Motley Fool Money - A Guide to the Backdoor Roth IRA, and Heirs Squandering Inheritances

Starting point is 00:00:00 Getting money in a Roth IRA through the backdoor and the amazing inheritance disappearing act. That and more on this Saturday personal finance edition of Motleyful Money. I'm Robert Brokamp, but this week I'm going to lay out the five steps to contributing to a backdoor Roth IRA and highlight a couple of potential landmines you definitely want to avoid. But first, let's look at some headlines from this past week or so. you know, the stock market has shaken off the concerns of war and rising oil prices and is now near all-time highs. In fact, the S&P 500 recently posted a 9.8% 10-day rally. According to the Carson Group, this was the 20th best 10-day return for the index since 1950. What happened a year after the other 19?

Starting point is 00:00:52 Well, the market earned a positive return in 16 of those instances, with the three instances of stocks being down a year later, all occurring during the dot-com crash of the early 2000s. The median 12-month return after all of those 19 essentially double-digit 10-day rallies was 20.8%. In the Facts vs. Feelings podcast, the Carson Group's Ryan Dietrich, a previous guest on our show, pointed out that the market hitting new highs in April has nearly the same frequency as those exceptional rallies, it having happened 19 times. And in all but one of those instances, the market ended the year in positive territory. As Ryan pointed out, a lot of this is just fun with numbers and not necessarily information you would use to make investing decisions,

Starting point is 00:01:32 but the reasons underpinning the rally, namely growing corporate earnings and high profit margins, are good signs. Next up, what do people do when they inherit money? Apparently, a lot of people spend it. That's the conclusion of a recent study from Corey Thompson of the University of Alabama and Russell James of Texas Tech University.

Starting point is 00:01:51 They looked at data from 2010 to 2018 to investigate how people handled inheritances compared to other infalls, like gifts, lawsuit reward, insurance settlements, things like that. The headline finding is that inheritances get burned through remarkably fast. Each inherited dollar increased next wave net worth by only 61 cents when measured roughly a year later, meaning that nearly 40 cents of every inherited dollar had been spent, and 42% of heirs had completely spent their inheritances. What makes this especially

Starting point is 00:02:22 striking is the profile of these inheritors. They averaged nearly $1 million in net worth, half had college degrees, and 89% were homeowners. So this isn't a story about financially unsophisticated people and happened across the wealth spectrum. Study also found that controlling for demographics and the amount of money received, people were more likely to spend down inheritances than other types of windfalls. The practical implication may be that the standard estate planning approach of a lump sum bequest at death may be the worst possible design, since it delivers a large amount of money at precisely the moment beneficiaries are psychologically primed to spend it away. The authors argue for time phase distribution, so maybe staggered principal releases or spendthrift

Starting point is 00:03:04 trusts or anewitized beneficiary designations, and propose that advisors reframe the estate planning conversation from how much should I leave to how much annual income should my heirs receive. And now the number of the week, which is 7.9%. That's how much cost for food companies jumped in March year over year, according to Bank of America Global Research and highlighted by Bloomberg. That's up from 4.2% in February right before the Iran War. The biggest cause for the jump, of course, is the spike in fuel prices. But three to six months from now, we could see additional upward pressure from higher costs for packaging, fertilizer, and other items that are either made from petroleum or have seen their shipments significantly curtailed by the closing of the

Starting point is 00:03:47 Strait of Hormuz. Next up, how to get money into a Roth IRA, even if you earn above the income limits when Motleyful Money continues. Local news is in decline across Canada, and this is bad news for all of us. With less local news, noise, rumors, and misinformation fill the void, and it gets harder to separate truth from fiction. That's why CBC News is putting more journalists in more places across Canada, reporting on the ground from where you live, telling the stories that matter to all of us,

Starting point is 00:04:18 because local news is big news. Choose news, not noise. CBC News. People look forward to retirement as a time of fewer obligations. It could also be a time of lower taxes, especially if you have money in Roth retirement accounts. Contributions are not tax deductible, but growth and withdrawals from Roths are tax-free as long as you follow the rules. Roths also offer another form of obligation freedom. Unlike traditional retirement accounts, Roth accounts are not subject to required minimum distributions at age 73 or age 75 if you were born in 1960 or later. Does that sound appealing to you? That consider contributing to a Roth IRA. In 2026, an individual can contribute $7,500 with an additional $1,100 if you'll be 50 or older by December 31st.

Starting point is 00:05:08 Just know that you have to meet some requirements to be able to contribute to a Roth IRA, you or your spouse, if filing jointly, must have taxable compensation at least equal to the contribution. But you can't make too much money. The amount you can contribute gradually phases out starting at a specific modified adjusted gross income based under filing status. So in 20266, the ability to contribute to a Roth IRA phases out for single filers and head of household filers at incomes between $153,000 and $168,000. Those figures are $242,000 to $2502,000.000. $5,000 for those who are married and filing jointly. Is your income too high?

Starting point is 00:05:48 Well, take heart because you can enter through the backdoor. A backdoor Roth IRA is a strategy that allows high-income workers to fund a Roth IRA by first making a non-deductible contribution to a traditional IRA and then converting the traditional IRA to a Roth IRA. Here are five steps to doing it. Step one, open a traditional IRA and make a contribution. Anyone who has earned income or is married to someone with earned income, can contribute to a traditional IRA regardless of the level of that income.

Starting point is 00:06:18 Step two, contact your IRA custodian and request a conversion of your new traditional IRA to a Roth. If you don't have a Roth yet, you'll first have to open one, and you may be able to do all this with just a few clicks of a button online. Now, there's some debate about how long you should wait between making the contribution and doing the conversion due to something called the Step Transaction Doctrine, which could lead the IRS to determine that instead of taking the two steps to contribute, to a non-deductible traditional IRA, and then another step to convert the Roth,

Starting point is 00:06:48 for all intents and purposes, you actually just took one step and contributed to a Roth IRA, which you may not have been allowed to do if you earn too much income. Now, the debate has been going on for years in the financial planning and tax communities about how long you should wait before you do the conversion, with more and more experts concluding that it's pretty much fine to do it as soon as the money hits your account. As far as I know, no one has ever gotten in trouble with the IRS for converting their back or Roth IRA too soon. But if you want to be a little bit more cautious, here's the advice from CPA Sean Mullaney, who is a former guest on the show and has really dug into this topic.

Starting point is 00:07:23 He suggests that you wait until the end of a month passes before doing the conversion. That way, you have the previous month's statement showing money in the traditional IRA. Just know that any earnings that accumulate in the traditional IRA before the conversion will be taxable upon conversion, but it shouldn't be very much. All right, let's move on to step three, which is, once the money lands in your Roth IRA, put it to work. Don't just let it sit there in cash. The whole point is tax-free growth, and that requires actually investing the money

Starting point is 00:07:50 in stocks, funds, ETFs, or whatever your long-term strategy calls for. Step four, include the contribution and conversion in your tax returns. So you'll receive Form 5498, which reports the IRA contribution, and Form 1099R, which reports the conversion. At tax time, file form 8606, this tells the IRS that you made a non-deductive,

Starting point is 00:08:12 after-tax contribution to your traditional IRA. This creates a paper trail showing that this money has already been taxed, so you won't be taxed on it again when you convert. And if you work with a tax professional, make sure you tell her or him that the contribution was after-tax, so she or he will notify a form 8606. And step five, repeat every year as appropriate. The backdoor Roth IRA isn't a one-time trick. It's a strategy that you can execute every single year you have earned income if that's the right move for your circumstances. Okay, so those are the five steps, not too difficult, but there's one big ugly fly in the ointment known as the pro rata rule. So if you have other money and other traditional IRAs, doing a backdoor Roth IRA gets a lot

Starting point is 00:08:55 more complicated. Here's why. When you convert money from a traditional IRA to a Roth IRA, the IRS doesn't just look at the specific dollars you're converting. It looks at the total balances of all your traditional IRAs, including SEP IRAs, simple IRAs, and rollovers from 401k's and then calculates what percentage of that total is after-tax money versus pre-tax money. This is known as the pro rata rule. Here's an example. Suppose you contribute $7,500 in after-tax money for your backdoor Roth conversion. But you also have a rollover IRA with $67,500 of pre-tax money from an old 401k.

Starting point is 00:09:34 Your total traditional IRA balance is now $75,000. Only $7,500 or 10% is after-tax. The other 90% is pre-tax. When you convert $7,500 to a Roth IRA, the IRS says, well, only 10% of that conversion is after tax. The other 90% is pre-tax and is taxable. The result is that $6,750 of the conversion, or 90% will be tax as ordinary income. Only $750 is tax-free. Fortunately, there is a way around the pro rata rule.

Starting point is 00:10:08 If your employer's 401k or 403B accepts incoming rollovers from traditional IRAs, you can roll your pre-tax money into that plan. This removes those pre-tax dollars from the pro-rata calculation. After the rollover, your only traditional IRA balance is the $7,500 after-tax contribution you just made. Your conversion is now 100% tax-free. The downside to the strategy is that you would likely have to sell all the investments in your traditional IRA before doing the rollover.

Starting point is 00:10:37 and then, once the money lands in your 401k or F3B, choose from among the investment options in your employer splitzer plan, which are often much more limited. This may not be a tradeoff you're willing to make, especially if you like investing in individual stocks and your 401k doesn't have a brokerage account or feature. Here are three other notes about the pro rata rule. Number one, the IRS cares about the balances in your IRAs

Starting point is 00:11:01 as of December 31st of the year of the conversion. So let's say you do a backdoor Roth IRA conversion in June, when you don't have any other money in a traditional IRA, you think that you don't have to worry about the pro rata rule. But then in December, you roll over money in a pretext for O&K to a traditional IRA and the money is there on December 31st. Now the pro rata rule comes into play. Number two, you only have to consider money in your traditional IRAs,

Starting point is 00:11:26 your spouse's IRAs aren't part of the calculation. And number three, inherited IRAs are also generally ignored when doing the prorata calculation. One exception, you inherit an IRA from your spouse, and you choose to make it your own IRA rather than keep it as an inherited IRA. And only spouses have this type of option. I'll close by pointing out that contributing to an IRA isn't the only way to increase the amount of money you have Roth accounts. Nowadays, most employer-sponsored plans offer the Roth option.

Starting point is 00:11:53 If yours doesn't, go ahead and ask for it, no reason not to offer it. There are no income restrictions on a Roth 401K, 403B, or the federal fish savings plan. Anyone can contribute. Also, the annual contribution limits are much higher. For 2026, for 401Ks, the contribution limit is 24,500, if you will be 49 or younger by the end of the year, 32,500 if between the ages of 50 and 59 or 65 and older, and 35,750 if between the ages of 60 and 63. If your plan allows for after-tax contributions and in-plan Roth conversions, you can contribute even more via a strategy known as the mega backdoor Roth, which is a whole other ball of wax.

Starting point is 00:12:36 And finally, you can always convert traditional assets to Roth assets and just pay the consequent tax bill. This may make sense if you expect to be in a higher tax bracket in retirement and or you expect your eventual RMDs to be quite large. So the backdoor Roth IRA is just one way to build up your tax-free Roth assets. However you do it, your future self will thank you. Amazon presents Jeff versus Taco Truck Salsa. Whether it's Verdei,

Starting point is 00:13:03 Roja or the orange one. For Jeff, trying any salsa is like playing Russian roulette with a flamethrower. Luckily, Jeff saved with Amazon and stocked up on antacids, ginger tea, and milk. Habaniero, more like habanier, yes. Save the everyday with Amazon. Time we get it done, fools. And this week I suggest you evaluate your mutual funds and stock picking prowess in light of the fact that this year is the 50th anniversary of the launch of Vanguard's S&P 500 index fund,

Starting point is 00:13:41 the first index fund available to individual investors. To mark the occasion, Vanguard recently released 50 stats about indexing, including the fact that since its launch, the Vanguard 500 has earned an annualized 11.58%. If you had invested $10,000 in the fund at its inception, today you'd have nearly $2.2 million as of the end of February. It's tough to beat an index fund, partially due to rock bottom fees. So if you invest in actively managed funds or pick investments

Starting point is 00:14:10 yourself, make sure you're keeping yourself honest by monitoring whether those funds or you are outperforming a relevant index fund over a span of five years or so. If not, then you might be better off just investing in a diversified collection of index funds and letting the market do its magic. And that, my fullest friends, is the show. Thanks for listening and thanks as always to Bart Shannon, the engineer for this episode, people on the program may have interest in the investments they talk about, and the Maudy Fool may have formal recommendations for or against, so don't buy or sell investments based solely on what you hear. All personal finance content follows Motley Fool editorial standards and is not approved by advertisers.

Starting point is 00:14:48 Advertisements are sponsored content and provided for informational purposes only. To see our full advertising disclosure, please check out our show notes. I'm Robert Brokamp. Fool on, everybody.

Motley Fool Money - A Guide to the Backdoor Roth IRA, and Heirs Squandering Inheritances

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