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A tax freight train is bearing down on your retirement. To protect yourself, you'll have to harness The Power of Zero.
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Hello. David McKnight. Welcome to The Power of Zero show. I’m the best-selling author of The Power of Zero, Look Before You LIRP, and as you found out last week, my latest book which is called The Volatility Shield: How to Vanquish the 4% Rule and Maximize Your Retirement Income. If you want to learn more about that book, please go to amazon.com. You can buy that book in paperback Kindle, and very, very soon, it will be out in Audible as well. I’m very excited to hear your feedback on that book. It's a little bit different, it's a novella, it's actually a plot that has characters and a cool twist ending. I hope you guys enjoyed the book that had a chance to read it already. If not, I would love it if you got a copy and posted your thoughts on Amazon by way of a review. By the way, you can also subscribe to this podcast, don't forget to do that. That way, every time we come out with a new episode, you get a little email ping in your inbox letting you know that it's there.
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Today, we are going to talk about two things. We're going to talk about the backdoor Roth which is not technically a Roth IRA, but it's a way to get money to the tax-free bucket in a more circuitous way. We're also going to talk about what are formerly known as Roth recharacterizations. They don't exist anymore but we're going to talk about the implications of that.
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First and foremost, let's talk about the backdoor Roth. Remember, with a Roth IRA, you have income limitations. When you start to hit $193,000 of modified adjusted gross income, the amount of money you can put into a Roth IRA begins to reduce. By the time you hit $203,000 of modified adjusted gross income, you can no longer do a Roth IRA. This is problematic for people that have a lot of taxable income in a given year. There is a way to get around this, but as usual, there are some strings attached—the IRS never lets you fully exploit any real gaping hole in the tax code—but let's work through this and see if we can understand what the possibilities are and then what some of the strings attached that we have to grapple with are. First of all, if you make more than $203,000 of modified adjusted gross income as a married couple, this is a great strategy to entertain. Basically, what happens is you do what's called a traditional IRA, it's not a Roth IRA, and I've got to warn you that with traditional IRAs, if you make too much money, you can no longer get a deduction for a traditional IRA. One of the great benefits of a traditional IRA is that you can deduct it against your taxable income, you decrease your taxable income now so that you can pay taxes on this later. Once you start making more than $123,000 of modified adjusted gross income, if you have a plan at work, you can no longer do a deductible IRA. You could do an IRA but you would just not be able to deduct it.
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Here's what a lot of people will do, especially those that make more than $123,000 and have access to a plan at work like a 401(k) or 403(b)—by the way, if you don't have access to a plan at work, you can make as much money as you want and still do a deductible IRA—but if you make more than $123,000, you can no longer deduct that IRA, which is not a problem because here's what we would do, let's say you contribute $7,000 to your IRA, you can't deduct it. For all intents and purposes, you're putting after-tax dollars into that IRA. It's now in your tax-deferred bucket. If you did nothing for now on out, then any growth that you would experience on that IRA would be taxable. The basis for that $7,000 that you contributed would not be taxable, but anything above and beyond that $7,000 that grows over time would become taxable. One strategy—this is the backdoor Roth strategy—says that you can convert that non-deductible IRA immediately to a Roth IRA, and because you did it immediately—when I'm talking immediately, it’s once you establish the IRA, you could literally do it the next day if you want, just sign in a piece of paper—you could convert that IRA to a Roth IRA, because you already paid taxes on that $7,000, you are not going to pay any additional taxation once it goes to the Roth IRA. In other words, you've put after-tax dollars into your IRA exactly like you might have had were you making a contribution to a Roth IRA, except it’s going into an IRA account, you sign one additional slip of paper that sends it over to the Roth IRA and now it's growing in your Roth IRA, or in your Roth conversion as it were, completely tax-free. It took an extra step but we ended up contributing $7,000 to a Roth-type account, it was just a little bit more of a circuitous route. This is what we call the backdoor Roth. If you have a plan at work like a 401(k), IRA, and you make more than $123,000, you can no longer deduct your IRA so you do what's called a backdoor Roth.
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Now let's talk about the strings attached. The IRS says that if you have money sitting in an IRA—not a 401(k), not a 403(b), what have you—but sitting in an IRA—I don't know nor do I understand the origin of this rule because it doesn't make sense for me, but this is one of the strings attached—if you have money in an IRA, you have to do one additional calculation. I'll give you an example here. Let's say that you have contributed $7,000 to this non-deductible IRA, let's also say that you have $100,000 sitting in a separate IRA. The IRS will force you to perform the following calculation: you'll take the money that's in that other IRA which is $100,000, you'll divide it by the total amount of money that's in your non-deductible IRA and in that other IRA—in this case, it would be $107,000—we would divide $100,000 by $107,000, that gets us to about 93%. Then what they would do is they'd say, “Okay, let's multiply 93% times the amount of money that you contributed to your non-deductible IRA which is $7,000.” We would take 93% of $7,000 that ends up being about $6,542, and you would actually have to pay tax on that conversion. You used after-tax dollars and then you paid another tax, feels very much like a double tax. You would probably want to seriously reconsider the backdoor Roth approach if you have money in an IRA. But what I have seen people do, which is shrewd, is you can actually roll your IRA into a 401(k), you now have no money in any other IRAs, and because 401(k)s do not trigger this extra calculation in this extra taxation, you would actually be able to perform the backdoor Roth conversion without any implications at all. This is a great strategy, however, what I would suggest is before you consider it, check out your portfolio. If you have money in other IRAs, you could end up feeling the pain for what feels like a double tax so be very, very careful before you undertake this strategy. If all your money is sitting in a 401(k) or 403(b) and you're making more than $123,000 threshold, feel free to do this strategy all day long.
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As for Roth recharacterizations, one of the interesting things about the Roth conversion is that you have to make up your mind about whether you want to do a Roth conversion by December 31st of any given year. It's not like a Roth IRA where you can postpone until April 15th of the following year to figure out if you want to do a Roth contribution for the prior year, with a Roth conversion, you have to make up your mind by December 31st, and really because Roth conversions can take some time, you should probably make up your mind about this by December 1st of any given year. But here's the issue, if you have to contribute, let's say in 2019, I want to do a Roth conversion in December of 2019, I really don't fully understand what the taxable implications are yet. I might not fully understand what tax bracket I'm going to be in. Why? Because I haven't done my taxes yet. I'm forced to make this very important decision about whether or not to do a Roth conversion before I even know what the taxable implications are. You might get a bonus at some point, you might have some extra income that comes in right before the end of the year, you may not fully understand the extent or implications of your deductions, what have you. Prior to the Trump tax cuts and the revision of the tax code, it used to be that you could do what's called a Roth recharacterization, in other words, you could undo the Roth IRA in the subsequent tax year if you felt like it wasn't a good deal or there are various implications if the stock market is up or if the stock market is down, you may feel like you want that money to grow either in an IRA or a Roth IRA, and depending on where the stock market is, you may change your mind.
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What happened is now, given the change in the tax code, you no longer have the ability to do a Roth recharacterization, in other words, if you decide in 2019 that you want to do a Roth conversion and then in 2020, you change your mind, guess what, there is no going back, there's no recharacterizing, there's no undoing what you just did. Why do I bring this up? It underscores the importance of (1) understanding the taxable implications of doing a Roth conversion, (2) it means that you probably need to work with someone that understands the implications of a Roth conversion, can take a look at your taxable situation, and can do a good job of surmising, as it were, what your tax bracket will be and what the taxable implications are. This is not something for the faint of heart, you do not want to do a Roth conversion if you don't understand the taxable implications. You have to remember that you no longer have the ability to undo what you've done. It has lasting implications. If you make the wrong move, then it could certainly come back to haunt you.
0:12:53
Today, we've talked about the backdoor Roth IRA, the big caveat there is you've got to make sure that if you decide to do it that you don't have money in other IRAs because you end up paying what feels like a double tax. As far as Roth recharacterization go, they no longer exist, so if you're going to do a Roth IRA, make sure you have all your ducks in a row, you understand the taxable implications even as hard as that is to do, meaning before you end up doing your taxes, if I had my way, I would have the IRS change that rule so you could do Roth conversions up until April 15th of the following year so that you can understand the implications of the Roth conversion itself. That's not the rule currently, so you need to understand that you need to be very intentional when undertaking a Roth conversion and fully understand the implications.
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Thanks for being on the show today. We will look forward to talking to you next week. Remember, subscribe and you can get our show emailed right to your inbox and you'll never ever miss a beat. Thanks for being with us. We will talk to you next week.
