Episode 85: Advanced Roth IRA Strategies: Backdoor, Mega Backdoor & Tax-Free Retirement Planning
Welcome to episode 85 of Accessible Finance for Retirement! In this final installment of our Roth IRA miniseries, hosts Eric and Rachael Johns take you beyond the basics and dive deep into advanced Roth strategies that can help you maximize your retirement savings. Whether you're a seasoned investor or just starting to explore Roth accounts, this episode is packed with actionable insights and expert tips. What you'll learn in this episode: -The latest on Roth conversions and how to decide if they're right for you -Strategies for high-income earners, including the backdoor Roth -How to use Roth accounts for tax diversification in retirement -Common mistakes to avoid with Roth IRAs -Real-life scenarios and listener questions answered
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Read the Transcript
Episode 85
Episode 85
Eric: [00:00:00] Welcome to episode 85 of Accessible Finance for Retirement. I'm Eric Johns. And I'm Rachel Johns. Let's dive in.
Rachael: This is our third and final episode in our Roth miniseries, and this one's gonna dive into some advanced Roth strategies and how to maximize, maximize, maximize, maximize the, uh, tax-free growth that you have available.
Eric: Mm-hmm.
Rachael: All right. So Eric, I wanna start with, um, a backdoor Roth. It's something that people may have heard of, may not have heard of, but what is it? How do you do it? Why is it good?
Eric: It's just the name for a Roth conversion that you're planning to do with some regularity, really. But it doesn't even have to be that.
It's just [00:01:00] a Roth conversion. That's it. That's what a back door Roth is.
Rachael: But then why wouldn't they not just call it a Roth conversion?
Eric: Because the front door Roth conversion or a contribution rather, sorry, has limits. If you make too much money. And your income right on line 11 of your return, then, uh, that's just your a GI, sorry, but if you make too much income, they won't let you contribute through the front door.
So we're, but for whatever reason, this has been allowed since what, 2016 I believe it was. And people weren't quite sure if it was legitimate or not. But time and time again, Congress has had the opportunity to close the loophole and they have neglected to do so continuously. And there are now rulings that have essentially.
You know, legitimize the practice
Rachael: that, uh, Congress members are likely the ones to Yeah, they're using it for
Eric: sure. That's correct. But, sorry. Anyway,
Rachael: so it wanna to contribute to a Roth, but you exceed the income limits. Correct. This is your mm-hmm. Back door.
Eric: Yeah. This is the option that's available to you.
Right. So there are a couple. There are a couple things to look out for, right? The pro rata and aggregation rules [00:02:00] you'll often hear about and we'll talk about sometimes. Mm-hmm. Um, what that means is you can convert your IRA balances, but when you do so, you are treated as if you're converting a portion of your total I RRA balances.
Right? So they're gonna aggregate or put together all of your IRAs. Does that make sense? So if you have like a sep IRA, a simple IRA, um, contributory, IRAA rollover ira mm-hmm. Um, those are all going to be added together. Okay. All right.
Rachael: So let's say that I wanna pursue this strategy. Give me a brief step by step, like what it looks like, start to finish, right?
So I have money, I wanna get it into a Roth. I can't go directly into the Roth because I exceed the income limits, right? Right. So where do I have to put the money
Eric: first? So I'm going to make a direct contribution to a contributory IRA or just a traditional IRA at a brokerage house. So I might transfer $7,000 from my community [00:03:00] or our community property account at Schwab to my.
Individual IRA, right? Because it has
Rachael: to
Eric: be contributory, IRA, right? Yeah. So I'm just taking money from my taxable account, putting it into my contributory, IRA account. Mm-hmm. Right to
Rachael: your traditional account,
Eric: correct? Mm-hmm. Um, traditional contributory, IRA, and then I'm just going to press, move money from the contributory IRA.
Right? It could, it Schwab calls it move money. It could be whatever your, uh, custodian calls it, right? Yeah. You're just transferring funds. You're just making a funds transfer. Electronic funds transfer from your traditional IRA. To your Roth, IRA.
Rachael: All right, so money goes from me. From my taxable account into a traditional Yep.
Then I convert that from the traditional into the
Eric: Roth Roth. I'm, I'm really just moving it. Right. So I'm just moving it
Rachael: from left to right.
Eric: Correct. Nothing's happened from a taxation standpoint yet, although when you do the move money movement from the contributory or traditional to the Roth mm-hmm.
They will typically ask you to classify this. They will say, you know, is this a distribution or is this a, [00:04:00] they'll usually it's just a dropdown. It'll say conversion 'cause. You know, algorithms and digitization of, they're smart now. Finance is smart enough now to realize what you're doing. Yeah. And so you just check the little con, you just put the conversion box on there.
Rachael: Surely that can't be so
Eric: that they know where, where to put it on your 10 99. Your 10 99. Okay. But
Rachael: surely that can't be the whole thing. Right? So like IP contributed to my traditional converted from traditional to Roth.
Eric: Mm-hmm.
Rachael: Now what?
Eric: Now I choose my investments in my Roth and wait for my tax filing deadline.
And then. Add form 86 0 6 to my tax return. So
Rachael: seems pretty straightforward.
Eric: It is. It really is. Um, and 86 0 6, you can you free tax USA or TurboTax or any of those softwares will, you know, have those forms and they'll ask you questions. That'll make the entry a little easier. I will say that. That form adds a little bit of, it's, it's just tricky to fill it out correctly.
You kind of want to, you could probably, I don't wanna, I don't wanna say you can Google it, but you could [00:05:00] probably figure out what a correct, um, 86 0 6 should look like for like a $7,000 back door Roth, you, I'm sure that's available online. Mm-hmm. And then you just wanna make sure that the output that they produce for you, if you're self preparing, is similar to that.
Right. You wanna make sure that it looks right. But what's, what's basically happening is you're just, you're making a non-deductible contribution. Mm-hmm. And then that's going to make you have, or that's going to substantiate your basis in your IRA. So they'll say, what's your basis of your, um, contributory?
IRA total IRA basis is what they'll call it. Yeah. And it'll, you'll just write 7,000. Mm-hmm. Right. And then it'll say, total I a balance, and it'll also be 7,000. So then the taxability there is gonna be zero. But the idea is you're not taking the deduction on schedule one for your IRA contribution.
Rachael: Okay.
So then questions, sorry about of say I have. You know, I have my money, I've taken it from my, uh, bank account and I've put it into my traditional.
Eric: Okay.
Rachael: Right. Um, life got really crazy. Life got really hectic. I did not convert it into a Roth for three [00:06:00] months.
Eric: Right. Is
Rachael: that a problem? Is it complicated? Does that create any challenges?
Eric: Not if you're still before the end of the calendar year. So with a Roth contribution for through the front door, you have until your unextended tax filing deadline. So usually April 15th. Mm-hmm. Um, for a Roth conversion, it has to be done by the end of the tax year, which is December 31st. So you have to have done it then.
But if you, I mean, if you do it the, if you make the, um, contribution, you know, anytime, October or sooner, really, I mean, um, September or sooner, you should be good to go.
Rachael: Perfect. So, yes, you may have heard murmurings of, you know, talk of getting rid of the backdoor strategy. There have been zero movements to make that
Eric: happen.
Every time that they do a new, um, um, secure act or secure act 2.0, everybody thinks, you know, any kind of revisions of the tax code. Honestly, we think that it would be. There like that, they would close this back door, this loophole because like why would you [00:07:00] have a limit to contributions if you're simply going to allow a way around that limit regularly?
Everyone has the same option around the limit I guess. It gives, you know, it's another us and tax planners more to do. That's kind of nice of them. Thanks.
Rachael: I imagine it's, it's, it's an intimidating thing to take on though, because it's yet another step that you have to take. Where you're having to file the correct form and do the things the correct way and Sure.
So the intimidation factor may alone be enough to disincentivize a number of people from pursuing this very valuable strategy.
Eric: Right. And if we're speculating on why the government does what they do, a, we'll be here a while, but also, um mm-hmm. I mean, part, part of what they're doing right is they're allow, they want conversions to be, um, legal and permissible because when you do a conversion, you're paying the tax.
Right. So, sure. Gaining, gaining additional tax revenue is always gonna be there for them. They want tax revenue today at the expense of tax revenue tomorrow, because they're not in office tomorrow. They're there now. Yeah,
Rachael: that's fair. [00:08:00] Um, okay, so we've talked about the backdoor Roth. Um, there's also.
Something termed a mega backdoor Roth. Yeah. Which sounds fake.
Eric: It sounds fake. Sounds
Rachael: fake. Right, right, right, right. What is it?
Eric: Um, this refers to the strategy. Alright, let's. I'm trying to, I'm trying to think of the best way to start. Um, I think the best way to start is your 401k plan has to allow it. Not very, not many do.
Okay. Okay. So they have to, your 401k plan has to allow for after tax contributions. Okay. So all the 401k ks are gonna allow, um. I shouldn't say all. I'm sure there's some exceptions. Most of the 401k, the vast majority of the 401k programs are gonna allow you to defer up to the annual maximum, which in 2025 is $23,500.
Okay. And then more if you're over, um, if you're 50 or older. So I can defer, right? I'm 39, I can defer my 23,500, and then my employer can match some percentage. Mm-hmm. And then [00:09:00] there's an aggregate. Total contribution, um, threshold of $70,000 in tax year 2025. Okay, so some plans allow for you to make after-tax contributions to your 401k after you've already done the 25 done, the 23 5, right.
And then, so you can essentially do your after-tax contributions up to 70,000. But you have to subtract out what you've deferred. So you're 23.5 usually, and then what your employer has is matched, right. You wouldn't want to contribute more so that your employer doesn't have any room to match you. That would be really bad.
You would be leaving free money on the table, right? Like
Rachael: if I contribute 70,000, then they're like, oh, right, we already filled out, we exactly. Give you any dollar buckets
Eric: already full. Our hands are tied guy.
Rachael: Okay. Yeah, exactly.
Eric: So you can't do that. But, so the idea is you can make your after tax contributions.
Mm-hmm. Right? Um, once you've already filled up your tax deferred contributions and then these after-tax contributions, your four, your, so your 401k plan has to allow for after-tax contributions, and then they have to allow for either [00:10:00] in plan conversions, right? Or, I'm sorry. Yeah. In plan conversions or in plan distri or.
In-service distributions, right? So you either need to be able to convert your after-tax, um, contributions to your after-tax 401k, to a Roth 401k in your plan. And again, some plans allow it. Most don't. Yeah. But some do. Or they have to allow for in-service distributions, which means. Usually you have to separate from service, like you have to be fired or quit.
You know, before you can take money out of the, before you can really access your 401k funds in any meaningful way before you can transfer them to an IRA and do what you want with them. However, some plans, some 401k documents will allow you to. Um, withdraw from your 401k while you're still working there and an, and an active employee in the company.
Right? So I can make these, and this
Rachael: is very atypical,
Eric: correct? Correct. This, but it, it allows for a really, it it allows for some pretty neat planning opportunities, right? So you wanna be able to think about it if you're at one of the companies that's [00:11:00] going to allow this.
Rachael: If you're not sure if you're at one of the companies that would allow this, HR is your best friend.
Eric: Correct. Talk to hr. Look, you could, or you can read the summary plan description, which is, uh. Pretty long usually and kind of tedious.
Rachael: Tedious, yeah. I go to hr. Yeah. Probably just ask. Yeah, just go to, just go to hr. Right. So
Eric: the, just to,
Rachael: so the, but the Mega Backdoor essentially allows you to do the backdoor without the like limitation on the amount,
Eric: correct?
Right. So Backdoor Roth is typically thought of as the annual contribution to the Roth. Mm-hmm. So you take the annual contribution limit, which applies to both Roth. And traditional IRAs. Mm-hmm. Right? And then instead of making a traditional IRA contribution, you're gonna make a non, well, you are, it's still a traditional IRA contribution, but it's not deductible on your return because you've exceeded the income phase outs.
Rachael: Right.
Eric: I know this is all very. Ridiculous sounding. That's why this is our,
Rachael: our deep dive. Right, right. Roth.
Eric: But so the idea though is what you can do with [00:12:00] this mega backdoor Roth is it enables you to, first you can go through the front door Roth, but you're probably not able to, especially if you're able to defer the 23.5 plus the you, you know, additional able to do that.
Your income probably. Yeah. Your income's going to knock you out of all of these things, right? Yeah, yeah, yeah. So you can't really do the front door Roth. You can't do the back door, so you can do your $7,000. Um, non-deductible contribution. You can make that conversion, but then also you can contribute to your plan documents.
Remember the employer match plus your deferral. Subtract that from the annual maximum. You can then make that as a non-deductible contribution to your 401k. Mm-hmm. And then you can either roll that out, the piece that's the non or the. I'm sorry, the piece that is your basis, right? So the non-deductible portion of your contributions, not your deferrals, because that's to your pre-tax account, correct?
Right, but it's the non-deductible portion. You're going to roll that out either to your own Roth IRA, that's called an in plan distribution. Right. Or you can have an in plan conversion where you convert it from a non-deductible portion of your 401k [00:13:00] two a Roth 401k.
Rachael: If this is feeling It's a lot. It's a lot.
It really is. It is. It's awesome.
Eric: It's great. I was gonna say I love it. There
Rachael: are a handful of people in this world that love this stuff.
Eric: Put me in coach.
Rachael: He's one of them. Um, it's important even if you don't know all of the details and nuances of it, that just to know that this is an option and to know what qualifies you to be able to take advantage of this option.
Um, if you find that you are not at a workplace that allows for this, then. That's okay. Mm-hmm. Let go of everything you've heard of for now. Um, so we have discussed in the last episode the importance of record keeping and making sure that you are, um, keeping track of whether you're doing a conversion or contribution and how much and what dates.
And this still holds true. Um, now Eric, in addition to back doors and mega back doors mm-hmm. There's also been a lot of talk lately. [00:14:00] It's all over social media now as everyone has determined that they are now financial experts. Um, that,
Eric: I'm glad I missed it.
Rachael: Right? You missed all the things, but it's all over social media now.
Like how to like game the system in the, in your estate planning. Right. And one of the things that's talked about a lot. Is, um, Roth accounts and how they can assist with estate planning. Okay. So can you help bridge those two things that we just talked about? Roth? We've talked about estate planning previously.
What role do Roth accounts play in estate planning?
Eric: So we're typically talking about, there's, there's a, the. S the way to think about it, right, is the, the funds are either going to be usually in a tax deferred account or a tax free account. And so the cost of the tax deferred account is going to be the taxation of those funds, either to you or upon your state, to your heirs.
So if you have heirs that are doctors, right, lawyers, whatever, they're, they're in. Very [00:15:00] high bracket brackets. Maybe they're in the 37% tax bracket, but you yourself are retired and you're just collecting your dividends and social security and everything else, and so you're in the 22% bracket or 24% bracket.
There's a difference there that you could, you know, fill your 22, fill your 24, maybe even go further, maybe fill the 32, because still if you fulfill the 32 bracket, every dollar that you're converting in the 32% bracket, you're still saving 5% as a difference in taxation. Right. On your, for your heirs because they don't have to pay that tax at 37% rate.
Rachael: Now to be clear, in order to make these, in order to be aware of these decision points and to make these decision points, you have to be having very open and candid conversations with your, that's true. Heirs about money and finances. You have to be aware of what their tax bracket are. You may not feel comfortable doing that or be in the know on where they are.
Um. So some of these conversations can be quite delicate. It's important to start having [00:16:00] conversations about estate planning and, and things like that with your kids because, and we've talked about this in previous episodes, um, we can't know what's gonna happen when, and you certainly don't wanna leave your heirs in a rough spot, unfortunate position.
So do have those conversations. Um. You know, but you may not know exactly that they're in the 37, so you may not feel comfortable pushing all the way up to the 32, but you're pretty comfortable. They're somewhere in the thirties, right? So you might be all right. Pushing up to the 28 and,
Eric: and again, it doesn't have to be in one year.
Correct. So you can come up with a medium term plan that says over the next 10 years, we're gonna fill up the 22 and 24, because we're pretty sure that our heirs are gonna be in the 37%. Right. You can even do some creative planning where you. Leave the tax deferred assets to those heirs that are not in the 37%.
You know, maybe you have one son or daughter that's a teacher and one son or daughter that's, you know, a doctor, right. Or a surgeon or whatever is gonna insert very high paying profession here. If
Rachael: you have a wide variance in earning,
Eric: yeah, [00:17:00] then you might leave, you might consider, you know, consulting with, you know, a state attorney or a planner that's going to tell you, Hey, look.
The after tax equivalent of this tax deferred balance in the hands of your 22% bracket air is, you know, X and then the Roth, the Roth balance, you can tell, you know, it's just gonna be what it is, right? Because you've already paid the taxes on those dollars. But the point is here, the, the calculus that you should be doing, or the way to think about it is you're, instead of playing tax arbitrage with your current self versus future self in terms of tax brackets, now you're playing it.
Current self, future self plus heirs. Yeah. Does that make sense? You have another, particularly if Yeah. Like if, if leaving a legacy to your heirs is, is part of your, you know, if you're concerned with that, if you want to, it's spark your goals or your plan. Exactly. Yeah. Some people don't want that and that's okay.
Rachael: Exactly. And this, so this is yet another thing to think about. Like, is this something that interests me? Is this something relevant for my planning purposes?
Eric: Right.
Rachael: The answer might be no.
Eric: Absolutely.
Rachael: Um, alright, so then Eric, we, um, the final [00:18:00] topic. For today is about, uh, tax diversification in retirement and its purpose.
Um, because, you know, we've, we've had people write into the podcast talking about how they have only, um, tax deferred retirement plans, and now they're wondering like, why do they need a Roth? Or they have people who are in tax for plans going, oh gosh, like now I'm scared I don't have a Roth. Um, so how.
Does tax diversification like play out in retirement? Why is it important and how does the Roth account feed into that?
Eric: Great question. So long and short of it, we're trying to be super intentional about the rates that we're paying taxes. Mm-hmm. If we see that we are at a, in an our artificially higher or lower, um, anomalously, I guess higher or lower bracket than we think we're gonna be in the future, we wanna draw on the accounts that are gonna.
You know, bridge that gap. So if we think we're artificially high this year, right? Or we're, we're [00:19:00] marginally higher than we would be in the future, we might wanna just pull from a Roth, because we don't really wanna pay any more taxes right now. Yeah. In the, in the higher accounts. However, there might be a year where, you know, social security hasn't kicked in yet.
We, we retired last year, maybe. Now we want to either convert funds, so we wanna pay more in taxes, or we're just happy. We need to spend the money. Yeah. We need to get money to spend, you know, go eat sushi from somewhere. Yeah. So you just pull it out of the tax deferred account. Yeah. Right. Because you're happy to realize the, the taxation in the 22% bracket, um, this year so that you don't have to pay it in the 32% later.
Right.
Rachael: And as a reminder, you know, the three buckets that we're talking about are the taxable, the tax free and the tax deferred and the more like funding all three of those buckets. Having money in all three of those buckets allows for maximum flexibility. Right. To meet the needs of your life as it changes.
Eric: Mm-hmm.
Rachael: The reality is that the tax situation you find yourself in while you're married versus while you're a widow, is gonna be very, very different. Um,
Eric: well, that's true, unfortunately. Yeah.
Rachael: And then depending upon your age or when you've had [00:20:00] kids, if you go from having dependents to not having dependents, if you go from, um, you know, working to not working if you own your own business, and so income is just.
Eric: Highway variable.
Rachael: Yes. So there's so many reasons why, um, the blanket assumption that people, it's so outdated, but it was the, you know, very popular mindset of when you retire, your taxes go down, and that may not always be the case. Um, so being able to have maximum flexibility to meet the needs of your current tax situation year to year is.
Incredibly important.
Eric: It's also worth noting that you, you or your heirs will pay tax on your tax deferred balances. The government's going to get their hands on that money regardless. So we, that's, that's one we talk about. We wanna pay taxes when they are the lowest rate because there's no option to never pay taxes.
Mm-hmm. I understand that. Like deferring at some people just think I'll deferred forever and that can be [00:21:00] my kids' problem. Sure. But just know that like they are paying taxes. Like you didn't, you didn't like beat the government, you know what I mean? Like you didn't hide the money. Right. They're still getting access to it.
Rachael: And so that really goes down to. How you view your, um, legacy desires. And it may be like, I worked hard for this money, I don't wanna pay taxes in it. And then whatever's left over, like they can go ahead and pay taxes. Sure. If that is what you want, totally fine. We just impress upon clients, the people that we speak to, that you want to be fully aware of the decisions you're making before you are making them.
Eric: Right.
Rachael: Um. Okay. And so oftentimes, you know, we'll have clients who are very concerned with, like, I worked hard for this money. I want as much as possible to remain in in the family. Um, and so it's really appealing to be able to pay taxes at the lowest rate, whether it's correct now from me or later from my kids.
Eric: Correct. Most of what we're solving for is the highest after tax balance. In either for yourself, for your spending, or for your heirs, right? Like we're looking for the most money that we can get from [00:22:00] what you have now in after-tax dollars to you. Correct? 'cause all that matters is the after-tax dollars is gonna hit your account that you can spend, right?
That's what everyone really wants.
Rachael: Yeah. So then to conclude our three part series on Roth. Um, I think it's important to just kind of review some of the key benefits about, like incorporating Roths into your retirement planning. Mm-hmm. Um, so the first is that it's tax free growth and, um, the withdrawals provide protection against future, uh, tax rate increases.
Um, the second thing is that they don't have RMDs, so it allows you to have a bit more control over your retirement income. That's true. Um, it can be a valuable estate planning tool to create, uh, tax free I inheritance potentials for your heirs. Um, particularly as we said, those who are in higher brackets, high brackets, um, it can allow for a significant reduction of your lifetime tax burden.
And then there are advanced techniques that we talked about today, like the backdoor and mega backdoor Roth [00:23:00] strategies that can expand the tax free savings capacity if on surface you don't qualify for participating in the Roth. Um, alright, Eric, anything else that you want to say about raw?
Eric: Just that they provide a fantastic tool for planning purposes.
They allow us, particularly Roth conversions, allow us to be very intentional about when we pay taxes and that's what we're out, that's what we're after. We wanna be very intentional about when we pay taxes and we wanna do so at the lowest marginal effective rate. Again, that could be shortened to marginal rate if you don't have to think about things like Irma or social security taxation, or net investment income tax.
Those are typically the three things. There are others, you know, child tax credits and um. And potential like, um, A OTC, uh, American Opportunity Tax Credit, lifetime Learning credit point is, we're just thinking about marginal brackets. Right. We want, when are we gonna be the lowest? Have we filled the lowest brackets relative to the future?
So like it actually might make a lot of sense [00:24:00] to pay taxes even in a marginal bracket as the high as 32 if we're certain that we're gonna be in a 37% later. Yeah. Then every dollar that we didn't allow to be taxed at 32%, we're now gonna be taxed at 37% later. Exactly. We're paying an
extra 5 cents. So
Correct.
It's all about your individual situation and then being very intentional and deliberate. About when you are going to pay your taxes. Mm-hmm. Because you're going to pay them, unfortunately. Alright. It'd be great if you didn't have to, but you're gonna have to.
Rachael: Yeah. And so it's a lot of information that, um, we've shared over the three episodes.
And if these are strategies that you're looking to implement, if it's something that you don't feel comfortable doing solo and you're looking to work with a financial advisor. Not all financial advisors are created equally. Hmm. And even those with the same designations may have different, um, interests or different knowledge bases.
So it's really important as you're going and shopping around and trying to find who to work with. You're finding someone who specializes in or really [00:25:00] knows a lot about retirement tax planning, um, specifically, so any other, um, points? No. No. All right. Um, if you have any specific questions, please don't hesitate to reach out to podcast@equilibriumfp.com.
Eric: Thanks guys.
Rachael: Till next time.
