Tag Archives: Roth IRA

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.

Introduction

As this is being re-published (January 2021), we are in the third filing season of the new Section 199A qualified business income deduction. It is an area of the tax law that practitioners are still digesting.

I have previously written on the basics of the Section 199A deduction. This post builds on that introductory post. It provides analysis on rules from the IRS and Treasury and gives examples of how the deduction works in specific situations.

Takeaways

Deductions such as the deduction for one-half of self-employment taxes paid and the deduction for self-employed retirement plan contributions reduce the qualified business income (“QBI”) qualifying for the Section 199A deduction.

In many cases, Section 199A reduces the tax savings on traditional retirement plan contributions. Taxpayers may want to consider Roth employee contributions instead of traditional employee contributions to retirement plans because of this change.

Some taxpayers may want to prioritize contributions to traditional IRAs and HSAs instead of contributions to self-employed and small business retirement plans to maximize their Section 199A deduction.

Potentially powerful tax planning opportunities exist whereby taxpayers can reduce their taxable incomes such that they can go from no Section 199A deduction to a significant deduction. See Managing Taxable Income below for one example.

Many small businesses (including many sole proprietorships and S corporations) should not make charitable contributions, since these reduce qualified business income deduction. Rather, the owners of these small businesses should make charitable contributions in their own names.

The IRS and Treasury have provided a safe harbor under which rental real estate activities can qualify for the Section 199A deduction.

Dividends received from mutual funds and ETFs investing in domestic REITs can qualify for the Section 199A deduction.

Below are examples and commentary addressing Section 199A.

Side Hustler

Mike works a full-time job. His W-2 for 2018 reports $90,000 of wages. Mike also receives $1,000 of qualified dividend income (“QDI”) in his taxable account. Mike has a side hustle where he nets $10,000 in Schedule C profit. Mike pays $1,413 in self-employment tax on that profit. Mike claims the standard deduction.

Recall that the Section 199A deduction is the lesser of:

20 percent of your taxable income less your “net capital gain” which is generally your capital gains plus your QDI; or,
20 percent of your qualified business income (“QBI”).

The deduction for one-half of self-employment taxes is factored into the determination of QBI. Thus, in Mike’s case, his Section 199A deduction is the lesser of:

20% of Taxable Income: 20% times ($90,000 plus $10,000 plus $1,000 less $707 less $1,000 less $12,000 = $87,293) = $17,459; or,

20% of QBI: 20% times ($10,000 less $707 = $9,293) = $1,859

In this case, Mike’s Section 199A deduction is $1,859.

Mike’s taxable income is determined by deducting, for adjusted gross income, one-half of the self-employment taxes ($707) he pays with respect to his side hustle income. However, that deduction for half of his self-employment tax must also be subtracted in determining his QBI.

Note further that the Section 199A deduction does not reduce self-employment taxes. The Section 199A deduction is only an income tax deduction. It does not reduce the amount subject to self-employment taxes (in Mike’s case, $10,000).

Sole Proprietor with a Solo 401(k)

Lisa owns a sole-proprietorship that generates $100,000 of business income in 2020 as reported on Schedule C. Lisa pays $14,130 in self-employment taxes. Lisa contributed $19,500 to her traditional Solo 401(k), and makes an employer contribution to her traditional Solo 401(k) of $18,587. Lisa is married to Joe who makes $75,000 in W-2 wages. Lisa and Joe claim the standard deduction.

The deduction for retirement plan contributions is factored into the determination of QBI. Thus, in Lisa’s case, her Section 199A deduction is the lesser of:

20% of Taxable Income: 20% times ($100,000 plus $75,000 less $7,065 less $19,500 less $18,587 less $24,800 = $105,048) = $21,010; or,

20% of QBI: 20% times ($100,000 less $7,065 less $19,500 less $18,587 = $54,848) = $10,970

In this case, Lisa’s Section 199A deduction is $10,970.

QBI has the effect of making certain income “80% income.” What I mean by that term is that only 80% of the income is subject to income tax. This has a flip side – some deductions become only “80% deductions,” meaning that only 80% of the deduction generates a tax break.

Notice that the Solo 401(k) contributions reduce the QBI deduction. Thus, Solo 401(k) contributions are now “80% deductions” due to the QBI regime. For example, if your marginal tax rate is 22 percent, the marginal tax rate savings on your traditional 401(k) employee contribution is only 17.6 percent. But years later, when you withdraw the money from the Solo 401(k) the money will be “100% income.” You will not get a QBI deduction for those withdrawals.

I blogged more about the 80% deduction phenomenon here.

This will cause many sole proprietors to consider Roth Solo 401(k) employee contributions instead of traditional Solo 401(k) employee contributions, since the the tax savings on traditional self-employed employee contributions is reduced as a result of the QBI deduction.

Note further that for the Solo 401(k) employer contribution there is no choice to be made because there is no option to make a Roth employer contribution. All employer contributions must be traditional contributions.

Another observation: If Lisa and Joe had a low enough adjusted gross income (under $105,000) and Lisa made a deductible $6,000 contribution to a traditional IRA, that contribution would not have counted against her QBI. A contribution to a health savings account would also not have lowered her QBI.

For taxpayers whose Section 199A deduction is limited by 20% of QBI, contributions to traditional IRAs and HSAs should be favored over self-employment retirement plan contributions, since the IRA and HSA deductions are 100% deductions while the self-employment retirement plan contributions are 80% deductions. Hat tip to Jeff Levine who made the retirement plan contribution prioritization point on Twitter.

For taxpayers whose Section 199A deduction is limited by 20% of taxable income, contributions to traditional IRAs, HSAs, and self-employment retirement plans are all 80% deductions, and thus Section 199A normally does not factor into determining how to prioritize these contributions. However, all of these are tools taxpayers may be able to use to lower taxable income to qualify for a Section 199A deduction, as discussed in the Managing Taxable Income section below.

S Corporation

Assume the facts are the same as the previous example, except for the following differences. Lisa operates her business as a wholly-owned S corporation instead of as sole proprietorship. Before any sort of compensation, the S corporation makes $100,000. Assume that in this case, the S corporation pays Lisa $50,000 of W-2 wages, which is further assumed to be reasonable. Lisa makes employee contributions of $19,500 to her traditional Solo 401(k) from those wages. The S corporation makes the maximum employer contribution of $12,500 (computed as $30,500 of Box 1 W-2 wages plus $19,500 of elective deferrals times 25 percent). Thus, Lisa will have flow-through income from the S corporation (reported to her on a Schedule K-1) of $33,675 ($50,000 less $12,500 less $3,825 — the employer portion of the payroll tax).

Thus, in Lisa’s case, her Section 199A deduction is the lesser of:

20% of Taxable Income: 20% times ($50,000 plus $33,675 plus $75,000 less $19,500 less $24,800 = $114,375) = $22,875; or,

20% of QBI: 20% times ($33,675 — the QBI) = $6,735

In this case, Lisa’s Section 199A deduction is $6,735 because in the S corporation structure, the business income is split between a salary the S corporation pays her (which is not QBI) and the flow through profit of the S corporation, which is QBI (assuming it is domestic trade or business income).

The S corporation has various pros and cons from a tax perspective. Lower employment (payroll) taxes are a significant benefit, while lower maximum employer retirement plan contributions and lower Section 199A deductions are drawbacks.

Managing Taxable Income

Jackie is a lawyer operating as a sole proprietor. Law is one of several specified service trade or businesses (“SSTBs”) where the benefits of Section 199A are completely phased out if your taxable income exceeds $213,300 ($426,600 for married filing joint taxpayers using 2020 numbers). In 2020 Jackie has $240,000 of Schedule C income from the business. His self-employment taxes are $17,075 in Social Security taxes and $6,428 in Medicare taxes, for a total of $23,503 reported on Schedule SE. Jackie takes the standard deduction.

Jackie’s taxable income is thus $215,848 ($240,000 less $11,752 less $12,400). Because Jackie’s QBI is from an SSTB and his taxable income is above $213,300, he cannot claim any Section 199A deduction.

Now let’s add some tax planning to the scenario. Imagine that early in 2020 Jackie realizes he won’t qualify for the Section 199A deduction based on his numbers. He decides to open a Solo 401(k), which he can make an $19,500 employee traditional contribution to, and he can make an employer contribution of $37,500 for total contributions of $57,000 (the maximum allowed). This radically changes his Section 199A math, since (as will be demonstrated) his taxable income is now below $163,300. Once your income is below $163,300, you qualify for the Section 199A deduction only subject to the computational limits. Thus, in Jackie’s case, his Section 199A deduction is the lesser of:

20% of Taxable Income: 20% times ($240,000 less $11,752 less $12,400 less $57,000 = $158,848) = $31,770; or,

20% of QBI: 20% times ($240,000 less $11,752 less $57,000 = $171,248) = $34,250

Thus, Jackie’s Section 199A deduction is now $31,770! By managing his taxable income (by maximizing retirement savings), Jackie turned a $57,000 deduction into a more than $88,000 of deductions. Sure, the $57,000 deduction for retirement plan contributions is an “80% deduction,” but it creates the additional $31,770 of a Section 199A deduction (which is itself a “100 percent” deduction).

Jackie also lowered his marginal federal income tax rate from 35 percent to 24 percent and reduced his taxable income from $215,848 to $127,078!

Note that contributions to a health savings account would be another tool to deploy to lower your taxable income if you are concerned about Section 199A’s taxable income limitations.

Taxpayers bumping up against Section 199A taxable income limitations will likely need to prioritize traditional employee contributions to Solo 401(k) plans over Roth employee contributions. In addition, self-employed taxpayers bumping up against the taxable income limits in 2021 may want to establish 2021 Solo 401(k)s (if they are eligible to do so) to lower taxable income in order to qualify for the Section 199A deduction.

It will be wise for taxpayers to consult with tax advisors to run the numbers on Section 199A and other tax planning considering the complexity of the rules and the potential benefits of successful planning.

Charitable Contributions

The IRS gave us a bit of a head-scratcher in the instructions to the new Form 8995. The Form 8995 is used (starting with 2019 tax returns) to compute the QBI deduction. In the instructions, it states that charitable contributions reduce QBI.

Here is an example of how that rule would play out:

Cosmo is the sole shareholder of Acme Industries, an S corporation. In 2019, Acme reports QBI operating income of $100,000 to Cosmo on his Form K-1. It also reports $1,000 of charitable contributions made by Acme during 2019. The total QBI Cosmo can claim from Acme Industries is only $99,000, as the charitable contribution reduces QBI, according to the IRS. This is true even if Cosmo claims the standard deduction and thus has no use for the charitable contribution on his 2019 tax return.

Personally, I believe the IRS is on questionable ground in claiming charitable contributions reduce qualified business income. However, with some rather simple tax planning (which I generally believe to be prudent), you can avoid this issue altogether. If you want to make a charitable contribution, simply do so in your own name. Do not have your business — whether an S corporation, a small partnership, or a sole proprietorship, make the charitable contribution.

Rental Real Estate

The IRS and Treasury issued Notice 2019-7 and Revenue Procedure 2019-38 providing a safe harbor under which rental real estate activity can qualify for the Section 199A deduction. A safe harbor is a set of requirements, which, if satisfied, automatically qualify a taxpayer for a particular benefit. Stated differently, a safe harbor is a sufficient, but not necessary condition, to receive a benefit.

While rental activities that constitute a trade or business can still qualify for the deduction if they do not meet the requirements of the safe harbor, as a practical matter it will be much easier to sustain the deduction if you can qualify for the safe harbor.

Requirements

The requirements to satisfy the safe harbor with respect to any “rental real estate enterprise” (a “RREE”) are as follows:

Separate books and records documenting the income and expenses of the RREE must be maintained.

At least 250 hours per year of qualifying activity must be done with respect to the RREE.

Starting in 2020, detailed records documenting the time spent on the RREE must be maintained (see Revenue Procedure 2019-38).

A statement electing the application of the safe harbor must be attached to the tax return.

Multiple Rental Properties

Rental property can be combined for purposes of determining if you have an RREE. However, residential and commercial real estate cannot be aggregated and must be kept separate. Thus, at a minimum if you own both commercial and residential property, you have two RREEs, and you must apply the tests to each separately to determine if each RREE qualifies for the safe harbor.

Qualifying Activities

In a bit of good news, the 250 hours can be done by the owner, agents, employees, and/or independent contractors. However, many activities do not count toward the 250 hours, including building and long-term redevelopment, finding properties to rent, and arranging financing. Qualifying activities include collecting rent, daily operation of property, negotiating leases, screening tenants, and maintenance and repairs.

Triple Net Leases

Triple net leases do not qualify for the safe harbor. For purposes of the rule, these include “a lease agreement that requires the tenant or lessee to pay taxes, fees, and insurance, and to be responsible for maintenance activities for a property in addition to rent and utilities.”

House Hacking

For those using house hacking to pursue financial independence, there are several considerations. If you house hack by renting spare bedrooms in your primary residence (tenants, Airbnb, etc.), then you do not qualify for the safe harbor with respect to the rent generated by your primary residence. However, if your house hack consists of renting out separate units in a single building, the rental income could qualify for the safe harbor if (i) those other units are separate residences and not your own residence for any part of the year and (ii) you otherwise satisfy the requirements of the safe harbor.

REIT Mutual Fund Dividends

Dividends from REITs and REIT mutual funds can qualify for the QBI deduction. Generally, box 5 of Form 1099-DIV will indicate those REIT dividends which qualify as Section 199A dividends.

Example

In 2018 Luke makes $50,000 from his W-2 job. He operates a sole proprietorship that generates a $4,000 taxable loss (which would have been QBI had it been net income). Luke also receives $3,000 of dividends from the Acme Real Estate Mutual Fund, which he holds in a taxable account. Acme’s Form 1099-DIV provided to Luke indicates in box 5 that $2,400 of the dividends are Section 199A dividends. Luke claims the standard deduction. In Luke’s case, his Section 199A deduction is the lesser of:

20% of Taxable Income: 20% times ($50,000 less $4,000 plus $3,000 less $12,000 = $37,000) = $7,400; or,

20% of REIT Dividends: 20% times $2,400 = $480

Thus, Luke’s Section 199A deduction is $480. He gets this deduction even though the dividend was paid by a mutual fund and even though he had a QBI loss. His QBI loss will carryover to 2019, and will reduce his 2019 QBI that potentially qualifies for the Section 199A deduction.

Lastly, note that if Luke held the Acme mutual fund shares in a retirement account (traditional and/or Roth IRA/401(k), etc.) or a health savings account, the REIT dividend would not have qualified for the Section 199A deduction.

Conclusion

Even as of January 2021, taxpayers and practitioners are learning new wrinkles in the Section 199A QBI deduction. For taxpayers with side hustles and small businesses, it can represent a significant income tax break. Some taxpayers will need professional help to determine how best to maximize the deduction.