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By John Bowens, Director, Head of Education and Investor Success – Equity Trust Company
Have you been told you don’t qualify to make a Roth IRA contribution because you make too much money? If so, there is an option you can explore, and it is referred to as the Backdoor Roth IRA contribution.
No, you will not find this terminology in an Internal Revenue Code (IRC) section, or Internal Revenue Service (IRS) Publication 590. This is a little-known, vastly misunderstood tax strategy that came into existence in 2010 when the tax laws changed, allowing all income earners to convert funds from a Traditional IRA to a Roth IRA.
A few months ago I published the article, The Great Retirement Plan Savings Crisis, which addressed the grim truth about a majority of Americans’ financial health in their retirement years. Over the last 15 years, I’ve taught thousands of investors about self-directed IRA investing in real estate and other alternatives. If there is one thing I learned, it is that individuals fail to maximize the potential of savings vehicles like Roth IRAs because they don’t understand the rules or were misguided.
A Roth IRA is referred to as an after-tax savings account, while a Traditional IRA is referred to as a pre-tax savings account. In other words, with a Traditional IRA, you don’t pay taxes on the money going in, but you are required to pay taxes when you begin pulling the money out. Be aware that if you withdraw funds for non-investment purposes prior to the age of 59½, you face a 10-percent penalty and income taxes. With a Roth IRA, you pay taxes on the money going in; therefore, there are no taxes when you distribute funds.
An easier way to think of the difference in tax environments: with a Traditional IRA you don’t pay taxes on the seed (contributions), so you have to pay taxes on the crop (withdrawals at retirement). On the other hand, with a Roth IRA, you pay taxes on the seed, so you don’t have to pay taxes on the crop. The Roth IRA can potentially be a powerful tax savings tool, as you are leveraging compounding interest in the absence of taxation.
The Roth IRA debuted in 1997, led by legislative sponsor Senator William Roth Jr. from Delaware. In fact, it took him multiple attempts to prevail in enacting into law the creation of the Roth IRA.
Tax law imposes income restrictions on those who want to contribute to a Roth IRA:
1. You must have earned income to contribute to a Roth IRA.
How do you define earned income? Think W-2 or 1099 income on which you are paying income taxes and payroll taxes (Social Security and Medicare).
As a real estate investor and teacher of real estate investors across the country, I find some individuals have a lot of income, but it is all classified as passive income.
For example, if you only have rental income, none of which you would likely be paying payroll tax on, you are not eligible to contribute to a Roth IRA. That said, if you have existing Traditional IRA funds, you can convert to a Roth IRA, which we will detail further in a moment. If you are retired and only have Social Security income, or pension or other retirement savings account income, this also is not considered earned income.
2. If you make too much money, you don’t qualify for a direct contribution to a Roth IRA.
To understand income limits for a Roth IRA, you need to know your Modified Adjusted Gross Income (MAGI). You might be thinking, what is MAGI? Your AGI could very well be the same as your MAGI. MAGI adds back in some exclusion from your AGI, such as student loan interest deductions and foreign earned income exclusions. For more information, visit the IRS website. If you are unsure, check with your CPA or tax professional.
These MAGI limits are going to depend on whether you are a single filer, married filing jointly or separately, and of course, the year in which are you making the contribution. For tax year 2022, the limits are as follows:
If your income falls beyond the MAGI limits discussed above, you may want to consider the “backdoor Roth” approach: First contribute to a Traditional IRA, which carries no MAGI restrictions, then immediately convert the Traditional IRA to a Roth IRA.
How is this possible? Prior to 2010, if you made over $100,000 MAGI, you were not permitted to convert from a Traditional IRA to a Roth IRA. In an effort to increase tax revenues, the law changed in 2010 allowing all income earners to convert funds from a Traditional IRA to a Roth IRA, opening up this backdoor approach.
Please be sure to read on as there are important considerations before initiating this process with your IRA custodian.
Video: How to Make a Backdoor Roth IRA Contribution
First, you have to understand non-deductible Traditional IRA contributions. When you or your spouse have a workplace retirement plan, such as a 401(k), 403(b), TSP, etc., and you are over a certain income amount, then your contributions to a Traditional IRA are not tax-deductible.
Let’s pause here because this one of the biggest misunderstandings in the retirement planning arena. People are told, or wrongly believe, “You can’t contribute to a Traditional IRA because you or your spouse have a workplace retirement account and make too much money.”
This is so far from the truth – you can still contribute; you just don’t receive a tax deduction. It is important to understand tax-deferred savings vs. taxable savings, whereby you are paying taxes on income in each year you generate profit. If you make a non-deductible contribution, you will need to complete a Tax Form 8606 included in your tax return. We encourage you to speak to your CPA or accountant who prepares your taxes.
The MAGI limits are as follows (2022):
When you make non-deductible contributions to a Traditional IRA, those funds are considered after-tax, so you don’t pay taxes on the amount when you withdraw it.
For example, let’s say you made a $6,000 Traditional IRA contribution that was considered after-tax. Through earnings and deductible contributions, you grow the account to $100,000. Now let’s say at 60 years old, you take $10,000 from the plan as a distribution. A portion of that amount will be taxable, and a portion won’t be taxable, attributable to the after-tax portion.
This determination of taxes upon withdrawal is what’s known as the Pro-Rata Rule.
The calculation is as follows:
$6,000 non-deductible contribution / $100,000 total balance of Traditional IRA = 6%.
$10,000 distribution x 6% = $600
$600 is non-taxable and $9,400 is taxable
When converting funds from a Traditional IRA to a Roth IRA, the same rules apply.
Keep in mind, the Pro-Rata Rule only takes into account money and assets held in a Traditional IRA, SEP IRA, or SIMPLE IRA. If you have 401(k)s, 403(b)s, TSPs, etc., those are not included in the calculation. For example, let’s say you have no other Traditional IRA funds and all your money is in 401(k)s. You can just simply contribute to the Traditional IRA and convert to the Roth IRA and not worry about the Pro-Rata Rule.
There is no reason to be fearful of the Pro-Rata Rule; you just have to understand the tax accounting associated with it. It’s always good to team up with a competent and understanding tax accountant or CPA. If they don’t understand, show them this article and ask them to research it for you. I work with many alternative asset investors, including real estate investors and private equity/hedge fund investors. I have found these investors to be incredibly passionate about tax-free savings and tax-free withdrawals and will pay extra to achieve that desired result.
Don’t allow this misunderstanding to create an adversarial relationship. This happens frequently, and it just takes some patience and understanding. Investing, financial planning, and wealth preservation is a team sport.
I have had the honor and privilege to educate thousands of financial professionals, including advisors and CPAs, as they assist their clients. Some investors prefer to take control of their retirement savings portfolio, thus becoming their own wealth manager. Many of these individuals invest away from the stock market and prefer to hold assets such as rental property, commercial real estate, land, private equity, private direct company investments, gold and silver, cryptocurrency, and other investments deemed “alternative.”
To aid in explaining this concept, I created this short YouTube video you can forward to your CPA or financial advisor.
Many 401(k)s now offer a Roth component, allowing you to make post-tax contributions. When you leave an employer, those funds can be rolled over into a Roth IRA. Note: there are no MAGI limits with a Roth 401(k).
If you are self-employed with no employees (with the exception of a spouse), you might consider a Solo 401(k) which, if set up properly, allows you to make post-tax contributions to a Roth component. Be aware that you have to meet the proper qualifications.
To explore this further, check out this educational video on YouTube:
Video: Solo 401(k) vs. Self-Directed IRA
Yes, you don’t have to perform this backdoor Roth IRA. If you have existing Traditional IRA/SEP IRA funds, you can simply convert them to a Roth IRA. The amount you convert is added to your ordinary income and you pay taxes accordingly. Some investors will convert in stages, meaning they will convert chunks year over year, thus lessening the tax burden over time.
Additionally, you might consider this movement towards the end of the year. For example, let’s say you convert funds in November. These funds will be present on your current year tax return. Then, just 60 days later you may convert another chunk of funds, which is presented on the next year’s tax return, thus spreading the taxes out over two years.
If you withhold funds from the IRA to pay for the taxes and you are under the retirement age of 59½, you will incur not just taxes, but also a premature withdrawal penalty of 10 percent on the amount you withhold. Alternatively, some investors pay for the taxes with outside funds to avoid this penalty and retain more tax-exempt dollars in their savings.
The first step is locating the right financial institution. If you are interested in investing in real estate and other alternative investments, you need a custodian that specializes in the custody of these unique assets. Equity Trust Company is a custodian that allows investors to invest beyond the stock market, in assets like real estate, notes, private equity, gold & silver, crypto currency and much more.
To fund a Roth IRA the “backdoor” way, you will need to request to open a Traditional IRA first and then a Roth IRA. Once you have contributed funds to the Traditional IRA, you then instruct your custodian to convert the funds to the Roth IRA.
John Bowens is one of the most sought-after and respected educators in the self-directed IRA industry, partly due to his unique ability to take a complex issue and break it down into simple-to-understand terms. Currently Director, Head of Education and Investor Success at Equity Trust Company, John draws from his 15 years in the real estate industry and his experience as an active real estate investor. In his travels across the U.S. and virtually, he has trained 60,000 investors during more than 300 workshops and classes, spreading the message about the power of building tax-free wealth and leaving a lasting legacy by investing in what you know best.
John contributed to the book “Self-Directed IRAs: Building Retirement Wealth Through Alternative Investing” with Equity Trust Company Founder Richard Desich, Sr., and has appeared on several national real estate and finance-related radio shows, including the Rich Dad Radio Show.
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