convert $7,000 over to your Roth. Okay, so you're trying to do a backdoor Roth, you have a balance in the account. Whenever you do this, dollars 7,000 out of, I guess, 100 or $107.7000 out of the total amount that's there, that is how much is not taxable. Okay? So if you divide that down as a percentage of the account, 7,000 out of a 100, right?

Jacob: 15:13

That that is going to be a very small percentage of the account balance, 7%. If we're just using round numbers here and kinda making it really simple for ourselves, 7% of the account is now not taxable, the other 93% is subject to taxation. Remember, because we had $100,000 in the account, and that is all tax deferred money, we add this after tax money to the account so that we can do this back to a Roth, and what this is doing, it's creating a pro rata issue. And so, again, we can't separate the two ourselves. Just what happens is it goes in, it's almost like a drop of like dye going down and you drop it into a glass of water, you can't go and pick the particles of dye out of the water.

Jacob: 15:52

It just permeates throughout the whole glass and changes the color of the water. You can't go pick out the dye and change it back. It's kinda like, you know, the toothpaste saying, you know, once you squeeze the the toothpaste out of the tube, you can't put it back in. Once you put money into a traditional IRA that's after tax money mixed in with it and kind of commingled, you can't undo that. Every single time what's going to happen here is the account is now divided as a percentage one way or another, and so every distribution that you take from your traditional IRA from this point forward is going to be taxed based on these percentage differences.

Jacob: 16:26

So again, 7% of every dollar that you would take out moving forward in this example, I'm giving you 7% would not be taxable of your distribution, the other 93% would be. So we go back to your Backdoor Roth contribution example. Let's say again, you had $100,000 in the account, you got $7,000 you did in the Backdoor Roth, Again, 7% of the account balance in this scenario is to be not taxable. So, soon as you convert your $7,000 over to your Roth IRA to finish out the Backdoor Roth contribution, 93% of that $7,000 you just converted is now taxable to you. So you created a tax bill that you cannot prevent because of the fact that you have money in a traditional IRA.

Jacob: 17:08

Now, let's say you don't have $100,000 in this IRA that you're using to do a back door Roth, but you have $100,000 in another IRA or another simple or another SEP IRA that's not the same one as this one. That doesn't matter. It's just a combination of all of your accounts. So if you've got five different IRAs and you're using one particular one for a Backdoor Roth and the other four have money in them, you don't get to do a Backdoor Roth without the pro rata rule because you have a singular IRA that you use for that with no money in it. All of your IRA dollars are combined and lumped into one total balance whenever we're figuring out this pro rata issue.

Jacob: 17:41

So this is something that again, most people do not know about and most people mess this up. And if they get audited, and they've done this for a number of years, they will have to pay taxes for doing this Backdoor Roth contribution the wrong way. Okay, So, just know that if you are trying to do a Backdoor Roth contribution, you have to make sure that no money is in your IRAs, again, all those different types of IRAs, at the end of the calendar year in which you do the Backdoor Roth contribution because you would be subject to the pro rata rule, which would then create a tax bill for yourself that you weren't expecting. Hopefully, did an okay job of explaining that. It can be quite confusing up front when you first listen to it.

Jacob: 18:21

If you do have questions about it, shoot me an email and I can maybe try to explain it a little bit better. But I'm also going to put a YouTube video out here in the next few weeks where I explain this visually and that might be helpful for you. So if you want to learn more about that, go check out my YouTube channel, you could subscribe, And when that video comes out, you can learn more about it visually, it might be easier to understand in that way, I can explain it using some actual data and numbers. Now, here's how this issue comes up in the most unexpected ways. Okay?

Jacob: 18:49

Let's say you have no money in a traditional IRA and you are used to having no money in a traditional IRA and it's been that way for a while. So you've been doing this Backdoor Roth IRA thing for a number of years and you're used to doing it, right? So let's say you did it this year right now, everything's normal just as you expected it to go. And then later in the year, you do a rollover out of your four zero one ks into your IRA because you retired or changed jobs or you just want to get some things consolidated and things like that. So now you have money in a traditional IRA.

Jacob: 19:18

But Jacob, I already did my backdoor Roth, there was no money in it at the time, so it doesn't really matter, right? Wrong. The pro rata rule is based on how much money is in the traditional IRA at the end of the calendar year, not based on what you had in the account at the time of the backdoor contribution and conversion. Okay, you following me there? You did the backdoor Roth contribution already, you rolled over funds into the account later, and then you thought you were good, but now because you have a balance at the end of the year, you're going to have a tax bill on at least a portion of that $7,000 that you converted over to your Roth because you have a balance in your IRA.

Jacob: 19:54

So that's a huge one. And I've seen this actually messed up by clients of mine where they, without telling me, they did a rollover, whether it be in service or post separation, they did a rollover from their four zero one ks without me knowing, and then they forgot or didn't realize that this can trigger an issue because we did a backdoor Roth contribution for them earlier in the year, but now because we're gonna have money in their traditional IRA, they're gonna have to pay taxes on that backdoor Roth contribution whenever they otherwise wouldn't have had to. So planning around this and understanding how the intricate details of this work is very important. It's not just as simple as putting money into a traditional IRA, converting it to a Roth and calling it good. You got a lot of things to look at and figure out here, because again, I see this messed up all the time.

Jacob: 20:37

Everybody thinks it's really simple. It is simple, but the fact is you have to understand these different nuances and things to look out for in order for you to do this correctly and not make some of these, I mean, fairly monumental mistakes. I mean, additional taxes on additional 7,000 is not expected. You gotta come up with that tax somehow, and you gotta pay that accordingly. So there's a lot here, and hopefully today's episode helps clear this up a little bit.

Jacob: 20:59

That way you can make sure you do this correctly or consult the right people to help you do this correctly, and know what to look out for and some of the pitfalls and things that I just see all the time done incorrectly. And one other thing here is I typically just recommend doing all of your Backdoor Roth contribution at one time. So let's say you just do a lump sum $7,000 put it in the traditional IRA, convert it the same day over to your Roth and do it like that rather than putting $500 a month or whatever the recurring amount would be, don't do it every month and do a Roth conversion every month. It gets really messy and gets really slimy that way and you don't want that to be something that's messy. You wanna do it all at one time, do it for the full year at one time, don't piecemeal it together over the course of a year, it gets really confusing and doesn't make the documentation or administrative side of it very simple or easy for yourself.

Jacob: 21:45

So that's what I would say, do it all at one time. It's way cleaner and easy for you to do. All right, I hope this helps. It can be a very tough thing to follow and understand. And again, my email inbox is open, so reach out to me.

Jacob: 21:59

If And you're curious, again, I've got this important numbers for 2025. If you've not requested that, I've got a copy for you. Shoot me an email, happy to send it over to you. You can use that. You can see the Roth eligibility limits.

Jacob: 22:10

You can see that here on this. And it's what I use all the time with my clients. So anyway, I hope this has been helpful and we'll talk to 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 jacobretirementanswers dot net.

Jacob: 22:30

And I'd love to answer that question for you right here on the show. Also, I 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.