The Personal Finance Podcast - The Back Door Roth IRA (How High Earners Can Get Money Into a Roth IRA!)

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Starting point is 00:00:56 Find your advisor at IG Private Wealth.com. On this episode of the personal finance podcast, we're going to talk about the backdoor Roth IRA. I'm your host, Andrew founder of dollar after dollar.com. And today on the personal finance podcast, we're going to talk about the backdoor Roth IRA. If you have any questions about this episode, hit me up on Instagram at Dollar A-F-T-R-Dolar. And follow us on Spotify, Apple Podcasts, or whatever. podcast player you love listening to this podcast to and if you want to help out the show head on over to apple podcast and leave a five star rating and review just head on over there and give the old

Starting point is 00:02:02 five star button a nice one-two taparoo so today on the podcast we're going to be talking about how to do a backdoor roth IRA and if you've never heard of the backdoor roth IRA before this is a way for high earners who don't meet the income limits of a Roth IRA to be able to actually contribute to a Roth IRA. And you know here at the Personal Finance podcast, we love our Roth IRAs. We love to stick money in our Roth IRA. And here's why. Because when you put your money into a Roth IRA, tax money goes in, then the money grows tax free and then the money can be pulled out tax free. But here's an amazing fact about a Roth IRA. If you, if you're a money, you're you contribute $500 a month into a Roth IRA for 35 years, and you get an 8% rate of return.

Starting point is 00:02:52 That means your Roth IRA would have about $1,086,069. Now, since you're only contributing $500 a month, that means if you contributed for 35 years, the total amount that you would have contributed or your principal would be $210,000. But the total amount is $1,086,000. That means it grew $875,000 grew inside your Roth IRA. What does that mean? You now have $875,000 that are tax-free. So this example shows the amazing power of the Roth IRA with just $500 a month over the

Starting point is 00:03:34 course of 35 years. If you stretch that out to 45 or 55 and you're still having that money within retirement for that long period of time, that's going to go into the multi-millions. you could have a multi-million dollar Roth IRA. Conversely, there's a traditional IRA, which is the same thing and has the same tax implications as a 401K. But a traditional IRA, you don't pay money on tax going in. The money grows.

Starting point is 00:03:58 And when you pull the money out, you have to pay taxes on that money. Now, paying taxes on that money when you pull it out, if you're at retirement age, isn't that big of a deal because you're not making much money. So it is an income tax. So you're not going to be paying taxes as if you were, you know, in your peak earning years, which is why I love to recommend Roth IRAs

Starting point is 00:04:17 to people who are in lower tax brackets. And as your wealth grows, then you can start to contributing and even getting more aggressive towards your 401K and your traditional IRA. Reason being is as your income grows, what happens? All of a sudden, you're in a higher tax bracket.

Starting point is 00:04:34 And when you're in a higher tax bracket, you want to avoid those taxes in your peak tax years. So what defends against that? A traditional IRA or your, 401k. Now, you should always be getting your 401k match no matter what. That's the first thing you should do with your money. Why? Because it's free money. And here at the personal finance podcast, we love free money. Free is my favorite number. But at the same time, you want to make sure as once you get your employer match, then you move over to your Roth IRA, max that bad boy out, then move over

Starting point is 00:05:09 back to the 401K once you max that out. That's the system and the order. that I like to go in. But what if you make too much money? Because in 2021, there are income limits. And the government only allows people who have a gross income below $208,000 in the year I'm recording this, which is 2021, if you're married or you're filed jointly. Or if you're single, it's $140,000 to contribute to a Roth IRA. So let me say that again.

Starting point is 00:05:35 If you're married and you make more than $208,000 and you file jointly, then you cannot contribute to a Roth IRA. And if you make over $140,000 a year in your single, you cannot contribute to a Roth IRA. So if your income is above these limits, if your income is too high, then the backdoor Roth IRA may be for you. Now, if you make less than that,

Starting point is 00:05:58 there's no reason to tune out from this episode. Reason being is, if you listen to the Personal Finance Podcast regularly, what do we want you to do all the time to build wealth? Increase your income. So this information is extremely important for you. specifically, if you want to get more money into your Roth IRA over time and you like the way that the Roth IRA grows in comparison to the 401k, you can also utilize this and not have to be

Starting point is 00:06:24 over the income limits because I'm going to show you, like the last episode showed you, how to get more money into your Roth IRA than just the $6,000 a year. So this episode is going to show the high earners how to get their money into the Roth IRA and it's going to show folks who just like the Roth IRA more how to get more money, into your Roth IRA in the long run. So the backdoor Roth IRA is a great solution for anyone. And this is where your personal finance and your financial education comes into play.

Starting point is 00:06:52 Because most people don't know how to do this. Most people don't understand that you can do this. If they're a high earner, they think they just have to go ahead and move on to a traditional IRA and they have no chance at a Roth IRA. And that's not the case because there's loopholes in place,

Starting point is 00:07:05 but these are legitimate loopholes because the IRS is specifically addressing these in different sections. No, this is completely legitimate. this is something anybody can do, but we're just not taught this. And this is where your financial education comes into play. Because this is what I would consider a hacker, a loophole. But if you listen to the personal finance podcast, then I'll give you all the loopholes, my friends. Now, one thing to mention is before you do this, before you do a backdoor Roth IRA,

Starting point is 00:07:31 the most difficult piece about this, the most complicated part of it is the tax implications. Because as you'll see, there are tax implications to doing this. You're going to have to pay taxes on money because you're taking it out of an account where you don't have to pay taxes going in and putting it into an account where you do have pay taxes going in. So there's going to be tax implications when you do this. So it's important if you don't have an accountant to at least consult with one who is familiar with this kind of stuff. I have an accountant who is amazing at this kind of stuff. My main accountant is fantastic when it comes to brokerage accounts and retirement accounts. So I always consult with him and make sure that we talk through this each and every year as I do it.

Starting point is 00:08:10 I just did it actually today I did my backdoor Roth IRA. So this is something that is worth it for you if you think you want to get more money into a Roth or you're a high earner. Now, if you're ready to rumble, let's get into it. I remember when I needed to hire someone fast, but finding the right person quickly felt impossible. And if you've ever been there, you know how stressful this can be. That's where Indeed comes in. When it comes to hiring, Indeed is all you need. Instead of struggling to get your job post noticed, Indeed's sponsor jobs help you stand out and hire

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Starting point is 00:10:55 More like habanier, yes. Save the everyday with Amazon. So what I'm going to do is I'm going to go through step by step how to perform a backdoor Roth IRA. Now, if you have a Vanguard account, I am going to link in the show notes a really good article on how to do this if you have a Vanguard account because it takes you step by step and shows you exactly how to do it through your Vanguard brokerage because Vanguard makes it really easy to do this. And so I'll show you how to do that. And I'll see if there's one for Fidelity and Schwab as well. And if you have any of those brokerages, you can utilize that as well. But let me give you a step

Starting point is 00:11:33 by step on how to do a backdoor Roth IRA conversion. So the first thing you want to do is if you don't have one already, you want to open up a traditional IRA. Now what a traditional IRA is, as we talked about at the top of the show, it's an account where you put your money in before taxes. Your money grows and you can pull it out, but you pay taxes when you pull the money out when you're 59.5. But you want to put your money into a traditional IRA.

Starting point is 00:12:00 Then once it's in the traditional IRA, you want to make sure that you wait. a few days and invest the money. The only reason why you're going to invest the money is because this shows the IRS that you had an intent to put the money into an IRA if for some reason you get audited for something else. That's the only reason why you want to do that. You don't have to do it, but that's what I would recommend doing. And that's something that I do every single time.

Starting point is 00:12:25 Because the last thing you want to do is when you're getting audited is raise red flags when the IRS is auditing you. So making sure that you at least. invest it, show and leave it in there for a few days, just to make sure that you show the IRS that you have intent to actually keep it in an IRA. The next one, number two, what you're going to do is you're going to convert your contribution to an IRA. So your brokerage or your IRA administrator will give you the instructions and paperwork. Like I said, I'm going to link to a couple of them in the show notes. And if you don't already have a Roth IRA, you need to open a new account during the conversion process.

Starting point is 00:13:00 So as you're doing this conversion, you can open up a. a Roth IRA. A lot of companies make it super easy as as you're trying to transfer the money and move it over to a Roth IRA and says, hey, you want to open a Roth IRA account? You go ahead and push yes and move on to the next step. Now let me explain something to you because if you listen carefully, I said you're going to convert your contribution to a Roth IRA. That's different than an actual contribution to a Roth IRA. So there's two ways to put money into a Roth. There's a contribution, which is what you traditionally do if you're putting in the traditional $6,000 a year into a Roth IRA, which is the limit at the time I'm recording this episode. And if you're over 50, then it's $7,000. And then there's

Starting point is 00:13:42 a conversion. And a conversion, you can actually move as much money as you want, but you're moving money from an IRA to a Roth. But as you do the conversion, it's taxable. We're going to talk about taxes in a second here. And this is actually what we were talking about. If you listened to last episode, when we were talking about how to access your retirement funds early, when we do these conversions, when we do these Roth conversions, when you go from an IRA to a Roth, that is where you're actually doing a conversion. You can move as much money as you want over there. Now let's say you have a $200,000 traditional IRA over time. You can actually convert that money into a Roth IRA. So you can get a lot more money into your Roth by doing this. But the key to understanding this, and this is going to be

Starting point is 00:14:25 number three, is you have to prepare to pay taxes because only post-tax stallers go into Roth IRAs. So if you're putting your money into an IRA, you're getting a tax deduction on that money that year that you put that money in. So when it's time to pay your tax return or file your tax return, just be prepared that you're going to have to pay taxes on the money that you converted specifically if it was tax deductible that year. Now, how much taxes are you going to have to pay? Well, it depends on something which is very specific, which is the pro-rater rule.

Starting point is 00:14:57 And we'll get into the pro-rater rule in a second. And then number four is to prepare to pay taxes on the gains in your traditional IRA. So if the money that's in your traditional IRA has been sitting there for a while and there have been investment gains, you're going to also owe taxes on the investment gains at tax time. So you've got to remember,

Starting point is 00:15:17 It's not just your contributions that are going to be taxed when you transferred over. It's also the gains that your money has made. So if your money's been in there for a long time, let's say you've had a traditional IRA for 20 years, where you're going to have significant gains in that traditional IRA, and you're also going to be paying taxes at that time. So many times when you do these transfers, the best possible scenario is to do these transfers at a time when your tax liability is extremely low. So if you're not making much money one year, that's a great thing.

Starting point is 00:15:47 time to do the transfer because that year alone, you're not going to have to pay as much taxes as you would if you're in your high earning years. So being in your high earning years is obviously a wonderful problem to have. So this isn't something like, I hear people complaining all the time about their tax bill when they're doing this kind of thing. Listen, if your tax bill is high, that means you have a good problem, my friend. That means you're making good money. And so that's a great problem to have. But as your gains grow, your tax bill is going to grow as well. So just being prepared for the tax ramifications when you do these conversions and doing them at optimal times is going to change the amount that you can actually transfer over. It's going to significantly change it.

Starting point is 00:16:25 So if you can time this correctly and make sure that you're actually doing it at the right time, that's going to be fantastic for you. Now, the big thing to understand is when you do these transfers, let's say you want to retire early and you want to do the rule like we talked about last week where you can pull your money out. You just have to remember the five-year rule because you can pull contributions out of your Roth IRA. But you have to wait five years before you can pull those contributions out without having to pay penalty. Now there's two things that you want to understand when you're doing the Spackdoor Roth IRA. And the biggest piece you want to do is make sure that you're minding the rules.

Starting point is 00:17:02 We talked about the tax implications when it comes to doing this and how you should most likely be talking to your accountant to make sure that you're minding the rules. But I just want to talk about a few of the rules so that you understand some of these things that you really have to know. The first thing to understand is the type of transfers when you do your back to a Roth IRA. Not all conversions are created equal. And there's three types. One is a rollover.

Starting point is 00:17:26 And that's where you receive the money from your IRA and deposit it into a Roth IRA within 60 days. So that would be considered a rollover if it's within 60 days. Then there's a trustee to trustee transfer. That's where the IRA provider sends the money directly to your Roth IRA provider. Or there's the same trustee transfer. and that's where your money goes from your IRA to the Roth IRA at the same financial institution. So the only difference between those two transfers, the trustee to trustee and the same trustee transfer, is one is if you were like banking at Fidelity and you transferred to your Roth IRA over at Vanguard.

Starting point is 00:18:04 And the other one is like if you had your traditional IRA and your Roth IRA both at the same financial institution. Now the big piece to understand though is the pro rata rule. What happens is the IRS decided to figure out what they were going to do when people had pre-tax and post-tax money in their IRA when they did these transfers. Because if you think about it, when you put money into your IRA and you wait a year until your tax year comes up, you get a tax deduction. What happens if you put money in your IRA and then transfer it over right away? So when you have pre-tax and post-tax money in your IRA, can you contribute to the post-tax

Starting point is 00:18:41 money? The answer is no, and it's because of the pro rata rule. Now at the top of the show, we talked about waiting a few days to allow your money to sit in the IRA. So it looks like you're actually actively investing in your IRA. But truthfully, the pro rata rule is why it would be better to actually allow your money to sit in a year in your IRA. So the only reason why we're recommending just a couple days for your first year is so that you don't miss a year that you can contribute to your Roth. And you want to get money into your Roth as fast as possible. But at the same time, this pro rata rule really makes it where you're,

Starting point is 00:19:14 better off leaving your money in that IRA or in that account for a year to let it sit there. Because what you don't want to do is you just don't want a bunch of confusion come tax times. Let me explain how the pro rata rule works. So when you're determining your tax bill on a conversion from a traditional IRA to a Roth IRA, the IRS is going to actually look at all your traditional IRA accounts combined. So if all your traditional IRA combined consists, say, of 70% pre-tax money and 30% after-tax money, that ratio determines what percentage of the money you convert to the Roth is going to be taxable. So in this example, the 70% pre-tax money and 30% after-tax money,

Starting point is 00:19:52 no matter how much money you convert or which IRA you pull from, 70% of the amounts you convert to the Roth will be taxable in this example. And the same goes if you're 50-50, 50% pre-tax money and 50% after-tax money, then 50% of the amount that you convert to the Roth will be taxable. You can't choose to convert after tax money. The IRS just will not allow you to do that. They just will not allow you to do that. And this is their way of actually combating.

Starting point is 00:20:19 There's a few frequently asked questions that I get when we talk about doing these backdoor Roth IRA conversions. So let's get into them. So when I talk to people about doing the backdoor Roth IRA, I do get a couple of the same questions. And one of the biggest ones is where should I open my Roth IRA or traditional IRA? And when you're going to do these backdoor IRAs, The easiest answer to that is to make sure you do it, A, at where your actual Roth IRA is sitting at the time that you're recording this, or if you don't have a Roth IRA where your traditional IRA is sitting.

Starting point is 00:20:49 Now, if you don't have either and you want to start implementing this strategy, all the big brokerages are great. Vanguard, Fidelity, M1 Finance, Charles Schwab, all of those brokerages are fantastic. In fact, Vanguard literally will walk you through the steps on how to do a backdoor Roth IRA and so will Fidelity. I'll leave some videos in the show notes that show you step by step exactly how to do that with those two brokerages. And I'll see if there's one for Schwab as well. But both of those will walk you right through it. Another question that I get all the time is do you think the backdoor Roth IRA will go away? Now, there have always been rumblings about this, but truthfully, I've never seen a credible source actually stating that it in fact will.

Starting point is 00:21:31 Nobody's actually, they've been saying this for years and years and years, that Social Security is going to go away, that the backdoor Roth IRA is going to go away, that the Roth IRA is going to go away, that the Roth IRA is, that the Roth IRA is, is going to go away. And they talk about it all the time, but there's no factual evidence to this. Now, there's been bills that have been put into place that have tried to prohibit some of the things that you can do in a Roth IRA or prohibit some of the things that you can do in an IRA,

Starting point is 00:21:52 but nothing's gone through to the point that you need to worry about it. As of right now, I don't see it going anywhere at this time. Now, that can change on a dime, but as of right now, it is here to stay. Another question. Is the backdoor Roth IRA legal?

Starting point is 00:22:08 absolutely. But the thing about the backdoor Roth IRA is the IRS doesn't like to call it a loophole or they don't like it being called a backdoor Roth IRA. In a few meetings, they've addressed it straight up because people have brought it up as a backdoor Roth IRA and they want to call it a conversion from a traditional IRA to a Roth IRA. So if you're doing documentation for this, specifically on records that go down your taxes, do not call it a backdoor Roth IRA. Make sure you're calling it a traditional IRA conversion. I would never utilize that term. backdoor Roth IRA. All that does is just raise red flags. That's all it does. So making sure that you're calling a conversion will allow you to just stay and keep it safe when you're going through that process. So let's sum this whole thing up. Let's sum up how to do a backdoor Roth IRA contribution safely. So the first thing you want to do is verify that there are no pre-tax IRAs like we talked about. If you do have pre-tax IRAs, then just try to roll them into your 401k if that's allowed. Just to avoid the IRA aggregation rule that 70-30, just to avoid all that. confusion. Instead, just make sure you have all post-tax money in there. Number three, contribute to a non-deductible

Starting point is 00:23:16 IRA or traditional IRA if eligible. Number four, invest the funds inside of that traditional IRA. Number five, like we just talked about, try to at least keep those funds invested for one year so you don't raise any red flags. If you can't do that and you need to contribute now, at least make sure you wait a few days to a few weeks. Number six, then convert that money to a Roth IRA. And then number seven, you can repeat steps two through five annually as desired. But do not at any point make a note that you're doing a backdoor Roth contribution. And then number nine, the last thing, is just make sure you have an accountant involved on the tax side so that you can make sure that you're nailing the tax side. That's the biggest thing. So if you do those nine steps,

Starting point is 00:23:59 you will be golden when you do these Roth IRAs because it is a tremendous account to have. It's a tremendous way to get more money into your Roth, especially if you're a high earner. Because high earners have no other option. This is the option to get money into a Roth if you are a high earner. And if you want to build wealth, you want to get your money in as many tax advantage accounts as possible, even if you're going to retire early. We talked about last episode how to access those funds if you're going to retire early. So if you haven't heard that episode and you're planning on pursuing fire or financial

Starting point is 00:24:30 independence, make sure you go listen to that episode. because it is possible to access your retirement funds early, and we go through the math as to if you even had to take the penalty what would happen. So make sure you go listen to that episode. And if you have any questions about this episode, hit me up on Instagram at Dollar A-F-T-R-dollar. And follow us on Spotify, Apple Podcast, or whatever podcast player you love listening to this podcast,

Starting point is 00:24:54 and if you want to help out the show, take that index finger, swipe on over to Apple Podcast, hit the five-star button, and leave a five-star rating and review on Apple Podcast. Thank you guys so much for listening to this episode. I truly appreciate each and every one of you.

Starting point is 00:25:08 I hope you guys have a great week, and we'll see you on the next episode. Thank you guys so much for listening. And if this is your first time listening, consider subscribing so you never miss an episode. And share this episode with a friend. And don't forget to leave a rating and review on iTunes as well, because our goal is to bring as much value to you as possible.

Starting point is 00:25:29 And we're trying to spread this message that money can buy freedom. That's what money is there to do, is to buy more freedom. So thank you again so much for listening, and I hope you have a great day. Rosen lasagna, medium power, 15 minutes. Sounds like Ojo time. Let's play. Feel the fun with Play Ojo, the online casino with all the latest slot and live casino games. What you win is yours to keep with no wagering requirements, instant payouts, and no minimum withdraws.

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The Personal Finance Podcast - The Back Door Roth IRA (How High Earners Can Get Money Into a Roth IRA!)

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