S&A Financial Services, Inc. Blog
This information can also be found on Small Business Financial Podcast , episode #5.
This particular awesome financial strategy is seldom used and often misunderstood.
This topic seems to be getting a lot of attention right now, most likely due to the fact that the market is taking a hit right now and this strategy seems to make more sense while the market is down in order to keep that possible tax liability down on the conversion…..but I don’t want to get ahead of myself here. I'll discuss tax liability shortly.
Now, the conversion part of this equation is just one step of the process. So, it’s actually more accurate to call this strategy a Backdoor Roth Contribution rather than a Roth Conversion.
It’s important to note that this strategy is directly in the crosshairs of our DC legislators….of course, right?
Leave it to government entities to allow a financial strategy........
Tell you specifically how it should be done ….
Then said strategy becomes pretty popular….
And then legislators say….whoa whoa whoa. This may be toooo good….
So let’s go ahead and figure out a way to change it so it’s not so advantageous, or better yet, just get rid of it all together.
So this was brought up to legislators as part of the Build Back Better Act in late 2021, but kind of died on the vine. They were literally negotiating on how to get rid of it and just died in the 11th hour.
Make note though, I’d say it’s just TBD as to when, or if, it gets resurrected. But for time being….it’s certainly still allowed.
This strategy can be used for various types of scenarios, but for purposes of this blog, I'll be "talking" to those small business owners that make too much money to directly contribute to a Roth IRA, this strategy is for you. You're going to learn how to get money into that Roth vehicle, even if your income is above the mandated limit.
First, let’s make sure we understand the logistics of the Traditional IRA. Essentially, you have 2 ways to contribute to a Traditional IRA. One, where you can get tax dedications on the contributions and another one where you DON’T get tax deductions on your contributions. Of course, as you may have guessed, the stipulation as to if you can get that deduction on the contribution depends on your income.
On your Roth IRA contributions, you DO NOT get any sort of tax savings up front due to the fact that contributions directly deposited into this type of account have already been taxed. Also, like I mentioned earlier, not everyone can contribute directly towards a Roth IRA….again, it all depends on your income for the year….and there’s phase-outs as well, again, depending on your income.
Of course, the most attractive feature of the Roth vehicle is that you’ll receive tax free distributions assuming 2 main qualifications are met
1. You owned the account for 5 years
2. You’re over 59.5yrs old.
If you meet those 2 requirements, you’re home free….
So, I’ve been in this industry for over 20 years and I’ve heard both sides as to what’s best....when it comes to funding pre-tax or post-tax IRA's. There are all kinds of examples as to how pre-tax or post-tax accounts are better. Seriously, there’s pros and cons of each, and it’s vital that you know this strategy will be case specific. Meaning, there is not a one-size-fits all. There’s somewhat of a guessing game involved here due to the fact we just don’t know the future of tax legislation. Each scenario has variables unique to it that makes it crucial that you’re working with a CPA planner and competent financial advisor to make sure this is in your best financial interest.
An old analogy that paints a picture of this strategy goes a little something like this….
Would you rather pay tax on the seed or the harvest….?
Asked differently....would you rather pay tax on that small bag of seed now (Roth IRA) or pay tax on that giant harvest those seeds produced in years down the road (Trad IRA)?
Now, of course, it’s a little more nuanced than that, but hopefully that helps paint a visual in your mind as to how this theoretically can work.
Odds are, the top 2 reasons you're interested in this Backdoor Roth strategy is...
1. As I mentioned earlier, your MAGI (adjusted gross income) is too much for you to contribute to Roth directly
2. You’d like to move a chunk of your Traditional IRA money into a Roth IRA.
Either way, you have to start w/ money inside a Trad IRA, right….
So, let’s simply go over the 2 step process of getting those Trad monies over to your Roth account.
First, of course, you’ll need to contribute to your Trad IRA.. no MAGI income limits to actually contribute to the Traditional IRA, but you’ll run into MAGI caps on taking deductions on those contributions.
Second, most likely, you’ll need to fill out paperwork to transfer those Traditional monies to the Roth account.
- Now , here’s where this can get tricky and I implore you to not go in this alone…. get your CPA planner and competent financial advisor involved.
- Reason being is that this is only a taxable event if you took a tax deduction on the Trad IRA contribution. I’ll elaborate on this a little later, but maybe, or probably, you didn't make as much money earlier in your career...... contributed to your Trad IRA, took that tax deduction, but found out later in your career that you made too much money to take that tax dedication on the contribution. However, you have one Trad IRA with tax deducted contributions AND non-tax deducted contributions. If that’s the case, which is pretty common….hang tight…
- Remember, anyone can do this strategy, regardless of age or income level.
- Essentially, when converting money from Trad IRA to Roth that includes contributions that were not deducted, it’s as if you directly contributed to your Roth IRA.
Now, for those of you out there, which is probably most of you, that have Trad IRA’s with contributions that were deducted AND not deducted, co-mingled in same account…there’s this rule out there called the Pro Rata Rule.
Essentially, what it entails is how those pre-tax and after-tax Trad IRA contributions are treated when converted to your Roth IRA.
Again, make sure you’re doing your own research and talking with your CPA planner and competent financial advisor….but, to hopefully clear it up a little for you, let me give you an example…
Let’s assume you already have $95k sitting in your Trad IRA and all that money was contributed and you received a tax deduction on the contribution and, of course, there’s some gains in there as well. So, that means you’ve essentially got $95k in your Trad IRA that HASN’T been taxed yet, right.
Next, let’s say you contribute $5,000 to your Trad IRA on a non-deductible basis, which of course, would be after tax money. You’re doing this because you’d like to get that $5k over to your Roth IRA using this Backdoor Roth strategy and you make too much money to directly contribute to a Roth IRA.
So, now you have $100k of Traditional money inside your Traditional IRA, of which, 95% of it is pre-tax and 5% is after tax money.
You next convert that $5,000 from your Trad IRA over to your Roth IRA.
Now, in your mind, you’re thinking, “great,” I just contributed $5k of after tax money to my Traditional IRA and then converted that money over to my Roth and this is a tax-free conversion. No, not true. The pro rata rule is going to get you here.
What the rule does is have you look at all your IRA monies and pro rate the after tax and pre tax portions. So, in this case, every dollar you converted over, the pro rata rule will assume that 95% of that $5k is pre tax money that was in your Trad IRA and the remaining 5% is after tax money. So, you do this conversion of $5k, you’ll end up paying tax on 95% of it. Only 5% of it will be tax free.
So, this pro rata rule can really trip you up if you have any pre tax money in any IRA’s out there. So definitely pay attention to that.
Without going into too many details here and risk putting you to sleep with this content, remember it’s very important that when completing the Backdoor Roth strategy that you take into account ALL IRA’s. Maybe you have a SEP IRA, Simple IRA, and a Traditional IRA....
Maybe you're looking to ONLY convert your Traditional IRA. Remember, the Pro Rata Rule WILL come into play and trip you up a little because you need to include ALL IRA's into the equation.....as stated by the Pro Rata Rule.
LEAN ON a professional that has experience with these types of transactions. You may blow it off now as not a big deal, but man, when it comes time to take these monies out and you get an audit letter from the IRS….boy, you got some problems.
Now, let me be straight with you in the fact that we didn’t cover ALL the variables and nuances of the Backdoor Roth strategy almost because it’s like a never-ending rabbit hole we’d be going down.
I realize this can get a little overwhelming, but not for that CPA planner and competent financial advisor. We’ll have specific questions we’d ask you, take a look at your tax return and knock this strategy out for you in matter of no time.
This is a great strategy when implemented correctly.