On This Episode
This week, we’re breaking down the Backdoor Roth IRA: the legal workaround that high earners use to get their money into a Roth and let it grow tax-free forever. We’ll walk you through exactly how it works, who it’s for, the one sneaky tax trap you need to watch out for, and whether it’s actually worth the extra steps. If you’ve ever been told you earn too much for a Roth, this episode is for you.
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Disclaimer: PFG Private Wealth Management, LLC is an SEC Registered Investment Advisor. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. The topics and information discussed during this podcast are not intended to provide tax or legal advice. Investments involve risk, and unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial advisor and/or tax professional before implementing any strategy discussed on this podcast. Past performance is not indicative of future performance. Insurance products and services are offered and sold through individually licensed and appointed insurance agents.
Marc:
This week on Retirement Planning Redefined, what is the backdoor Roth IRA? Let’s talk about it. Let’s break it down.
Hey everybody. Welcome into the program. This is Retirement Planning Redefined with John and Nick from PFG Private Wealth. And this week, guys, and actually the next two episodes, we’re going to talk about the backdoor Roth, even the mega backdoor Roth. And just kind of do some recapping on the Roth in general. Why would you want to do it? What is it? How do you set them up? Is it useful? All those kinds of things that might pertain to doing the backdoor Roth, which sounds like it’s not above board, but it completely is.
It’s an actual totally legal strategy that you can use, but it’s got that kind of weird name to it. So we’re going to kind of break that down for folks this week and help people learn a little bit more about that on this episode and next episode. So we’ll get into it right now. John, how you doing buddy? You doing all right?
John:
Hey, doing all right. After four months of a kitchen remodel, it’s almost done.
Marc:
Yeah, nice.
John:
So life almost going back to normal. So I will say there’s a little more pep in my step lately.
Marc:
Nice. You can get a brand new kitchen that you still won’t use because you’re so used to doing something else.
John:
You know what? I have been cooking quite a bit with my daughter.
Marc:
Oh, okay. Nice.
John:
I told myself I’m going to use this thing. So we got cookbooks and it’s pretty cool.
Marc:
Nice. Very cool. Very good. Well, Nick, how are you, my friend?
Nick:
Good, good. Just moved into new house this past weekend with my new wife. So a lot of new stuff going on last few months, but we’re excited and happy.
Marc:
Yeah. Well, that’s fantastic. And of course, it’s a busy time of the year too, right? Springtime, all that good stuff. And conversations around tax efficiency become a big deal, hence the conversation around Roths and Roth contributions and how to do them. So I guess let’s just dive in. What should somebody know? Why would someone want to do one? Nick, why don’t you start us off?
Nick:
Sure. So for a Roth IRA, there’s a couple kind of key elements to it that we tend to focus on with people. As a reminder, the conversation that we have with people is that there’s essentially kind of three phases of taxation for accounts. When the money goes in, is it taxed or tax deferred as it grows? Is it taxable each year or does it grow tax deferred? When you take out withdrawals, is that withdrawal going to be taxable or is it not going to be taxable? So with a Roth, you’re making contributions with after tax dollars, so you’re not getting a deduction. The money grows tax deferred, so you don’t get a 1099 each year. And then when you take out the money, it’s a tax-free withdrawal. A couple of the other kind of key factors to consider when you’re doing this is that one of the benefits of having a Roth account is that Roth accounts do not require RMDs or required minimum distributions.
When funds were in a Roth 401k, they used to require having minimum distributions, but they no longer do. So no Roth money is something that we don’t want clients to have. We want to make sure that clients end up having some Roth money in retirement. One other factor to take into consideration, because the upside on Roth accounts are tax-free, that’s oftentimes where we will suggest that clients put their more growth-oriented investments for their overall allocation. That makes a lot of sense when you have a tax-free upside.
Marc:
All right. So John, so now talk to us a little bit about, I guess the Roth conversion, maybe a little recap there, and then some things to ponder.
John:
Yeah. So part of the backdoor Roth IRA strategy is conversions. That’s a step in the process. And I know we’ve talked about this in the past, but it’s always good to recap. And I think people hearing things over and over again, it really sits well with them. So how it works with Roth conversions are there are, number one, no income limits. So anyone can do it. So whether you’re making 50,000 a year or 300,000 a year, or if you’re retired, you can go ahead and do a Roth conversion. So that’s caveat number one. Some people do think they’re limited because in the past there were, I think in the early 2000s, there was income limits and those no longer apply. And how that works is Nick talked about the different phases of money. So let’s say you have some money in an IRA and it was tax deferred, everything’s pre-tax, so you did a deduction going in.
You can basically convert it all to a Roth IRA and it now turns into tax-free. How that works is whatever amount that you convert in that year, that becomes taxable income to you. So if you decide that, hey, I’m going to convert 30,000, your taxable income goes up by 30,000 in that given year. So important to really look into tax planning. We’ve talked about all this in the past, but before you do anything like this, you want to look at, hey, what does this do for my tax bracket? If you’re under the age of 59 and a half, it bypasses a 10% penalty. So you can do a conversion basically when you’re 40 or 50. So you’re not subject to that 10% penalty when you do a conversion, which again, some people just might need to hear that because they might say, “Oh, I can’t do a conversion yet because I’m not above 59 and a half.” And then also to have a count in the current year, you have to do it by December 31st.
Marc:
Gotcha.
John:
And another caveat with Roths is the five-year rule. So whenever you do a conversion amount under the age of 59 and a half, it’s subject to the five-year rule, or if you’re converting to your first time having a Roth, it’s subject to the five-year rule. So things to really take into account other Roth rules even once you convert because they still do apply.
Marc:
Okay. All right. So we got some kind of background information there on these two pieces. So Nick, what’s the backdoor Roth? As I said a minute ago, it sounds like it’s sneaky, but it’s not. I mean, you could totally do it. So what’s the deal to know here?
Nick:
Yeah. So the biggest cause or reason or most prominent reason that somebody would take advantage of using this strategy would be because their income limits or their income from a household standpoint, or if they’re single, exceed the income limits on being able to make a contribution to a Roth IRA.
Marc:
Yeah. You usually hear that, right? We make too much, we can’t do it, right?
Nick:
Yep, exactly. So for a quick kind of recap, for 2025, married finally jointly, the full contribution was if you were making under $236,000 a year, married filing jointly, then there’s a phase out period. So you’re fully phased out above 246,000. All right. For single, those numbers are 150 and then 165 for the phase out. Those numbers went up a little bit in 2026. So now married filing jointly, the phase out starts at 242,000 and then it’s fully phased out 252, single 153K for the year and then phases out at 168. So the thought process is, all right, you’re diligently saving into different accounts and you are looking for additional places to save money into, and your income exceeds the limitations. So you thought you were kind of out of not having the ability to make the contribution to the account. And that’s kind of the triggers that people should keep in mind like, hey, does this make sense to me?
It’s like, I’m higher income. I’m looking for a place to put money. I make too much money to make a regular contribution to a Roth IRA. Hey, is this something that I might be able to do?
Marc:
Gotcha. Okay. So now you’ve got the limitations, the reasons why. So now you have that understanding of, okay, is the backdoor Roth right for me? John, what’s the strategy of how to do it?
John:
Yeah, so Nick went into the income limits. And something before I go into the strategy is people understanding what an after tax non-deductible contribution is to a regular IRA. And when I get into the strategy, I’ll explain why this is important to understand. So most people, when they make IRA contribution, they deduct it, which Nick talked about the three phases, and that’s kind of the perception. hey, I make an IRA contribution, I can deduct up to 7,000, whatever the number it is in that year.
Well, you can, no matter what your income is, make an after tax non-deductible contribution. So what that means is, let’s say if you put that 7,000 into the IRA, you don’t deduct it’s after tax, and any growth moving forward is tax deferred and subject to taxes when you pull it up, but your after tax dollars are not subject to taxes. So just wanted to clarify or explain that when we go into the strategy, because this is going to be an important factor of understanding how that works.
Marc:
Gotcha. Okay.
John:
So the strategy works like this. It’s kind of different phases. So phase one is you determine what Nick said, should I be doing this? I want to save some extra money. And then you look at, okay, let me go ahead and make a non-deductible contribution to a traditional IRA. And what I stated earlier, it doesn’t matter what your income is. You can make a non-deductible contribution up to the IRA contribution limits for that given year. All right. So that’s first step is that. Then before there’s any earnings at all, because I just went over where with a non-deductible contribution, any earnings are subject to taxes. So let’s say you put in 7,000. So really that day before it’s invested, even in a money market or cash, because there might be some earnings there, you convert it to a Roth IRA. So you basically transfer it into the Roth IRA account and there’s a conversion paperwork to do and stuff like that, but you just basically transfer it in.
Now, where this works is there’s no earnings to tax. So basically what you’re doing is you’re taking that after tax contribution in the IRA, transferring/converting it to a Roth. Now it’s in the Roth bucket, and now all those earnings become tax deferred and tax-free when you pull it out. So that’s kind of the whole preface of it is that, let me do this conversion immediately, and that’s the way that you kind of do the back door.
Marc:
Okay. Right. So you’ve gone through this process, you’re thinking about the strategy. What are some considerations, Nick, to ponder here?
Nick:
Yeah. So really the cleanest, easiest, most simple way to do a strategy like this is if you do not have funds in your own IRA. So there’s a rule called the pro rata rule. And if you have other pre-tax money in a traditional IRA, and you want to execute kind of the backdoor Roth via the conversion, there are limitations on the amount that you will be able to convert without having any tax implication. So the ideal person is, let’s just kind of use an example of a couple, maybe early to mid 40s income, household income exceeding like $275,000. They’re putting a chunk of money into their 401ks and they’ve got good savings, a reasonable mortgage, and they’re looking where to kind of divert some money because they don’t have any of their own IRAs. The process is we open up a traditional IRA, we open up a Roth IRA, make the contribution to the traditional IRA, and then immediately execute the conversion.
That with the fact of them not having any money inside of their traditional IRA avoids the pro rata rule, and we just use that traditional IRA account to fund the conversions on an annual basis. So as a reminder, the contribution limits apply. For 2025, the contribution limit under the age of 50 is 7,000 per year over the age of 50 with the catch-up is 8,000. 2026, those numbers bumped up a little bit, it’s 7,500, and then for some reason they decided to pick 8,600 instead of 8,500, because who knows, why not?
John:
Keeping you on your toes, Nick.
Nick:
Yeah. Yeah. Just why not have it 600 if you can? So one kind of way, especially this time of year, that ends up, if people have free cash sitting in the bank, done this a few times this year so far, where they can make the non-deductible IRA contribution for 2025 and 2026 so we can put in 14,500 to 16,600 a bigger chunk, immediately convert it right away, and then you have the bigger amount going in. So that can be a nice way to kind of front load it and get the ball rolling.
Marc:
Gotcha.
Nick:
A quick reminder on that too is you want to make sure you file a form 8606 to report non-deductible contributions and the conversion. So there’s a tax form when you do this.
Marc:
Gotcha. So John, ultimately, I think people kind of want to know, is something like this right for me? How do I know? How do I do it? I mean, I guess the first thing I would advise is you certainly probably don’t want to tackle this on your own. You want to probably talk to professionals to help you with this because from the standpoint of even if finding out if it’s right for you, not to mention you want to make sure you do it right.
John:
Yeah, that’s 100% because that pro rata rule Nick mentioned is very sneaky.
Marc:
No, the government’s sneaky. Get out of here.
John:
Yeah. It’ll mess with you because a lot of people aren’t aware of it. If you have 400,000 in IRA and you’re like, “Oh, let me do a backdoor Roth.” You do it and all of a sudden you get a penalty from the IRS and it’s like, hey, we got you. You didn’t follow our rules. So that is number one. Definitely work with a tax advisor, financial advisor when you’re doing this type of strategy to make sure that you’re doing this to make more money and have more flexibility, not have penalties. So just do it right and make sure it’s in line. That’s number one. And then the next step is the name of our podcast, retirement planning. You want to make sure that this fits in with your plan and it makes sense. Nick gave a great example of you have some savings that is maybe not getting the best tax advantages of it.
This is a nice way to shift some money and say, “Hey, let me be more tax efficient.” Just from experience, having no RMD and retirement can be a big deal for some people, that way it’s not really forced income to them, which is nice. Having that tax diversification of assets where it’s depending on what the tax environment is, you can determine, “Hey, this is what I want my tax bill to be in a given year.” And we’ve talked about the bill last year where you have certain deductions. So again, it’s nice to have flexibility. Big one, legacy planning, which I don’t think we’ve hit yet with the Roth accounts, your beneficiaries inherited tax-free. So they get it tax-free. And with that new IRA rule, inherited IRA rule where you only have 10 years to pull it out, it’s a pretty big deal. So there’s definitely a lot of benefits.
If it works for your situation, it’s a great strategy and definitely worth taking advantage of while you can.
Marc:
Yeah. And that’s the point is finding out, is it right for you? And to the point of the complication, the conversation, as you just mentioned, they eliminated the stretch IRA a number of years ago and the IRS just got around recently to identifying exactly what the rules around that were. So it takes them five years sometimes to settle on rules for things that they put in place 10 years ago.
So having the conversation with professionals who deal with this stuff day in and day out is very important to find out if it’s the right fit for you. Again, especially, I mean, Roth conversions and Roths out there in general have been around for quite a while and so has the back door. It’s just a matter of understanding if it’s the right situation for you based on earnings and all that good stuff.
So if you need some help, as John mentioned, the name of the podcast is Retirement Planning Redefined. Get on the calendar, have a conversation and redefine your strategy with the team at PFG Private Wealth. Again, pfgprivatewealth.com. That’s pfgprivatewealth.com. Or call them at 813-286-7776. And guys, what we’ll do is we’ll talk about on the next session, the mega backdoor Roth, because that sounds even crazier, and we’ll go from there and get into that chat. So guys, thanks for breaking it down. Nick, always appreciate your time, buddy.
Nick:
Thanks, Mark.
Marc:
John, as well, thank you so much. And enjoy that kitchen, man. Get in there and make something good.
John:
I will. I’ll keep you posted.
Marc:
All right. We’ll see you next time here on Retirement Planning Redefined with John and Nick.