You've probably heard of a Backdoor Roth IRA, but its often explained in a complex way that makes it sound like a difficult account to open. In this episode, we'll talk through how to get the benefits of a Roth IRA when you're over the income limit to contribute. Spoiler: it's not as tricky as you think.
[00:00:00] Welcome to The More Sense Than Dollars podcast, where your host is Nick and Harry. Hello listeners! We're back for another episode. It's another one about retirement accounts. And this is a term that you may have heard and may have wondered what it is.
[00:00:31] It sounds a risk-a, or a shady, shady, yeah I think is a good word. Backdoor Roth IRAs. But they're not that scary. And we will explain what they are when you should get them out of do it all of that, who shouldn't, who shouldn't. So stay tuned.
[00:00:54] First Nick, give us your two cents. What's on your mind recently? Is this something coming up at work now that it's like review? We're going through a review process and it's promotion, cycle. And I'm continuing to move more into the world of management.
[00:01:12] And it's something I'm struggling with the change in skills that you're expected to develop. I've been in a very technical role in my whole career. And it was very easy for me to know when I was improving my technical skills.
[00:01:28] There were things that I knew I couldn't do before that now I can do. Or this type of project used to take me a week, now I get it done in the day. I'm getting better at those skills.
[00:01:40] It's a lot harder for me right now to know what I'm getting better at management skills. Yeah, more intangible. Right, there's not an objective. Can't measure it as measuring stick to use for that. So it's definitely something I think I used to take for granted.
[00:02:00] That being a manager is just an easier job. You're not actually doing any work or just dealing with people. But learning that's not the case. Yes, an interesting transition. That's a good one. What about you? I've been thinking about the decreasing quality of clothes and items recently.
[00:02:23] I feel like as prices are going up, quality is not maintaining. And so we're paying more for things that don't last as much. Shirts, shoes, things like that, furniture and upsetting because there are certain places you can pay for quality and the last a long time.
[00:02:44] But you used to be able to get clothes at Target that would last a long time. They don't last as much. I wonder what the research says about this. Yeah, there's also something to be said. There's an expectation to have a bigger wardrobe these days. Yeah. That's true.
[00:03:06] We're, you know, even a not so well off family might have one set of really nice clothes. That was the only one. If you ever had an occasion to dress up, right? That one in you would save up and splurge on that.
[00:03:20] We're now, I think there's an expectation to have a variety of things for any situation. Good point. Okay. I think we should start this with a recap on Roth versus traditional IRAs because we're going to say IRA so many times this episode.
[00:03:40] And we did that episode when, when, when, the season one. I guess we talked about IRAs. I don't even know. So yeah, it was a long time ago. So let's differentiate them. Let's start with, we should start with the traditional IRA.
[00:04:00] Often just called an IRA, but we need to call it traditional because we're talking about different types. So what is the traditional IRA? It has many of the same benefits as a 401k. The major difference is that a 401k needs to be sponsored by an employer.
[00:04:22] That is something you contribute to through your work, through your employer. Whereas a IRA stands for individual retirement account. And it's kind of in the name, but any individual can open an IRA and contribute to it. There's no requirement for that to go through an employer.
[00:04:43] Yeah, so you're getting your contributions tax deductible. Meaning whatever you put in that year, you at the end of the year say you put in that much and it comes off with your taxable income. That's pretty big difference between the 401k and the IRA.
[00:05:01] The 401k contributions are pre-tax. They're just coming straight out of your paycheck. Right right. On the other hand, with a traditional IRA, you are going to be using dollars that have already been taxed to contribute to that. It's not coming straight out of your paycheck.
[00:05:19] Something to note here is that whether or not you can deduct those contributions to the IRA when tax season rolls around depends on a couple things. One, do you have an employer-sponsored plan? Like a 401k?
[00:05:37] If you do, then the next step is what is your actual income level? So as of 2024, there's a phase out from 77,000 to 87,000. So if you're making over 87,000 and have an employer-sponsored plan, any contributions you make to the traditional IRA are non-tax deductible even though they were made with
[00:06:05] post tax dollars. If you're under that limit or if you don't have an employer-sponsored plan, some or all of the contributions will be tax deductible. Yeah, those are nice because you're lowering the amount you owe in taxes today.
[00:06:22] You don't have to deal with paying taxes on that money. It's going to be taxed as regular income when you withdraw it. But it's fine if you're going to be in the same or a lower tax bracket. You're just deferring the tax.
[00:06:39] So actually if you're in a lower tax bracket, in retirement, you think you're going to live off less than you are now. It's actually even better because you'll be paying less tax on that money than you paid when you put into it. Yeah, so.
[00:06:53] And the last thing I'll say about these is that in my experience, most people end up for open an IRA as a place to roll over their 401k funds when they leave a job.
[00:07:10] You can contribute directly to it IRA, but you can also just use it as a place to collect all of your 401k contributions from previous employers. Okay. So that's the traditional IRA Roth IRAs. What are these? How are they different?
[00:07:32] So whenever you see the word Roth, you know you're working with, and I say the word Roth, but it's actually someone's name. But whenever you see Roth, you are working with after tax dollars because Roth 401k is do exist and I want to confiscate it too much.
[00:07:48] We're just talking about IRAs. But it means that you are contributing to an individual retirement account. It's not tied to any employer. You are using money that has already been taxed and contributing it to an IRA.
[00:08:02] The difference is that because it's already been taxed when you withdraw from that in retirement, you will not pay taxes on it. And that includes all of the growth. Yeah, so the trivia background is like Nick said, comes from a name William Roth who
[00:08:19] is a senator, a US senator and wanted away for people to access IRAs more easily and not an avoid taxes. He's a Republican senator. And in 1997, the Roth IRA was introduced. So like Nick said, this is a nice way to have retirement savings that aren't taxed
[00:08:45] and very nice if you're going to be in a higher tax bracket when you are withdrawing it. Because I already dealt with those taxes back when I contributed it. And now I don't have to pay it.
[00:08:56] If I did have to pay it now, I'd be paying more tax on it. Right. And it can be tough. It can be tough to guess what kind of tax bracket you're going to be in 40 30 20 years from now.
[00:09:12] And so if you've listened to any of our flow chart episodes about how to structure your goal money and which accounts that goes into for retirement, usually we say get that employer match on the 401k, then max out your off and go back to the 401k.
[00:09:29] And that it's kind of hedging because you make sure you have some free tax dollars invested, which works out nicely if you are going to be making more when you retire.
[00:09:43] But you also have a lot of those free tax dollars in the 401k in case you are making less. So it sounds great, but there is a problem. There's an income limit problem.
[00:09:59] And so is this limit to who can contribute to Roth IRAs and how much is changing every year? And so in 2024, the range is anyone making less than 146,000 can contribute the full 7,000 or whatever the cap is for that year. Anybody making over 161,000, this is all individual.
[00:10:31] It's a little different and it's more for married filing jointly. But individual 161,000 can't contribute anything. But between those numbers there's a sliding scale where you can contribute some of that. And I guess we'll go into that a little bit more when we get into the back door Roth.
[00:10:53] And that should be right now where we get into. Okay, so I want the benefits of the Roth IRA. You sold it so well. It's after tax money and I don't have to deal with setting anything aside or whatever in retirement.
[00:11:08] But I make over 146,000 or I make over 161,000. And whatever, I have problems with contributing the max amount. Incomes the back door Roth IRA. Yes. And so there's few pieces here that allow this to be a thing.
[00:11:31] And so one part one is that you are allowed to convert IRA accounts between traditional and Roth. That's part one. There used to be an income cap on IRA conversions, similarly to how there's an income cap on contributions to a Roth.
[00:11:52] However, in 2010 the income cap on conversions was removed. And so now we're in a situation where anyone can convert from a traditional to a Roth, but not everyone can contribute directly to a Roth. So what we have now is the back door Roth IRA.
[00:12:16] And so you can contribute up to the seven, as of 2024 it's $7,000 whether we're talking Roth or traditional. That's the IRA limit. So you can contribute up to 7,000 in the traditional even if you're over that 161K limit.
[00:12:35] And then convert that traditional into a Roth and reap all the benefits of it being a Roth IRA. You have post tax money and all that. So that's, I mean, that's it in a nutshell. We'll go through a little bit more of how to do it.
[00:12:51] But it's not as crazy as scary as it sounds. You're just converting a traditional to a Roth IRA. There's some rules and stipulations and things of course we're dealing with the IRS here. But you're already covered. Yeah, go ahead.
[00:13:05] Last thing I'm going to say just to legitimize this whole operation, there were some questions or thoughts in the community that this could be something that gets shut down. Or that's you could get penalized for years later.
[00:13:20] The IRS in 2018 did clarify that this is okay to do for the time being right there may be a change in the future that prevents you from continuing to do it. But as I've written now, this is totally fine to do.
[00:13:36] And a lot of brokerages took that as the go ahead to make it, you know, a default option in their services they provide. Yeah, ready. Some of them might start to be like, come like a one-click thing.
[00:13:50] Yeah, it's just like on the, you don't need to necessarily work with an advisor and go through community process. You can just tell them I want to do a backdoor Roth IRA and they will know when they have a process for doing these things now.
[00:14:02] Yes, so this is a it's technically a loophole, but it is all legal and legitimate. And everybody knows about it.
[00:14:10] And I think it would be very politically unpopular to get rid of it, especially for the high earners who have a lot of say in campaign contributions and things. There was no attempt to get rid of it.
[00:14:23] Yeah, yeah, we have seen that part of the COVID aid packages and it was stripped from that and it is still a shock down of 2024. All right, so just back to recapping on the the limits. So you talked for 2024, 7000 for Roth and traditional combined.
[00:14:42] So to all of your IRAs, it's 7000 total. And that's higher. Remember we talked about we've talked about catch up periods in the past. If you're over 50 years old that goes up to 8000, right? You can contribute up to 8000.
[00:15:03] We let's give us some examples of how a sliding scale works because there's a lot of people who fall in that middle ground between 146,161,000. So say you're making they haven't they haven't come out with the full exact calculations for
[00:15:23] 2024 yet, but if you can contribute 7000 if you're making under 146,000 then if you're making 150,000, you might be able to contribute 6000. So not the full 7000, but you could do 6000. Say you're up towards the higher end. Maybe you're making 158,000 pretty close to the limit of 161.
[00:15:48] Maybe you can only do a 1000 out of the 7000. So you start to get squeezed out and really limited as you get higher up in that scale. It's nice that it's not a that you can still do some, but yeah, you're you're missing out on a lot of
[00:16:06] contributions as right close to that. And just clarify these limits and the sliding scale are all applying to the Roth. So if if because of your income, you can only contribute a 1000 to the Roth. You still could contribute 6000 to the traditional IRA. Yes, good.
[00:16:24] And up to that combined 7000 IRA limit. Yep, all right. I think we kind of went through like who should do it? When's it a good time to do, but you want to start with like yeah, so the who would you recommend this to?
[00:16:43] Right. The first and most obvious one is for anyone making over 161k that wants to contribute. Once the benefits of a Roth IRA and just can't contribute at all to one thing, they're the primary group that would be interested in this. Yep.
[00:17:01] A secondary piece which is obviously related is if you're somewhere on that sliding scale between that 146 and 161,000, you may want to either contribute what you can to the Roth and then use a backdoor Roth to contribute the rest or you may decide to just contribute that full amount
[00:17:23] to a traditional and do the conversion to a Roth just to make things easier. You don't need to split the posits, you just say I'm going to do it all as a backdoor.
[00:17:34] Yeah, if you don't we'll get into why but if you don't already have a traditional IRA with with money that you did tax deductible in it this starts to become more appealing. It starts to get a lot easier.
[00:17:49] And we also mentioned, I don't know if we mentioned but Roth IRAs don't have required minimum distributions so if you want to avoid them then a Roth IRAs could for that. In our last episode we mentioned that if you are the person that opened the Roth IRA
[00:18:07] there's no required minimum distributions. If you inherit a Roth IRA, that can come with required minimum distributions depending on your state. Okay, so you decided I want to do this and ready for the backdoor Roth IRA.
[00:18:29] First thing you need to do set up a traditional IRA account and make your contributions to it. This is where I'm going to throw up a big red flag and say stop, listen this part's important.
[00:18:43] This whole process gets significantly messier if you already have a traditional IRA with funds in it. To the point that I would recommend for most people, if they are in that situation, to not do a backdoor Roth IRA until you have taken care of that traditional IRA.
[00:19:07] You're going to want to ping a lot of tax on it. Right. They call it like, so here's the problem. You put money, you deducted the money that you put into the traditional IRA on your taxes. You didn't pay tax on that money. It's in that account.
[00:19:27] You start to put in money that you did pay taxes on. How do we know exactly what was what? They call it like cream in the coffee, once the creams in there, how do you separate the cream from
[00:19:39] the coffee again? Once it's in there, we don't know what part of the growth was on the stuff that was taxed, and so you're going to pay, you're going to wind up paying taxes on more than
[00:19:50] you should just because it's impossible to separate them. Right. That says you owe taxes on some of this. We can't know for sure because it's all mixed together. So we're going to make sure that your
[00:20:05] bank, where you're definitely going to pay what you're supposed to be paying and a little extra because we can't be sure. If you're going to if you're going to fall on one side of not enough for too much,
[00:20:15] they make sure it's on the too much side. Oh yeah, they're not going to short. Sure themselves. So yeah, I think it's starting. If you already have one that starts to get tricky, you have to
[00:20:26] you're either accepting you're going to have to pay this penalty or, or it's not a penalty. It's just paying taxes on it or you have to move that money somewhere else. You could roll it into a 401k,
[00:20:40] but pros and cons there too, right? Right. On whether you're capital. You need to have a 401k plan. So if you are self-employed or you work for an employer that doesn't offer one,
[00:20:53] you may not have a 401k to roll these into. There's also the chance that you are 401k provider doesn't allow rollovers. So that's step two, you have to check if you have one,
[00:21:06] do they even allow this to happen? And next kind of branch here is you can only make one IRA rollover per year and so maybe you started a new job. Maybe the reason you have a traditional
[00:21:23] IRA in the first place is you rolled over your old 401k into an IRA. You can't roll that IRA into another 401k until a year is passed. So maybe you can't even roll it over.
[00:21:38] There's also some other pros and cons to rolling an IRA into a 401k. There's a little lot of similarities between the two, but there are differences in how they're treated. There's different implications in bankruptcy for example between the two just as an example.
[00:21:56] So we'll probably post that list and maybe even do a few trips owed on the pros and cons of rolling an IRA into a 401k or vice versa. So if you're any have an IRA,
[00:22:09] you gotta weigh those the cost benefit there is it worth it to get this back to a Roth IRA. But if you have an empty, if you found a way to move it out or you don't have one,
[00:22:21] very simple. You set it up, make your after tax contributions to it, up to the limit, up to the 7000. And then on your brokerage like Nick said, you just go on the website, fill out a little
[00:22:35] bit of paperwork, find the the part of the site that says back to a Roth IRA and convert it. You're just taking the money from the traditional putting it into a Roth IRA. It's the easiest
[00:22:49] with the same brokerage, but you can have them if for some reason you want to open it at another one. You can have them wire the money to a Roth IRA at another account. Right and one more rule
[00:23:02] for those funds you've converted from a traditional to a Roth IRA. Even though in a Roth IRA you can withdraw your contributions at any point, tax free or penalty free. If you've converted
[00:23:18] money from a traditional to a Roth, you need to wait five years before touching that money. Yeah, just leave it. So again, probably don't want to be touching this until you're retired. We've reiterated that fact many times. You shouldn't be dipping into your retirement account unless
[00:23:36] it's an absolute worst case emergency. But there's that additional limit on when you can pull penalty free from a Roth when it's been converted as opposed to direct contributions. Yep, so that is a backdoor Roth IRA. Hopefully we took some of the stigma
[00:23:58] and confusion out of it. Your brokerage will do it most of it for you. Yeah, have to. It's something given the income limits on that sliding scale. It's something that doesn't apply to most people, or talking pretty high salaries at this point. But it is something that's going
[00:24:19] to be relevant to some listeners and I bet there's even in a higher number of listeners that it's not relevant for right now that it will end up being relevant. Yeah, and so this is one
[00:24:33] of those things. Again, I've mentioned a few times you best time to learn about something is before you need to know what you're learning about. And so if you've been contributing to your
[00:24:44] Roth IRA all along, follow in the flow chart, you should know these limits and how to work with them. If your salary hits these levels instead of continuing to contribute and finding out
[00:24:58] when you file your taxes that you goofed up. Yep, you've been doing the max every year. But now it's problem and now it's a good time to learn about it so you don't get into that situation.
[00:25:11] Yeah, to be able to do this as soon as your eligible is nice, you get all the growth and returns and don't have to look back. So that is how it works. If you have any other questions about it,
[00:25:23] let us know. We've had a fun time learning the ins and outs of backdoor Roth IRAs and how they work. Let us know if you have any other questions. Maybe we'll talk about the mega backdoor off IRA. Yeah, there's that too.
[00:25:43] All right, thank you all very much for listening. We will see you in the next episode. Hi everybody. You've been listening to the more sense than dollars podcasts.