Tag Archives: Backdoor Roth IRA

The SECURE Act’s Impact on the FI Community

In late December 2019 the President and Congress enacted the SECURE Act. The SECURE Act makes some significant revisions to the laws governing IRAs, 401(k)s, and other retirement accounts. This post discusses the impacts of these changes on those pursuing financial independence.

The Big Picture

The SECURE Act is a big win for the FI community, in my opinion. 

The FI community significantly benefits from IRAs, 401(k)s, and other tax-advantaged retirement accounts. However, the federal government is facing increasing debts and annual deficits. That puts tax-advantaged accounts in the crosshairs. What Congress gives in tax benefits Congress can take away.

So what does the SECURE Act do? First, it actually gives us a couple more tax advantages during our lifetimes (see “Opportunities” below). Second, it significantly reduces the tax advantages of inherited retirement accounts for our heirs.

For those either with large retirement account balances or planning to have large retirement account balances, any change in tax laws is a potential problem. We should be glad that this round of tax law changes has occurred without our own retirement accounts being negatively impacted. Congress has passed the bill to our heirs, which, right or wrong, is a victory for us. 

When you see people in the financial press squawking about how awful the SECURE Act is, remember, it could be a whole lot worse–your retirement account could have been more heavily taxed during your lifetime! 

For those pursuing FI, the ability to use tax-advantaged retirement accounts remains the same, and in a couple small ways, has been enhanced. The next generation still has all those retirement account opportunities, even if they won’t be able to benefit from inheriting retirement accounts as much as they do under current law. 

Opportunities

Traditional IRA Contributions for those 70 ½ and Older

Starting in 2020, those aged 70 ½ and older will be able to contribute to a traditional IRA. This will open up Backdoor Roth IRA planning for those 70 ½ and older and still working. For those still working (or doing side hustles) at age 70 ½ or older, this is a nice change.

Remember, regardless of age, in order to contribute to an IRA, you or your spouse must have earned income. 

RMDs Begin at 72

For those attaining age 70 ½ after December 31, 2019, the age at which they will need to take RMDs will be 72, not 70 ½. This gives retirement accounts a bit more time to bake tax-deferred. It also slightly expands the window to do Roth conversions before RMDs begin. However, this last benefit is tempered by the fact that you must take Social Security no later than age 70. Roth conversion planning to reduce taxable RMDs should be mostly completed well before age 70 ½, regardless of this change in the law. 

Note that taxpayers can still make qualified charitable distributions (“QCD”) starting when they turn age 70 ½. While pre-age 72 QCDs won’t satisfy RMD requirements, they will (a) help optimize charitable giving from a tax perspective (by keeping adjusted gross income lower and avoiding the requirement to itemize to deduct the contribution) and (b) reduce future RMDs.

Annuities in 401(k)s

The new law provides rules facilitating annuities in 401(k) plans. This one requires proceeding with extreme caution. If your 401(k) plan decides to offer annuity products, you need to carefully assess whether an annuity is the right investment for you and you need to fully understand the fees charged. 

Remember, just because the law changed doesn’t mean your asset allocation should change!

Leaving Retirement Accounts to Heirs

This is the where the SECURE Act raises taxes. The SECURE Act removes the so-called “stretch” for many retirement plan beneficiaries. For retirement accounts inherited after December 31, 2019, only certain beneficiaries will be able to stretch out distributions over their remaining life (or based on the age of the decedent if over 70 ½ at death). For nonqualified beneficiaries, the rule will simply be that the beneficiary must take the account within 10 years of the owner’s death (the “10-year rule”).

My overall opinion on the SECURE Act stated above, planning for the next generation is important. Particularly if you are already financially independent and want to help your children become financially independent, the SECURE Act has significant ramifications.

Spouses

If your current estate plan features your spouse as your retirement account primary beneficiary, the SECURE Act should in no way change that aspect of your plan. Fortunately, the many advantages applicable to spouses inheriting retirement accounts will not change. Spouses remain an excellent candidate to inherit a retirement account. 

Minor Children

If you leave your retirement account to your minor children, they are exempt from the 10-year rule (and can generally take distributions based on IRS RMD tables that are generous to younger beneficiaries) while they are still minors. Once your children reach the age of majority, they will have ten years to empty the retirement account. 

The exception to the 10-year rule applies only to your minor children. It does not apply to your grandchildren, your adult children, and the children of others (including nieces and nephews). 

Other Eligible Beneficiaries

The exceptions to the 10-year rule apply to your spouse, your minor children, the disabled, the chronically ill, and persons not more than 10 years younger than you at your death. All others will need to empty retirement accounts within 10 years of inheritance. This will require some significant planning in cases where the beneficiary has inherited a traditional retirement account to strategically empty the account over the 10 year window to manage adjusted gross income, taxable income, and total tax. 

Planning

For those of you with estate plans involving adult children, the passage of the SECURE Act may well require revisions to your plans. First off, as a practical matter, your revocable living trust may need modifications. Many have designated a trust as a retirement account beneficiary. To do so properly requires conforming with specific income tax rules. Those with trusts as the beneficiary of their retirement account would be well advised to, at a minimum, consult with their lawyer to determine if the language of the trust needs updating.

Second, understanding that inheriting a traditional retirement account will now mean accelerated, and possibly significantly increased, taxation for their heirs, many will want to consider Roth conversion planning. Roth accounts will be subject to the 10-year rule, but the good news is that the beneficiary can keep the assets in the Roth account for 10 years, let it grow tax free, and then take out the money in 10 years tax free. Not too bad.

Roth conversion planning to optimize your heirs’ income tax picture is now even more important. However, it should not be done if it will impose a financial hardship on the account owner during their lifetime. The first priority should be securing the account owner’s retirement. Only if the account owner is financially secure should they consider Roth conversion planning to reduce their heirs’ tax liability.

Conclusion

Tax rules are always changing. This round of changes is a victory for those pursuing financial independence. Any tax law change that does not negatively impact your path to financial independence is a win. 

For those considering the financial health of their heirs, particularly their adult children, the SECURE Act should prompt some reconsideration of estate plans. Often it is wise to consult with professional advisors in this regard. 

FI Tax Guy can be your financial advisor! FI Tax Guy can prepare your tax return! Find out more by visiting mullaneyfinancial.com

Follow me on Twitter: @SeanMoneyandTax

This post is for entertainment and educational purposes only. It does not constitute accounting, financial, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, legal, and tax matters. 

Fixing Backdoor Roth IRAs

Watch me discuss Backdoor Roth IRA tax return reporting on YouTube.

The word is out. The Backdoor Roth IRA is a powerful tax planning tool. You may believe that by previously executing Backdoor Roth IRAs, you have planned well and received a great tax benefit while building retirement savings.

Is it possible you are mistaken? It is possible you did not complete the Backdoor Roth IRA correctly? 

It may be true that you have successfully completed the two independent steps of a Backdoor Roth IRA: a traditional, non-deductible IRA contribution followed by a later Roth IRA conversion. It may also be true that you had no balances in a traditional IRA, SEP IRA, and/or SIMPLE IRA as of December 31st of the year you did the Backdoor Roth IRA. 

Year-end tip: The deadline to clean out traditional/SEP/SIMPLE IRAs (by rolling them into employer retirement plans such as 401(k)s) so as to optimize a Backdoor Roth IRA is December 31st of the year of the Roth IRA conversion step. As a practical matter, you should not complete the Roth IRA conversion step until you have cleaned out the traditional/SEP/SIMPLE IRAs. Life happens; there is simply no guarantee you complete the clean out before December 31st. Failing to do so will significantly increase the tax on your Backdoor Roth IRA. 

But you may not have correctly reported the Backdoor Roth IRA on your tax return. This last step is too-often overlooked. Below I discuss how to properly report a Backdoor Roth IRA, a potential tax return mistake that could have cost you thousands in erroneous taxes, and ways to fix the mistake. 

Backdoor Roth IRA Example

Charlie is single and 35 years old. He is covered by a retirement plan at work. In 2018 his W-2 salary was $200,000, and thus he did not qualify to make a Roth IRA contribution for 2018. He has no balance in a traditional IRA, SEP IRA, or SIMPLE IRA. He decides to do a Backdoor Roth IRA. 

On September 2, 2018, Charlie contributed $5,500 to a traditional, non-deductible IRA. On October 10, 2018, he converted the entire balance in the traditional IRA, then $5,510, to a Roth IRA. 

So far, so good with the Backdoor Roth IRA! But Charlie’s not done yet. Let’s look at how the Charlie should file his tax return and the pitfalls he should avoid.

Backdoor Roth IRA Tax Return Reporting

Early in the year, Charlie should receive a Form 1099-R that looks like the following from his financial institution.

Charlie’s Backdoor Roth IRA Form 1099-R should look something like this. Note that the “taxable amount” is the full conversion amount ($5,510) and the box indicating that the taxable amount has not been determined is checked.

This requires precise tax return reporting to ensure Charlie increases his taxable income by the correct amount to account for the Backdoor Roth IRA. An error in the tax return reporting could erroneously overstate his adjusted gross income and thus cause him to pay significantly more to the IRS and state tax agency than he owes.

There are two places Charlie needs to report the Backdoor Roth IRA: Pages 1 and 2 of Form 8606 and lines 4a and 4b of the Form 1040.

Let’s start with the Form 8606. Below is the correct way for Charlie to file Page 1 of his Form 8606.

Lines 1, 6, and 11 of the Form 8606 are crucial to properly reporting a Backdoor Roth IRA and computing the nontaxable portion of the Roth IRA conversion.

Notice a few things about this form. First, on line 1 Charlie reports his traditional, non-deductible IRA contribution of $5,500. Second, on line 6, Charlie reports the total combined value of his traditional IRAs, SEP IRAs, and SIMPLE IRAs as of December 31, 2018. He can find this number on the Forms 5498 that his financial institutions send him and the IRS regarding his IRA accounts. To have a very efficient Backdoor Roth IRA, ideally Charlie should no balance in these accounts on December 31, 2018, and thus Charlie can, and does, report zero on line 6. If Charlie has any such balances the total must be reported here and it will cause his Backdoor Roth IRA to be partially (maybe mostly) taxable. 

Next, Charlie reports his Roth IRA conversion amount on line 8. This is the total taxable amount he converted, reported to him in Box 2 of the Form 1099-R, $5,510. The mechanics of the Form 8606 then lead to lines 11 and 13, the nontaxable portion of Charlie’s Roth IRA conversion. In Charlie’s case, this is $5,500. This is because he is entitled to recover all $5,500 of basis he has in his traditional IRA (as computed in this part of the Form 8606). This $5,500 number is required to correctly prepare Page 2 of the Form 8606 and line 4b of the Form 1040.

Form 8606 Line 18 should be reported on Line 4b of Form 1040 for a 2018 Backdoor Roth IRA.

Page 1 computed how much of Charlie’s basis he can recover and the nontaxable portion of his Roth IRA conversion. Page 2 answers the second question: How much of Charlie’s Roth IRA conversion is taxable? Line 16 is simply line 8, and line 17 is simply line 11. Subtracting the nontaxable portion of the Roth IRA conversion from the total converted amount yields the amount of the Roth IRA conversion that is taxable. In Charlie’s case, it is only $10. This amount goes to Charlie’s Form 1040, line 4b. 

This is how a Backdoor Roth IRA should look on your Form 1040. Notice the very small number on Line 4b.

The Wrong Way

The following is what Charlie’s Form 1040 might look like if his Backdoor Roth IRA is misreported. 

Heed the warning of my chicken scratch: a four figure number on Line 4b after a Backdoor Roth IRA is likely an indication that either the tax planning or the tax reporting is off.

How might this happen? It could be that a Form 8606 simply was not prepared, or it was incorrectly prepared. Sometimes the Form 1099-R is misunderstood. People see that $5,510 is the “taxable amount” in line 2 of the Form 1099-R and believe that must be the taxable amount reported on line 4b. But remember, the Form 1099-R has a box checked indicating that the taxable amount is not determined. The Form 8606 is what determines the taxable amount created by the Backdoor Roth IRA (in Charlie’s case, $10). 

As a check, you should ensure that the Lines 18 of your previously filed Forms 8606 agree to the appropriate line on the Form 1040 (line 4b in 2018). If there are discrepancies (and/or a Form 8606 was not filed for a Backdoor Roth IRA), that is an indication there is likely an error on the tax return. If Line 18 on the Form 8606 is a four-figure or greater number after a Backdoor Roth IRA, it is very likely that either the tax planning or the tax return reporting went wrong somewhere.

We can see how deleterious this error is for Charlie. If he filed his tax return the wrong way, his federal taxable income is overstated by $5,500. In his case, this caused him to erroneously owe $1,760 more in federal income tax ($43,613 minus $41,853 — hat tip to ProConnect Tax Online for the tax calculations). If Charlie lives in a state with a state income tax, he will also overpay his state income taxes because of this error. 

Filing an Amended Tax Return

Imagine that Charlie filed his tax return as pictured in the Wrong!!! picture above. What can Charlie do?

Charlie’s remedy is to file an amended return. This entails refiling the Form 1040 and all of its related forms and schedules (including the Form 8606) with the correct amounts. It also entails filing a Form 1040X. This form presents amounts as originally filed and as corrected, with the difference illustrated. It also requires a narrative submission explaining the changes made on the amended tax return.

There are several things to keep in mind when filing an amended tax return. First, a taxpayer filing an amended return is under an obligation to correctly report amounts. If, as part of the exercise of fixing a Backdoor Roth IRA through an amended tax return, the taxpayer learns that other amounts on the originally filed tax return were incorrect, he or she must correct those amounts if they choose to file an amended return. 

Second, there is a deadline for amending a federal income tax return (the so-called statute of limitations). Generally, the deadline is three years from the later of the tax return due date (if originally filed on or prior to the initial tax return due date) or the filing date (if filed after the initial tax return due date). This later deadline applies anytime the taxpayer files after the initial due date (including, for example, a timely post-April 15th tax return filing made after filing for an extension). 

If the amended return claiming the refund (because of the corrected Backdoor Roth IRA tax return reporting) is filed after this three year deadline, the IRS cannot and will not issue a refund to the taxpayer due to the statute of limitations. There are limited exceptions to this rule (such as when the IRS and the taxpayer have mutually agreed to extend the statute of limitations). 

States have their own statutes of limitations, which may or may not be the same as the federal statute of limitations. In my home state of California, it is a four-year statute of limitations instead of a three-year statute of limitations. 

The statute of limitations means the clock is ticking to correct Backdoor Roth IRAs not correctly reported on previously filed tax returns. In many cases, taxpayers learning they have incorrectly filed a tax return (for whatever reason, including an erroneously reported Backdoor Roth IRA) are well advised to seek professional assistance in amending their tax returns. 

Further Reading

I have previously blogged about Backdoor Roth IRAs for beginners here and about tactics to employ if you want to do a Backdoor Roth IRA but currently have a balance in a traditional IRA, SEP IRA, and/or SIMPLE IRA.

FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com

Follow me on Twitter: @SeanMoneyandTax

This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.

SEP IRA Versus Solo 401(k)

If you qualify for both a SEP IRA and a Solo 401(k), is there a clear winner? In the past, it was often the case that the tax benefits of a SEP IRA and a Solo 401(k) were similar, particularly if you also had access to a 401(k) plan at a full-time employer. Today the landscape has changed, and in most cases, there’s a clear winner.

This post discusses whether a SEP IRA or a Solo 401(k) is better in situations where the self-employed person qualifies for both plans.

Note that both plans have eligibility requirements. For example, under the tax rules, if you employ anyone other than your spouse for 1,000 hours or more during the year you are ineligible for a Solo 401(k). There are additional tax rules and separate (and additional) plan rules to consider to determine if you are eligible for a particular SEP IRA and/or Solo 401(k).

The Basics

Both the SEP IRA and the Solo 401(k) are self-employed retirement plans. They can be established by legal entities (in this context, often S corporations) or they can be established by individuals that have self-employed income. That self-employment income generally must come through a sole proprietorship or through a limited liability company (“LLC”) that is disregarded for tax purposes and reported on a Schedule C filed with the individual’s tax return. 

SEP IRAs

A SEP IRA allows only “employer” contributions. For this purpose, your own sole proprietorship or disregarded LLC can be your employer. 

Generally, the employer can make annual contributions of up to 25 percent of eligible W-2 compensation (from a corporation) or 20 percent of an individual’s self-employment income, limited to $66,000 of contributions in 2023.

Today, many financial institutions (including Fidelity, Schwab, and Vanguard) offer low-cost SEP IRA options.  

A SEP IRA can be established for a tax year by the deadline for filing that tax year’s tax return, including extensions. 

The administrative compliance burden of a SEP IRA is generally very manageable. 

History of the SEP IRA vs. the Solo 401(k)

Watch me discuss the history of both the SEP IRA and the Solo 401(k).

Solo 401(k)s

A Solo 401(k) (sometimes referred to as an “Individual 401(k)”) is a 401(k) plan established by a self-employed individual for their own benefit. 

The main advantage of the Solo 401(k) is that it allows annual contributions by the self-employed individual in his/her role as the “employee” and annual contributions by the self-employed individual (or S corporation) in his/her role as “employer.” 

Employee contributions are limited to the lesser of earned income or $22,500 ($30,000 if 50 or older) in 2023. Employer contributions are limited to up to 25 percent of eligible W-2 compensation (from a corporation) or 20 percent of an individual’s self-employment income, limited to $66,000 of contributions in 2023. Total employee and employer contributions are limited to $66,000 ($73,500 if age 50 or above) in 2022. 

Today, many financial institutions (including Fidelity, Schwab, and Vanguard) offer low-cost Solo 401(k) options.

The administrative compliance burden of a Solo 401(k) is generally very manageable, but note that once there are more than $250,000 in the plan and/or the plan is closed, a Form 5500-EZ must be filed.

The Clear Winner

At this point, you might be saying, “Great, both the SEP IRA and Solo 401(k) are attractive. Is there really a big difference between them? Should I care too much about which plan I establish?”

The answer is that in most cases, the Solo 401(k) is the much better option for a self-employed person. If you are considering a SEP IRA over a Solo 401(k) in a situation where you qualify for both, you ought to think twice about that decision.

Here are the main reasons why the Solo 401(k) is much better than the SEP IRA in most cases.

Employee Contributions

The Solo 401(k) allows employee contributions. If your self-employment income is relatively modest, this greatly increases the amount you could contribute. For example, if Jane, under age 50, has a side-hustle that earns her $10,000 in 2023 after the deduction for one-half of self-employment taxes is accounted for, her maximum Solo 401(k) contribution is $10,000, while her maximum SEP IRA contribution is only $2,000 (20% of $10,000).

Note that this assumes that Jane has contributed $12,500 or less to a workplace 401(k) or similar retirement plan. Using the 2023 limitations, $22,500 is the maximum total employee deferrals Jane can make to her 401(k) and similar plans, so Jane’s other employer retirement accounts should also be considered.

Section 199A and 80% Deductions

I have previously written about the new Section 199A qualified business income (“QBI”) deduction and its impact on self-employed retirement plans. Traditional contributions to both Solo 401(k) plans and SEP IRAs create, for many taxpayers, deductions that are only “80% deductions.” Here is an example.

After self-employment taxes, Joe, a single taxpayer, earns $120,000 from his sole-proprietorship. Joe makes a 10 percent employer contribution ($12,000) to either his Solo 401(k) or SEP IRA. In the 24 percent marginal tax bracket, he expects to save $2,880 ($12,000 times 24%) on his federal income taxes. He is surprised to learn that he only saved $2,304 on his federal income taxes. 

How is that possible? While Joe is correct that he receives a $12,000 retirement plan contribution tax deduction, he failed to consider that he lost $2,400 of his QBI deduction. A traditional Solo 401(k) contribution and a SEP IRA contribution is an 80% deduction. In Joe’s case, he received a net federal income tax deduction of only $9,600 (80 percent of $12,000). 

Why then would Joe prefer a Solo 401(k) to a SEP IRA? Because the Solo 401(k) gives him a planning option that avoid the 80% deduction issue. Instead of making traditional contributions to a Solo 401(k), Joe can make Roth employee contributions to a Solo 401(k).

Note further that Joe could possibly implement Mega Backdoor Roth IRA planning by making after-tax contributions to his Solo 401(k). Many Solo 401(k) plans do not offer this option, but some do.

The SEP IRA does not offer these options. 

Not all financial institutions offer the Roth Solo 401(k) and the after-tax Solo 401(k) contribution options. It is important to understand the features of any particular Solo 401(k) before you adopt it as your plan. 

For upper income taxpayers, the 80% deduction phenomenon may not be an issue, considering that the ability to claim the QBI deduction is reduced or eliminated above certain income thresholds. These taxpayers need not prefer the Solo 401(k) to a SEP IRA for QBI deduction reasons, but may prefer to have the increased planning ability, such as the ability to make Roth and/or after tax contributions to the Solo 401(k) that a SEP IRA does not offer. They may also prefer the Solo 401(k) for the reasons discussed below.

Backdoor Roth IRA Planning

The Backdoor Roth IRA is a great planning tool. But the Pro-Rata Rule can cause significant snags. For example, if you execute the two independent steps of a $6,500 Backdoor Roth IRA in a year when you have a separate significant traditional IRA, SEP IRA, or SIMPLE IRA at year-end, you will cause most of the Backdoor Roth IRA to be taxable. 

The SEP IRA is a significant roadblock to the ability to execute an efficient Backdoor Roth IRA. A Solo 401(k) does not cause this problem with the Backdoor Roth IRA. For this reason alone many will want to choose a Solo 401(k) instead of a SEP IRA, even if they plan on making traditional deductible contributions to the plan. 

Catch Up Contributions

If you are age 50 or older, you can make up to $7,500 (in 2022) in catch up employee contributions to a Solo 401(k).

This option does not exist for a SEP IRA. Thus, for high earning self-employed persons age 50 or older, a Solo 401(k) has an additional advantage over the SEP IRA.

Solo 401(k) Book

This post was originally published in 2019. In 2022 I published Solo 401(k): The Solopreneur’s Retirement Account, a book that goes into much more depth about Solo 401(k)s.

Conclusion

If you qualify for both, generally the Solo 401(k) is better than a SEP IRA. If you are going with a SEP IRA over a Solo 401(k), you should understand the reasons for doing so. Finally, self-employed retirement plans is an area that taxpayers usually benefit from receiving personal advice from a qualified tax advisor. 

FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com

Follow me on Twitter at @SeanMoneyandTax

This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here. 

What to Do if You Don’t Qualify for a Backdoor Roth IRA

In my last post, I discussed the basics of the Backdoor Roth IRA, which can be a great planning tool for some higher income Americans. But not everyone qualifies for a tax-efficient Backdoor Roth IRA. Recall Jennifer’s case:

Jennifer makes too much to qualify to make a Roth IRA contribution in 2022. She contributed $6,000 to a nondeductible traditional IRA on April 19, 2022. She also had a separate traditional IRA with no basis. As of December 31, 2022, that separate traditional IRA was worth $93,998.53.

If, in 2022, Jennifer were to convert the $6,000 that she put into the nondeductible traditional IRA to a Roth IRA she would increase her taxable income by over $5,600. Ouch!

Options

Jennifer has two possible options to qualify for a much more tax efficient Backdoor Roth IRA. The first option is to use her workplace 401(k), 403(b), or 457 plan. Some 401(k) plans and other workplace plans allow participants to “roll in” amounts in traditional IRAs. Workplace plans are not required to offer participants this option. If a workplace plan does, it can be worthwhile to consider this option in order to facilitate Backdoor Roth IRA planning.

Of course, there are considerations that go beyond income tax planning, including the quality of the investment choices available in a traditional IRA versus a workplace 401(k) or other retirement plan, and the expenses associated with each option.

A second option is rolling the traditional IRA into a Solo 401(k) plan. Jennifer must have a Solo 401(k) plan from self-employment and the plan must accept IRA roll ins in order for her to do this. As with workplace retirement plans, Solo 401(k) plans are not required to accept traditional IRA roll ins, and any decision must appropriately consider the relevant non-tax issues (as discussed above). Further, a Solo 401(k) plan has several requirements (including the conduct of a trade or business) that should be carefully considered before opening a Solo 401(k).

Considerations

Trustee-to-Trustee Rollover

If Jennifer wants to roll her traditional IRA into a workplace retirement plan or Solo 401(k), she should structure the transfer as a “trustee-to-trustee” direct rollover of the money between the financial institution holding the traditional IRA and the workplace retirement plan or Solo 401(k). If instead of a trustee-to-trustee direct rollover, Jennifer receives a check from her IRA financial institution payable to her, she has 60 days to roll over that check (i.e., to get it to her workplace retirement plan or Solo 401(k)). If she does not move the money within the 60 days, the distribution from the IRA is taxable, subject to early withdrawal penalties if Jennifer is under age 59 ½, and cannot be transferred into a retirement plan.

Timing

Roll ins should be completed by December 31st of the year of the Roth IRA conversion. Otherwise the pro-rata rule will bite, because there will be a balance in the taxpayer’s traditional IRAs at year-end. That balance will attract a sizable portion of the $6,000 of IRA basis established by the nondeductible traditional IRA contribution. This causes the Roth IRA conversion to grab little basis and thus be tax inefficient.

For simplicity’s sake, it is usually best to clean out traditional IRAs, SEP IRAs, and SIMPLE IRAs and then make the nondeductible traditional IRA contribution.

Basis

Prior to implementing a traditional IRA to 401(k) “roll-in” strategy, Jennifer should review all of her traditional IRAs to ensure that she has no basis in any existing traditional IRA. IRA basis amounts cannot be rolled into the 401(k) and must be left behind under the rule of Section 408(d)(3)(A)(ii) and this technical write up.

SIMPLE IRAs and SEP IRAs

Those with amounts in SIMPLE IRAs, need to be careful. During the first two years of the SIMPLE IRA account, it cannot be rolled into a plan other than another SIMPLE IRA plan. Doing so would create a taxable event, subject to both early withdrawal and excess contribution penalties (on the transfer to the non-SIMPLE IRA).

Thus, if Jennifer’s traditional IRA balance is in a SIMPLE IRA and she first deposited into the SIMPLE IRA less than two years ago, she must wait until the two year window has expired to roll her SIMPLE IRA into a workplace retirement plan or a Solo 401(k).

In addition, those with a SIMPLE IRA (beyond the two year window) or a SEP IRA from their current employer may not be allowed in-service distributions. Thus, they would not be able to roll over those accounts into a 401(k)/Solo 401(k)/403(b)/457. Additionally, amounts may be added to these accounts prior to December 31st. These considerations make it difficult to successfully execute Backdoor Roth IRA planning for those currently covered by an employer’s SIMPLE IRA or SEP IRA.

December 31st

Any Backdoor Roth IRA planning should involve an additional diligence step: ensuring that as of December 31st of the year of the Roth conversion step, the taxpayer has a zero balance in all traditional IRAs, SEP IRAs, and SIMPLE IRAs. This helps ensure the Backdoor Roth IRA is a tax-efficient tactic.

Illustrative Example

Jennifer expects to earn $300,000 from her W-2 job in 2022, is covered by a workplace 401(k) plan, and expects to have some investment income. On March 1, 2022, Jennifer has a $90,000 balance in a traditional IRA but otherwise has no balance in a traditional IRA, SEP IRA, or SIMPLE IRA.

On March 2, 2022, Jennifer directs her workplace 401(k) plan and her IRA custodian to roll her traditional IRA to her workplace 401(k) plan. Her traditional IRA is rolled into her workplace 401(k) through a trustee-to-trustee direct rollover.

Jennifer contributes $6,000 to a traditional IRA on April 20, 2022. The contribution is nondeductible. Because the contribution is nondeductible, Jennifer gets a $6,000 basis in her traditional IRA. Jennifer must file a Form 8606 with her 2022 tax return to report the nondeductible contribution.

On May 2, 2022, Jennifer converts all the money in her traditional IRA to a Roth IRA (a Roth IRA conversion). At that time, Jennifer’s traditional IRA had a value of $6,001.47. Jennifer also ensures that as of December 31, 2022, she has a $0 balance in all traditional IRAs, SEP IRAs, and SIMPLE IRAs.

If Jennifer executes the above steps as described above, she will get the desired result. Done in this manner, the Roth IRA conversion step results in an increase in Jennifer’s taxable income of just $1.47 ($6,001.47 fair market value less $6,000 of traditional IRA basis).

Tactics vs. Goals

What if Jennifer’s workplace retirement plan does not accept roll ins? What if Jennifer doesn’t have access to a Solo 401(k)? What if Jennifer’s workplace retirement plan accepts roll ins but does not have quality investment options and/or charges high fees?

Remember, Jennifer’s ultimate goal is not to do a Backdoor Roth IRA. Her goal is financial independence! She should not let what I call the “tyranny of tactics” distract her from her ultimate goal.

The Backdoor Roth IRA is a great tactic to employ toward achieving that goal. But it’s okay if you can’t use this particular tactic. Plenty of people have and will achieve financial independence without executing a Backdoor Roth IRA.

If you can’t use the Backdoor Roth IRA for whatever reason, simply use other appropriate tactics, including but not limited to a high savings rate, to achieve your financial goals.

Further Reading

I discuss how to properly report a Backdoor Roth IRA on a tax return and what to do if has been incorrectly reported here.

FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com

Follow me on Twitter: @SeanMoneyandTax

This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.

Backdoor Roth IRAs for Beginners

If you read enough FI blogs, you will eventually come across the term “Backdoor Roth IRA.” This post answers the question “What’s the deal with Backdoor Roth IRAs?”

Why Do a Backdoor Roth IRA?

Why would someone do a Backdoor Roth IRA? The Backdoor Roth IRA gets money into a Roth IRA in cases where the taxpayer earns too much to make a direct annual contribution to a Roth IRA. Doing the Backdoor Roth IRA gets money that would have been invested in a taxable account into a tax-free Roth account. Further, the money in the Roth account gets better creditor protection than money in a taxable account.

History of the Backdoor Roth IRA

Before 2010, what is now referred to as a Backdoor Roth IRA would have been permissible and/or necessary in only relatively limited circumstances, and then only in years prior to 2008. But a 2006 change in the law opened up the Backdoor Roth IRA in the form we know now (starting in 2010).

Two fundamental concepts must now be addressed. The first is a Roth IRA contribution.

Roth IRA Contributions

This post discusses Roth IRA contributions in detail. Simplified, U.S. citizens and residents with earned income can make an annual Roth IRA contribution of up to $7,000 in 2024 ($8,000 if 50 or older). Done for many years, it can be a tremendous wealth building tool, since it moves wealth into an account that is tax-free (if properly executed).

The one catch is that your “modified adjusted gross income” (or “MAGI”) must be below a certain threshold in order to make a Roth IRA contribution. To make a full contribution in 2024, your MAGI must be less than $146,000 (if single) or $230,000 (if married filing joint).

Because of these limits, many taxpayers are unable to make a Roth IRA contribution. Further, based on the qualification rules for traditional deductible IRA contributions, most taxpayers unable to make a Roth IRA contribution are also unable to make a deductible traditional IRA contribution.

Roth IRA Conversions

The second fundamental concept is a Roth IRA conversion. A Roth IRA conversion is a movement of amounts in traditional accounts to a Roth IRA. This creates a taxable event. The amount of the Roth IRA conversion, less any “basis” in the traditional account (more on that later), is taxable as ordinary income on the taxpayer’s tax return.

Prior to 2010, only taxpayers with a modified adjusted gross income of $100,000 or less were allowed to do a Roth IRA conversion. This amount was not indexed for inflation and applied per tax return, making it particularly difficult for many married couples to qualify.

In 2006, Congress changed the law, effective beginning in 2010. As of January 1, 2010, there is no modified adjusted gross income limitation on the ability to do a Roth IRA conversion. The richest, highest earning Americans now qualify to do a Roth IRA conversion just as easily as anyone else.

The Backdoor

Okay, so there’s no MAGI limitation on the ability to execute a Roth IRA conversion. So what? Aren’t they taxable? What’s the advantage of doing one?

Recall I mentioned a taxpayer’s basis in a traditional account. Basis in an IRA occurs when a taxpayer makes a nondeductible contribution to a traditional IRA. Here is an example.

Mike expects to earn $300,000 from his W-2 job in 2024, is covered by a workplace 401(k) plan, and expects to have some investment income. Mike has no balance in a traditional IRA, SEP IRA, or SIMPLE IRA.

Mike contributes $7,000 to a traditional IRA on April 20, 2024. The contribution is nondeductible. Because the contribution is nondeductible, Mike gets a $7,000 basis in his traditional IRA. Mike must file a Form 8606 with his 2024 tax return to report the nondeductible contribution.

The “backdoor” opens because of the confluence of two rules: the ability to make a nondeductible traditional IRA contribution and the ability to do a Roth IRA conversion regardless of your income level. Let’s extend Mike’s example a bit.

On May 2, 2024, Mike converts all the money in his traditional IRA to a Roth IRA (a Roth IRA conversion). At that time, Mike’s traditional IRA had a value of $7,011.47.

What result? To start, all $7,011.47 is taxable. All money converted in a Roth IRA conversion is taxable. Uh oh! But there’s good news for Mike. Mike gets to offset the $7,011.47 that is taxable by the $7,000 of basis in his traditional IRA. Thus, this Roth IRA conversion will only increase Mike’s taxable income by $11.47 ($7,011.47 minus $7,000).

The combination of these two separate, independent steps (a nondeductible traditional IRA contribution and a later Roth IRA conversion) is what many now refer to as the Backdoor Roth IRA. Notice this is only possible because of the repeal of the MAGI limitation on Roth IRA conversions. Under the rules effective prior to 2010, Mike would have been allowed to make the nondeductible traditional IRA contribution, but his income (north of $300,000) would have prohibited him from a Roth IRA conversion.

The Backdoor Roth IRA allows Mike to obtain the benefits of an annual Roth IRA contribution without qualifying to make a regular annual Roth IRA contribution.

December 31st

Any Backdoor Roth IRA planning should involve an additional diligence step: ensuring that as of December 31st of the year of the Roth conversion step, the taxpayer has a zero balance in all traditional IRAs, SEP IRAs, and SIMPLE IRAs. This helps ensure the Backdoor Roth IRA is a tax-efficient tactic.

The Pro-Rata Rule

The Backdoor Roth IRA works well for someone with Mike’s profile. But it does not work well for everyone. Let’s change up the example a bit.

Jennifer’s story is the same as Mike’s story above, except that she had a separate traditional IRA before she did her 2024 nondeductible IRA contribution. That separate IRA had no basis. As of December 31, 2024, that separate traditional IRA was worth $92,988.53.

This one change in facts dramatically increases Jennifer’s taxable income from the Roth IRA conversion. Jennifer must apply the so-called Pro-Rata Rule to the Roth IRA conversion. Even though her two IRAs are in separate accounts, they are treated as one IRA for purposes of determining how much of Jennifer’s $7,000 of basis she recovers upon her Roth IRA conversion.

Jennifer starts with $7,011.47 of income (the amount she converts). To determine the amount of her $7,000 of basis she gets to recover against the proceeds of the Roth IRA conversion, we must multiply that $7,000 times the amount converted ($7,011.47) divided by the sum of the amount converted and her traditional IRA balance at the end of the year ($7,011.47 plus $92,988.53). Thus, Jennifer gets to recover 7.00147 percent of the $7,000 of basis, which is only $490.80. This results in Jennifer’s Roth IRA conversion increasing her taxable income by $6,520.67 ($7,011.47 minus $490.80).

What was a great idea for Mike becomes a horrible idea for Jennifer when she has a significant balance in another traditional IRA.

Note further that Jennifer would have the same bad outcome if that $92,988.53 traditional IRA was instead in a traditional SEP IRA or in a traditional SIMPLE IRA.

Tax Reporting

Assume Mike did his Roth IRA conversion and did not have any other money in traditional IRAs in 2024. He will get a Form 1099-R from his financial institution. In box 1 it will report a gross distribution of $7,011.47 (the amount of the Roth IRA conversion).

In box 2a the Form 1099-R will say that the “taxable amount” is $7,011.47 and box 2b will be checked to indicate that the “taxable amount not determined.” Wait, what? How can $7,011.47 be the taxable amount while the next box claims the taxable amount is not determined? The answer is the basis concept discussed above.

Mike’s financial institution does not know the rest of Mike’s story (his income, retirement plan coverage at work, IRAs at other institutions, etc.), so it has no way of determining how much basis, if any, Mike recovers when he did the Roth IRA conversion. Box 2b simply means that Mike might have recovered some basis, but the institution is not in a position to determine if he did.

Form 8606 helps complete the tax reporting picture. By filing that form, Mike establishes that he was entitled to $6,000 of traditional IRA basis and how the pro-rata rule applies (if at all) to his Roth IRA conversion. It is important that Mike file a properly completed Form 8606 with his timely-filed 2024 federal income tax return.

When Mike files his 2024 Form 1040, he puts $7,011.47 on line 4a (“IRA distributions”) and $11.47 on line 4b (“Taxable amount”). Most tax return preparation software will round cents to the nearest whole dollar.

Note that failing to report the transactions on the Forms 8606 and 1040 in this way can result in Mike paying an incorrect amount of tax.

Further Reading

This post discusses what you can do if you find yourself in Jennifer’s situation to get a result similar to Mike’s result. I discuss how to properly report a Backdoor Roth IRA on your tax return and what to do if has been incorrectly reported here.

FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com

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This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.