Podcast 96: Can Backdoor Roth Conversions Help to Create Tax-free Income?

When creating a retirement plan there are a lot of factors to consider, but have you heard about how converting your traditional IRA into a Roth IRA has the possibility of creating tax-free income in the future? Joining Gregory to discuss this topic is Jude Heath of J Heath & Co CPAs.


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Gregory Ricks  00:00

Hey, welcome. I’m your host Gregory Rick’s a financial advisor here to answer your questions and help you win with your money.

Podcast Intro / Outro  00:10

On today’s episode of the Ask Gregory podcast we have a longtime guest of the show Jude Heath, Co-founder of J Heath & CO CPAs. And he’s going to be joining Gregory to answer the question. Can backdoor Roth conversions helped to create tax free income in the future? We also have a complimentary download waiting for you on this topic. If you go to gregoryricks.com/podcast96 . Again, that is gregoryricks.com/podcast96

Gregory Ricks  00:36

Hey, I had a question what call or utilize the backdoor Roth because there’s a income rule that excludes you if your income reaches a certain level that you can’t do Roth contributions. There’s no income limit on Roth conversion, so he doesn’t have a traditional account. So he does a contribution to a traditional account and then converts it short time thereafter. And does that yearly for him and his wife, he’s over 50. So it gets 14,000 into his Roth account every year. By doing so but they don’t have any traditional accounts. Here’s the question. He’s thinking of moving money from his 401k this year, and wants to still get in his backdoor Roth contribution this year. And one reason he wants some of that money move because he’s doing a universal life insurance strategy for tax free income into the future. I told them that your backdoor Roth is and I haven’t looked it up. But I said I just don’t think Uncle Sam’s gonna let that fly that you shift to a traditional account and habit in an account traditional money besides what you’re doing on the backdoor Roth, because then they’re going to say no, that was pro rata. You can’t have that money come over and have a traditional account with value besides what you’re doing on the backdoor Roth, I think that’s a taxable event. And they’re going to pro rata reject that contribution. What do you think?

Jude Heath  02:26

I agree, we get pro rata exclusion problems all the time, when we run the numbers with clients, they’re opted out, they can’t backdoor or they can’t convert, because the pro rata problem.

Gregory Ricks  02:41

So backdoor Roth, and you’re seeing that, because this kind of stuff? Well. I moved that money in. But I also didn’t have it before I moved it in in the tax year, he’s trying to create an order of his own, not the order of the IRS, they’re going to look at was both in the same tax year, they don’t look at it by day or moth, they’re gonna say no, you cannot convert that whole $7,000 contribution, because you also had a traditional plan in place that year. So they’re going to fire it back where you were trying to do it. And they said, No, you can’t do that after tech convert that after tax contribution, you’re going to you can convert a portion of it, but it’s subject to the size of the traditional account, which you’re doing pro rata, you want to help them with pro rata, because I know we’ve done some people like what is pro right? It’s one of those weird words that will cost you tax dollars.

Jude Heath  03:45

So it’s simple in that to me, of course, numeric number with numbers wise, if your colors, are you, right, if you know, if your Roth is 10% of your other of your other investments, then they’re going to limit that, that Roth contribution to be just 10%, not the full amount. And so when we’ve run the numbers in the past, that’s the first thing we do is we say, well, you know, we don’t need just your your Roth piece that you’re looking to try to convert. We you know, we want all of your all of your qualified investments. And so we’ll talk about that we’ll add that up. And a lot of times when when we get down to the bottom number of clients to satisfiable I can’t I can’t do the full amount know what the IRS rules require you to only do the percentage piece of the total. And so it’s it’s just something you have to abide by the

Gregory Ricks  04:45

short answer I gave you erosion in proportion is what pro rata means. And if you and the core of that rule, you can do that backdoor Roth if you don’t have a traditional account With money in it, you can’t have a traditional account with any value because you’re setting up a traditional account and a Roth account. And that traditional account is taking the contribution only for that year. And then you can convert it because there’s no income limits, but you can’t say, Well, that’s an that was in another account that 100,000 Ira, now it’s in your name, so you can’t do it, you’re gonna be taxed in proportion, the IRS rule is pro rata. So remember that and if you have any questions, call my office call Jud? I’ll connect you with you. We can, we can help you with that. And once again, do it with planning, don’t do it spur of the moment. But that’s what they they make that assumption, oh, I can just convert my contribution, regardless of what you have. Now, if your money’s in your 401 K, that’s fine. You can do the backdoor Roth with a traditional account, but you can’t have an IRA account. So we were talking about what if you did a conversion, and we talked about this, you could do last or more subject to your margin in your tax brackets. What I mean by margin, let’s say in the 22% tax bracket, your household income is $100,000. That top of the 22% tax brackets 178,000. Plus, you get a standard deduction for both of you. What’s that around? 20k 25? Yeah, so that’s almost 100,000 margin right there. But let’s say if you’ve got a big old fat tax infested IRA, 401k, Jutes, like in that, yeah, tax infested a cow. And you kind of say, well, you could, you could shift as much as 100,000. But there’s a tax bill on that. But I talked earlier, what if you do 33,000 For three years in a row, so we’ll just keep it at that simple math, but you could end up doing less, you might say, well, you know, I’m in the 12% bracket, my income was 60 after deduction, so it gives you about a 23 month, you can you can convert 20,000 In that case, but earlier some 33,000 a year for three years. And that gets you to 100,000. And in 30 years, that could compound at 7.2%, hypothetically, to $800,000. And you only had to pay tax on 100,000, you made it simpler, because you said on the break, what’s the worst tax rate could be on that 33,000.

Jude Heath  07:44

While we were talking about most folks are in the 20s. And as you know, from doing a lot of returns, most folks, you know average a little small refund either, you know some child tax credits or something like that. And, you know, say a $3,000 refund, you know, if it costs you six $8,000 For this conversion, now you’re only out four or five. And if you plan it, the beauty of that is you could go up on your withholdings a little bit throughout the year, cost even less. And so it comes to the fact that it’s almost paid for anyway, when you do it in small increments like what you’re talking about.

Gregory Ricks  08:23

That’s one reason to look at the tax efficiency report, you provide one we provide one and look forward to kind of see what would be the impact of that plan for it don’t just on a whim, because when you do a Roth conversion. And I need to explain this you used to could change your mind. But a few years, they pulled that off the table, it was called RE characterization. It’s really no such thing anymore. Because once you do a Roth conversion, it’s done. So you need to look to what that tax bill is going to be because I had people re characterize like, Oh, that was clear of what the bill is going to be. But you know, when it actually shows up, it’s like, Oh, my God, I don’t want to do it now. When now when you do it, you have to you can’t change your mind. You can’t have regrets. It’s kind of like buying that f150 driving it off the lot. And the wife says Why did you do that? Take it back. I don’t know that. That’s such an easy thing to take that truck back. Okay. Well, that said, But you gave me a number if we do 33,000 When you kind of look at what’s the tax bill, so you don’t have any deductions for most people about $6,500 Is what you said Correct? Any we’re kind of good. Worst case. You said worst case Max taxpayer? About 11k? Yes. Okay. And if you can pay that now you’ve got 33,000 And for most people are probably most of the population are somewhere between two Well, the 24% most taxpayers are in that range that pay taxes, not everybody pays

Jude Heath  10:07

taxes, and most taxpayers get a little small refund. Yes,

Gregory Ricks  10:12

awesome. So it’s not that bad of a hit, then you and you have that 33,000 Go into an account, and it can start working. And then you do it two years in a row, you’ve got 100,000 there. And what if you didn’t do any more thereafter, it just didn’t work right for you, because now you’re in retirement, let’s say, and you just don’t have the room in your budget. But we can let that money compound. And that’s the magic of it is being able to put it to work and leave it alone for a good period of years. And if you could do so for 20 years, that 100,000 At 7.2% goes to 400,000. Here’s one of the other things regarding estate planning is when both of you die in the household, the husband and wife as an example, and you’re leaving it to your kids, they have to spend the money down in 10 years, these IRAs, these tax infested accounts that you have, they have to spend it down in 10 years, that’s that’s the rule going forward. If it’s a ra, so you’re not go back. It’s a traditional account, most of you are leaving behind tax infested accounts, so they gotta spend it down. They gotta pay taxes, it’s gotta go on top of their income and such, it’s not optional. It has to be done during the 10 years, finished out in bearing year 10. So you’re impacting and meaning you’re gonna cause that money to be taxed even more in the future, doing good thing by leaving it behind. But what if a chunk of that became that Roth and crew for 30 years? You’re leaving behind? 800,000 Yeah, they have to spend down but does it go on to 1042? It No, it does not it does not ever go on the 1040 Ross this kind of this magical thing that we have couple rules. That Roth hat account has to be alive for five years for you to take money out tax free and you’ve got to be beyond age 59 and a half couple simple things. No biggie because we want it to grow any other thoughts on tax savings

Jude Heath  12:31

so the main thing for us is you know to keep up with your your taxes and your your bookkeeping on a regular basis. If you have a small business, it’s just helpful to have all that pulled together where we can take a look at it on a regular basis and advise and really protect you from like you say making any tax missteps sometimes like like you were alluding to Gregory, you know, people, they get this big thing of, I’m, I’m going to I’m going to do something and then they do it immediately without consulting with an advisor and turns into a mistake so that proper planning is

Gregory Ricks  13:07

worth Yeah, I think it’s really important to reach out and get some guidance and help especially when you’re coming in the money. Don’t shortcut it. Have Uncle Sam sending you those letters later.

Podcast Intro / Outro  13:19

Thanks so much for listening to ask Gregory where we answer your financial questions. You can find us anywhere a podcast can be found and on YouTube and Facebook Live every Saturday from 10 to one subscribe, leave a review and tune in next time. And don’t forget we’ve got a complimentary download waiting for you on this topic if you go to gregoryricks.com/podcast96 Again that is gregoryricks.com/podcast96

Disclosure  13:49

Gregory Ricks & Associates is an independent financial services firm that utilizes a variety of investment and insurance products. Investment advisory services offered only by duly registered individuals through AE Wealth Management, LLC (AEWM). AEWM and Gregory Ricks & Associates are not affiliated companies. Gregory Ricks & Associates, The Total Wealth Authority is our trademarked tagline, it does not promise or guarantee investment results or preservation of principal nor does it represent a certain level of skill. Investing involves risk, including the potential loss of principal. Any references to protection, safety or lifetime income, generally refer to fixed insurance products, never securities or investments. Insurance guarantees are backed by the financial strength and claims paying abilities of the issuing carrier. Please remember that converting an employer plan account to a Roth IRA is a taxable event increased taxable income from the Roth IRA conversion may have several consequences including but not limited to a need for additional tax withholdings or estimated tax payment the loss of certain tax deductions and credits, and the higher need on taxes for Social Security benefits and higher Medicare premiums. Be sure to consult with a qualified tax advisor before making any decisions regarding your IRA. This podcast is intended for informational purposes only. It is not intended to be used as the sole basis for financial decisions, nor should it be construed as advice designed to meet the particular needs of an individual’s situation. Gregory Ricks & Associates is not permitted to offer and no statement made during this show shall constitute tax or legal advice. Our firm is not affiliated with or endorsed by the U.S. Government or any governmental agency. The information and opinions contained herein provided by third parties have been obtained from sources believed to be reliable, but accuracy and completeness cannot be guaranteed by Gregory Ricks & Associates. Any media logos and/or trademarks contained herein are the property of their respective owners and no endorsement by those owners of Gregory Ricks & Associates is stated or implied Gregory Ricks & Associates has a strategic partnership with tax professionals and attorneys who can provide tax and/or legal advice. AEWM, Gregory Ricks & Associates, WJ Blanchard Law, LLC, J Heath & Co. and Mortgage Gumbo are not affiliated companies. This show is a paid placement.