Backdoor Roth Like A Pro (part 1 of 2)

by | May 18, 2018

 

 

SEE FULL VIDEO TRANSCRIPT BELOW:

– What’s up, everybody? Justin Harvey, here, I hope you’re doin’ well.

Want to take a few minutes and talk about a really important tax planning strategy for physicians. Now, if you’re a doctor, out there, you probably already know the number one, biggest line item on your expenses, each year, is the money that you send to Uncle Sam. So, any tax planning strategies which you can enact that will have the benefit of lowering your taxes over time, allowing more money to stay in your pocket and to be working for you, is going to have a compounding effect that will be very, very beneficial, as the years pass. So, the strategy that I wanna discuss with you, today, is the backdoor Roth contribution. This is something that many of you in the medical community are probably already aware of, but if you’re not, stay tuned, ’cause this is a great thing to think about, to consider if it’s appropriate for you. It’s a way to move money into a tax-free account, and allow it to grow tax-free, be removed tax-free, and save you a bundle of taxes.

So, for whom may this strategy be appropriate? And, the way that I answer that question is anybody who’s a high earner, who’s making a household income of $200,000, or more. And, the reason that there’s this threshold, is that $200,000 is the point at which you are no longer eligible to contribute directly to a Roth IRA. You are also not eligible to make a tax deductible contribution into a traditional IRA.

So, real quick, Roth IRA is a tax-free account, an account that, once you get the money into that account, you will never pay a penny of taxes as long as you’re alive, as long as you don’t break certain rules. The traditional IRA, the tax-deductible IRA, is an account that, whenever you put money into it, it lowers your taxable income in the current year. So, if I put $5,500 into a traditional IRA, in the current year, I would experience reduction of my taxable income of $5,500 in the current year, and that would allow me to pay less taxes, right now. So, these are different from each other, because a Roth, you pay taxes up front, and then it grows tax-free for forever, traditional IRA, you defer taxes in the current year, but you are not able to experience tax-free growth, you’re gonna pay it, whenever you take it out. Now, again, you’re not able to access the Roth or a tax-deductible traditional IRA at all if you have income exceeding the 200K threshold.

But, there is a way around this threshold, where you can actually contribute to a traditional IRA in a different type of way, that allows you to, ultimately, get these funds to a Roth IRA. And so, this is what we call a nondeductible IRA contribution. So, for somebody who doesn’t have any money in an IRA, currently, they can make a $5,500 contribution to a traditional IRA, however, there’s no tax benefit, it’s what they call a nondeductible contribution. It does not reduce your AGI in the current year. However, what this does allow you to do, is then have ammo, have money in this account, to be able to do a Roth conversion. So, what a Roth conversion is, is whenever you have money in a traditional IRA, you cause a distribution to happen from that account, and convert it into Roth IRA dollars. So, you now have a new account that’s Joe Smith Roth IRA, that the assets are going to reside in, that those assets can then grow tax-free for forever. Now, whenever this conversion happens, it’s actually a taxable event for any assets that have been deposited tax-deferred.

If you put money in, in the past, and experienced a tax break in that year, this is gonna be taxable, and this is gonna be not the right thing. But, if you have an empty IRA that you can put a nondeductible contribution in, so that all the assets in this IRA are nondeductible, you’ve never had a tax break from them, whenever you do this conversion, it’s gonna happen tax-free, because you’ve already paid taxes on all those dollars already, and whenever the assets move to a Roth account, there is nothing that’s gonna have to come outta your pocket in order to placate the IRS. So, the result of this strategy is $5,500 that goes from a nondeductible IRA, converted into a Roth IRA, that will then grow tax-free forever, in this Roth IRA account. Really, really beneficial, as you let this compound over time, year after year.

Obviously, this is a very powerful tax planning strategy, especially for high earners. Now, one important note is that if you have other IRA assets, where you have experienced a tax benefit through tax deferral, either rolling over a 401k, or making IRA contributions directly, you cannot do this strategy, you’re not able to, because of, what they call, the pro rata rule, which the IRS enacts, you’re not able to isolate any after-tax dollars in an IRA, and only move those to a Roth. It just, if you try to do a conversion, it just causes a big tax problem. So, I’m gonna do a quick case study in my next video, but something to think about. If you are a high earner, and you’re not currently taking advantage of, or you’ve never considered, backdoor Roth contributions, I would encourage you to talk to your financial advisor, or tax professional, to see if that might be right for you.

Thanks for taking the time to watch this video. Hope you have a great day.

Disclaimer

Herein contains my one-take thoughts on financial concepts, behavioral investing, money management strategies, financial media, and letting you “behind the curtain” on my efforts to help move my physician clients toward financial independence.  Nothing on this site should ever be considered to be advice, research or an invitation to buy or sell any securities, please see my Website Disclaimer page for a full disclaimer.

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