Using the Backdoor Roth IRA for High Income Earners
Hey, what’s up, everyone! Henry here from Disruptive Money Management and today we’re going to be talking about the backdoor Roth IRA. In my earlier piece, I pitted the Traditional IRA alongside the Roth IRA and officially crowned the Roth IRA as a must-have in everyone’s financial plan. If you haven’t checked it out, be sure to give that a listen. Most financial advisors have historically recommended the Roth IRA for those that are just starting out and in their first jobs. Often, financial advisors will bypass the Roth IRA and advocate for the Traditional IRA because of the tax-deductible benefits at higher income levels. But again, going back to the big picture, if you are already saving in the 401k and that is pre-tax dollars already, the Roth IRA is a better compliment to your overall financial plan. When in retirement, you ought to have multiple different buckets that you can draw from, whether it is tax-deferred like the 401k and Traditional IRA, tax-free like the Roth IRA, and perhaps even taxable accounts.
Now, what happens if your income is higher than the allowable limits for directly contributing to the Roth IRA? This occurs if your income as a single filer is higher than $124,000 and $196,000 if you’re filing a joint. So if you’re in that category, you’re considered a HENRY. A HENRY stands for High-Earner-Not-Rich-Yet. So for those of you making a good income and cannot directly contribute to a Roth IRA, this is for you!
Step One - Open both a Traditional IRA and Roth IRA
The process for HENRY’s contributing to a Roth IRA starts with having two accounts. Wherever you want to invest, whether it is at Fidelity, Vanguard, Charles Schwab, or any other custodian, you want to open both a Traditional IRA and a Roth IRA.
Step Two - Making Deposits
Step two consists of depositing your contributions into the Traditional IRA. I generally recommend that you do the full amount that you plan on converting in one-go. What I mean by that is if you intend on contributing the total $6,000 or $7,000 if you’re over age 50, you want to contribute the entire amount and make this type of conversion in one transaction as opposed to contributing throughout the whole year and having to make multiple conversions.
The reason why you want to do this as opposed to spreading your contributions throughout the entire year is that the conversions typically have a cost at your custodian. This process can range from $50 to $100 per conversion, so you don’t necessarily want to be converting too much because the conversion fees can quickly add up. The plan also is to keep the cash that you deposited into the Traditional IRA non-invested until you perform the conversion so that you don’t incur taxable liability, which leads us into Step 3.
Step 3: Stay In Cash Until Conversion Occurs
Step 3 is ensuring that your funds stay in cash within the Traditional IRA account, which is why it is crucial you use a brokerage account like the ones I suggested earlier as opposed to directly investing in a mutual fund company like American Funds or into a JP Morgan mutual fund account. Typically, the mutual fund companies will automatically invest your deposits into a specific mutual fund that has a market volatility. If the investments in the Traditional IRA go up in value, you’ll run into a taxable liability during the conversion, which is why you want to set up the accounts with a brokerage firm that allows you to keep your money sitting in cash. The money stays non-invested, which means no growth potential, which is another reason why you want to do this type of deposit and conversion in one lump sum as opposed to making ongoing monthly contributions throughout the entire year. The best way to do this is to keep your money in a savings account until you accumulate enough to perform the conversion.
Keeping the funds non-invested is critical and allows for a smoother conversion when you move the money from the Traditional IRA to the Roth IRA.
One thing that is critical to note here is that the conversion works best for those that don’t already have an outstanding Traditional IRA. The reason being that the IRS sees your IRA balance as a whole as opposed to what you’re trying to convert. I’m going to give you two scenarios:
Scenario A: Let’s say you start the year with no Traditional IRA because you’ve been predominantly saving in a 401k at your place of employment. This scenario is well and beautiful; you’ll proceed to open both a Traditional IRA and a Roth IRA, make the deposits into your Traditional IRA and perform the conversion with no problems. This process is the cleanest and most tax-efficient way of doing this as the deposit has had no inherent growth or earnings. Because there are no earnings, you can’t have taxable implications.
Scenario B: Let’s say you have an outstanding Traditional IRA from a previous employer that you had rolled the money into when you left. Let’s say, for instance, that balance is $100,000. You do not want to contribute $6,000 into the Traditional IRA and perform the conversion into the Roth IRA because the IRS sees your cumulative total balance of $106,000. When you make this type of conversion, there will be inherent taxable liabilities because the conversion has a pro-rata rule. The reason being is because the IRS will see all of your Traditional IRA, SEP-IRA, and Simple IRA’s as one balance and not separate. It doesn’t matter if you have opened a new Traditional IRA with zero balance just for this reason alone. The IRS will count the entire asset as one category. From that point forward, the calculation is taking the conversion amount and dividing that by the total outstanding balance. In this case, $6,000 divided by $106,000, which means that your conversion of $6,000 is about 95% taxable.
So if you’re in Scenario B, which may be where many of you fall under, you’re going to find that having 95% of the $6,000 taxable during the conversion makes it less appealing, and you’ll be right. This whole podcast is dedicated to maximizing your funds, but having 95% of the conversion subjected to taxes would be counter-intuitive.
Does that mean you’re stuck and out of luck? No, not quite. If you’re starting this out early in your working career and your rollover Traditional IRA is relatively small, it may not hurt for you to do a conversion of the entire amount because of the attraction of tax-free income. Following that philosophy, for those with smaller rollover balances, it may make sense to bite the bullet now when your tax bracket is still minimal, and the balance is relatively low.
If, on the other hand, if your rollover Traditional IRA balance is higher and using the example of the $100,000, you still have options.
Most employers sponsored plans allow for the rollover of prior 401(k) funds even after you have transferred it to a Traditional IRA. So, for example, if you had rolled over $90,000 from your previous employer in a Traditional IRA and that value has now grown to $100,000, you have the option of rolling that $100,000 into your current 401(k) plan. If you do that, now your existing Traditional IRA balance gets reduced to zero, and the pro-rata rule no longer applies to you.
For those that are self-employed and do not have access to an employer-sponsored plan, you can structure a Solo 401(k) or also what is commonly known as an Individual 401(k). A Solo 401(k) is primarily designed for self-employed individuals who receive income outside of a traditional W-2 employee structure. Solo 401(k)’s can be used for a wide variety of independent income.
For instance, you can be an utterly self-employed contractor or consultant. If your primary income is all derived from self-employment revenue, you have access to this retirement account.
Solo 401(k)’s are also available for those that are part-time entrepreneurs. You can run a side business selling products on Etsy. If you’re driving Uber or Lyft to supplement your income on the weekends, you have access to this.
You could be a software developer that works on the weekends for personal clients and get paid directly, that income qualifies for self-employment purposes.
I know of physicians who came finished med school working part-time on the weekends as an independent contractor for companies outside of their usual 9-5. That counts as a self-employed income.
The possibilities for self-employment to access the Solo 401(k) is practically limitless. In a separate episode, I’ll go more in-depth on the Solo 401(k) and why for high-income entrepreneurs, a Solo 401(k) is vastly superior to the older SEP-IRA.
Step Five: File IRS Form 8606
The last step that you have to take with using the Backdoor Roth IRA strategy is to file or have your accountant file IRS Form 8606 when you do your taxes. IRS Form 8606 is submitted per individual, so if you and your spouse are doing this, you’ll want to make sure both are included in the taxes. The most important part of IRS Form 8606 is correctly inputting the dollar amount of your conversion in the appropriate lines, and if you stuck to the model of keeping the funds non-invested during the time frame, you’d have no issues on this.
One thought that I want to throw out there is that there are no current legal frameworks surrounding the backdoor Roth IRA. From an IRS standpoint, the deposit of funds into a non-deductible Traditional IRA is perfectly acceptable, as is the Roth conversion of said funds. If this weren’t legal, it wouldn’t be an allowable transaction as per the IRS regulations. However, in the past, there have been discussions around the steps upon which everything is taken and whether the intention of performing the above steps to contribute funds into a Roth IRA where otherwise non-allowed is acceptable.
Many in the financial advisor community would recommend their clients to take a delayed approach from when the funds have been deposited into a Traditional IRA and then ultimately converted to the Roth IRA. The thinking behind this is that while the overall process is not out of bounds, the results and the planned thought process of the conversion could likely be. Often, the advisor would end up recommending individuals wait months or even a year before they do the conversion. This delayed approach was recommended because if these steps are not taken in a simultaneous concerted effort, the process itself cannot be considered as one single step.
When it comes to that Step Transaction Doctrine as it is known, the IRS doesn’t have a way of determining when that initial deposit and the subsequent conversion was made. Nowhere on your tax documents do you notate a deposit date on the Traditional IRA, and nowhere on the tax documents does it notate a conversion date into the Roth IRA.
A lot has changed since this strategy was first thought out, and in 2017, the IRS and Congress seem to have finally put that caution aside when they brought forth the Tax Cut and Jobs Act. It appears that they had finally recognized the method as something that can be done and did so when they submitted the following in the Act:
“Although an individual with AGI exceeding certain limits is not permitted to make a contribution directly to a Roth IRA, the individual can make a contribution to a traditional IRA and convert the traditional IRA to a Roth IRA.”
And there you have it! The Roth IRA, with its tax-free income source upon retirement, should be a part of everybody’s plan. Those that are previously excluded from contributing directly to the Roth IRA due to exceeding income limitations can rest easy knowing that they, too, have a way to make this contribution.
That’s it for today, my friends. If you have more specific questions about the Roth IRA and how to make contributions to it, if you’re a HENRY, please feel free to reach out to me. If you have any questions on other topics or have topics you want to be explored, do drop me a line, and who knows, if it’s a fascinating topic, I can work creating an episode on it in the future.
For now, I wish you all an excellent rest of your week. Thanks for tuning in, please subscribe if you have not already and if you find the information useful, please share with your friends and family.