A recent episode of The John Chapman Show featured a conversation with fellow WorthPointe advisor Matt Addington, CFP® about backdoor Roth conversions — a follow up to a previous episode where the pair talked about Roth conversions in general. 

During the show, John and Matt talk about the why behind wanting to have a portion of your portfolio in a Roth IRA, the mechanics of a backdoor Roth conversion, the major barriers that often disqualify investors, and mistakes to look out for. They also introduce a mega backdoor Roth strategy that may be used within an active 401(k) plan.

Listen here.

Audio Transcription

Speaker 1: (00:02)

Welcome to The John Chapman Show, where we talk about retirement readiness strategies to help you grow and preserve your wealth so that you get the most from life with the money you do have. Are you on track? John is an employee of WorthPointe, LLC. All opinions expressed by John and podcast guests are solely their own opinion and do not necessarily reflect the opinion of WorthPointe. This podcast should not be relied upon for investment decisions and is for informational purposes only.

Speaker 2: (00:34)

Are you considering a backdoor Roth conversion strategy? Hey everyone, it’s John Chapman. This week, I’m back with Matt Addington, my coworker at WorthPointe, following up on a podcast episode from this summer, when we talked specifically about Roth conversions and we didn’t get time in that episode to dive deep on one specific type of conversion, which is called the backdoor Roth. And in this episode, we talk about the ins and outs of the backdoor Roth and some of the things that you need to look out for, because it can present a number of hurdles and challenges if it’s not executed correctly. So if you’re considering how to manage your portfolio and thinking about the tax considerations in the future, and want to be able to use a vehicle like a Roth account to get tax-free growth, be sure to listen to this episode with my coworker, Matt. If you haven’t already, you can subscribe to this show or you can leave a comment or a rating, and you can email me directly@thejohnchapmanshowatgmail.com.

Speaker 2: (01:35)

And with that, let’s dive into today’s episode. A couple of weeks ago, Matt, we talked about Roth conversions and we had some listener feedback that was curious about backdoor Roths, and we didn’t touch much on it the first time we chatted. So I thought I’d have you back on, Matt, so we could talk specifically about a backdoor Roth: the process, how it works, and the things to look out for. And then I also want to touch on a mega backdoor Roth conversion, because a few listeners have also commented on that. In case you haven’t gone back, make sure to listen to my first episode with Matt from a few weeks ago, but Matt, just in case for folks who haven’t listened, why is it that we’re so focused on talking about Roth IRAs to begin with? What’s really the main point of why this is so important?

Speaker 3: (02:20)

Yeah. Well, thanks for having me back on, John. I certainly appreciate that. And you know, the answer is fairly simple. You want as much money in after-tax as you can, especially something like a Roth, so that in retirement you have a big pile of money that you’ve already paid taxes on, so you don’t have to pay any more taxes. So that’s the goal. That’s the reason people are looking for this. Now there’s some pros to that and some cons to that. And really at the end of the day, what we believe is that you should basically have diversified buckets as well. Right? You should have some buckets that you can draw from in retirement

Speaker 3: (03:00)

that you are going to have to pay taxes on, because it’s kind of like diversifying your tax liability as well. And then you have some buckets that you don’t have to pay taxes on. And so the Roth is one of those.

Speaker 2: (03:11)

Yeah, I think that’s a good point. If I think back on past conversations, who this really hit was the people that are in their sixties right now, where they no longer had pensions from work and they got converted almost completely to a 401(k) and Roth IRAs weren’t much of a thing until most recently. So it’s these people that are retiring now that might only have investment accounts that are in a pre-tax 401(k) or traditional IRA. And so every time they go to pay themselves in retirement, they’re paying ordinary income taxes on that. And so what we’ve learned from that bummer situation is that those people, their taxes aren’t anywhere lower in retirement than they were in their working years. And so a way for future generations of retirees—people in their fifties and forties or thirties—they’ve got a longer time horizon. And just the same way that we want to be diversified with our stock and bond investments, we really should be diversified, like you said, Matt, with our investments for a tax purpose. We’ve got a brokerage account, a traditional IRA and a Roth IRA, right?

Speaker 3: (04:13)

Yeah, that’s exactly right. And the real issue, John, is that we don’t know what’s going to happen with taxes. We can guess that taxes are gonna go up in the future. You know, we’ve got a lot of stimulus to pay for. There’s currently another stimulus bill out there right now. That’s looking like it may get approved. So there’s a lot of reasons we could see taxes going up in the future. And so having money you’ve already paid taxes on in retirement, that you don’t have to worry about what happens with taxes in the future, is key.

Speaker 2: (04:43)

So I want us to talk specifically about backdoor Roths, and I want to throw out a big disclaimer, of course, you need to talk with your tax advisor; nothing we say today is tax advice. And my concern is that I’ve had others in the past that want to engage in this strategy of doing a backdoor Roth, but they don’t do it correctly. And so that’s what raises a big red flag for me, Matt. So we’ll get into some of the nitty gritty in just a second, but let’s talk first. Why is it that somebody would have to do or what forces them to even think about a backdoor Roth in the first place? Why can’t they just normally contribute to a Roth IRA?

Speaker 3: (05:17)

Yeah. The answer is not everyone qualifies to contribute to a Roth IRA, right? There’s income limitations. It’s obviously lower for individuals than it is for married filing jointly, but you know, let’s just use kind of a round number. Let’s say it’s $100,000 for an individual or $200,000 for married filing jointly. If you make more than that, you likely can’t contribute to a Roth directly. 

Speaker 2: (05:43)

Okay. That’s a big, big point that I just want to make sure to pause on. So for folks that are high income earners and we’ll call that and we’re using round numbers. So it’s not exactly this, but it’s about $100,000 for an individual and $200,000 for married filing jointly. If you earn over that as a household, you’re completely disqualified from contributing to a Roth IRA, right?

Speaker 3: (06:02)

Yeah, that’s right. 

Speaker 2: (06:05)

Okay. So it’s this high income earner that’s even going to consider it in the first place. So let’s pretend there is a married family. They make over $200K and they’re wanting to engage in the backdoor Roth. Just break down what the actual process would be.

Speaker 3: (06:17)

Yeah. So first of all, what is it? The only reason we have to talk about the backdoor for them is because they make too much. So they are quote unquote disqualified from actually making a direct contribution to the Roth. So what a backdoor Roth is, is a way for them to actually get money into that Roth this year, even though they aren’t qualified to do that. 

Speaker 2: (06:38) So how do they do that? 

Speaker 3: (06:41) Here’s what you do. You actually make an after-tax contribution to a regular traditional IRA. Okay. So what that means is traditionally, when you make a payment into your IRA, you make it a pre-tax; that means you get a tax deduction that year. Well, this is going eventually into a Roth. So we do an after-tax contribution, and then we immediately convert that. So let’s say we’re going to put $5,000 in, okay? We’re going to make that on an after-tax basis into our IRA. Okay?

Speaker 2: (07:11)

Okay. So that’s money from like your checking and savings. You move it into the brokerage company, right?

Speaker 3: (07:15)

Okay. And then we immediately convert it into a Roth, okay? Let’s just call it basically a Roth conversion. Right? 

Speaker 2: (07:24)

Okay. Probably some forms involved with something like that or from phone calls, probably.

Speaker 3: (07:28)

Definitely going to be some forms and phone calls involved. And, you know, we definitely want to make sure you are talking to your advisor and your tax advisor to make sure that you have the correct forms involved. You want to make sure you can get credit for contributions. You want to make sure that the IRS knows how much of it is after-tax, right? So there’s some things that are involved there. You want to make sure you have your professionals help you out there.

Speaker 2: (07:52)

Uh, obviously there’s gotta be a catch to this, because doesn’t that sound like a sweet deal. I mean, if I’m making $300K and yada yada, and I make too much money to put into a traditional IRA, I obviously want money tax-free to pull from a tax-free bucket when I’m in retirement. So what prohibits me from doing the backdoor Roth conversion every single year?

Speaker 3: (08:14)

Well, I would say nothing is going to keep you from doing that, but what might keep you mentally from doing that is that you’re paying taxes. So for somebody that’s looking to do this as typically a high income earner. So maybe they’re already in the 40 percent tax bracket. So let’s say you could get a tax break for the contribution. Well, now you don’t. So you’re putting money in there that you’ve already paid taxes on, call it 40 percent taxes. And so that’s really what it’s going to boil down to. But the benefit though is that it’s going to grow compounded year after year, and you don’t have to pay taxes on it later. So maybe it makes more sense for the younger populace to do that because they have more time for that to grow than it does somebody who, you know, just retired.

Speaker 2: (09:01)

So one of my big red flags that I want to make sure people know about it, and it’s sort of hard to be able to describe this over an audio podcast, but you’ll have to go visually with me, Matt, is that some people aren’t aware that in the process of doing this backdoor Roth, they’ve triggered more taxes on themselves than they otherwise thought they were going to. And what I mean is for folks that let’s say, if they already have a traditional IRA account, let’s say they worked at a company and they were there for five or six years. And after they left, they took out their 401(k) and they rolled it over into a traditional IRA. Let’s just say they’ve got $90,000 in that traditional IRA. Right? Well, when they go to make this backdoor Roth, they first put it into a traditional IRA and then they move it into a Roth IRA. Well, let’s say that $5,000 they put it into a nondeductible traditional and then move it to a Roth. Well, when it moves to the Roth, they’re being taxed on that pro-rata with the other money that they have. Pre-tax. So let’s talk a little bit about what the implications of that are. So you go in thinking that this might be, you know, a back door, meaning I’m being sneaky, it’s a loophole. And so I don’t have to pay any taxes on it, but that’s not correct, is it Matt?

Speaker 3: (10:14)

It’s not. Yeah, it’s not. So the whole pro-rata thing, it can be very complex to get through just in words, without a white board or something. But yeah, so you may be thinking that you’re getting $5,000 of after-tax money and that’s going to be converted to Roth when really only 5 percent of that amount, maybe after-tax, gets converted. So now you’re going to have additional money in what was a pre-tax IRA now has another $4,000 of after-tax money in there that you have to keep track of. 

Speaker 2: (10:49)

Right. And so there’s a tax form 8606 that needs to be filed. And that way it reconciles what bucket of your total IRA money is after taxes, pre-tax, and that just takes a little bit of extra legwork. So it’s not the end of the world, but I just want to make sure that those listening I’ve just, I’ve seen others get a sticker shock when they go to file their taxes. And they thought I completed my backdoor Roth so I shouldn’t pay any taxes on this. And it’s no, because, because it’s pro-rata, that distribution is taxed with the other $90,000 or so. So that $5,000 moves into the Roth. And you know, you might be stung by that. So a few other things I’ve heard for folks that are really going the extra mile, there are ways to get around this, the hiccup.

Speaker 2: (11:31)

And that is either if let’s pretend you don’t have any traditional IRA money whatsoever, maybe you’ve worked at one company your entire career, and you’ve been there 10 plus years. Well, if you just have a large sizable 401(k), and you’re a high income owner, then you can engage in this backdoor Roth conversion strategy. And since you have no other traditional IRA assets, there’s nothing to be pro-rata taxed. But the second thing is, if somebody were to use, let’s say like a self-employed 401(k), they’re an entrepreneur. And they started a company and they have just them as an employee and no one else, they can have a solo 401(k). And that again, looks and feels like a regular company 401(k), so they can engage in this strategy. So that’s for people who are really, really wanting to push the envelope and go the extra mile, Matt, but I have seen that strategy done outside. So what else would you have to say for those that are looking to implement on a backdoor Roth strategy?

Speaker 3: (12:24)

Just tread lightly, make sure that you’re making the right decision. Don’t just do it because you think you should do it; talk to your advisor first, make sure you’re looping in your tax advisor as well, because what you think may be a huge benefit to you actually may be more of a tax situation or a tax nightmare. But again, even though there’s the pro-rata things, maybe it’s still beneficial to do it. So again, it’s something you want to chat with your advisor and your tax advisor about.

Speaker 2: (12:51)

Let’s switch gears and talk for just a minute about a mega backdoor Roth conversion strategy. And this is less well known and it certainly is going to apply to a smaller percentage of the audience. So for those that don’t have this applicable, if you don’t work for a Fortune 500-type company, this might not apply to you, but I do want to be able to address it since some of the folks Matt and I have worked with, this pertains to them. So let’s set this up really quick. A mega backdoor Roth conversion specifically relates to your company’s 401(k) and not the traditional IRA or Roth IRA as we were first talking about. So I want to just wipe the slate clean here for a sec. We’re now talking about your current company where you’re working, and your regular contribution. So Matt, what’s the typical limit that folks can contribute into in their 401(k)?

Speaker 3: (13:40)

I believe this year $19,500 is the most that you can personally contribute into a 401(k).

Speaker 2: (13:47)

Right under age 50, $19,500. 

Speaker 3: (13:50)

Good clarification. 

Speaker 2: (13:52) 

Yeah. So you know what the backdoor Roth conversion is in your company and your 401(k) custodian has to authorize this ahead of time, but sometimes they’ll make it known to you. And so essentially what this is, is above and beyond your normal 401(k) contributions. Again, think high earner here. If you’re making $400,000 and you could comfortably contribute the $19,500 already. And if you still have some wiggle room to contribute above and beyond that, that’s going to go into a special bucket called after-tax money. And your custodian might allow for you to immediately move that from after-tax money into the Roth bucket inside your company’s 401(k). If you didn’t do the Roth conversion strategy, what would happen to that after-tax money? Let’s say, after you separate from that company, you try to roll this over in the future. What happens to that bucket of money?

Speaker 3: (14:47)

Okay. So the after-tax money, what happens to that? A couple of things can happen. Okay.

Speaker 3: (14:52)

Number one, you can roll over your pre-tax, just to a regular IRA, and then you can actually take a check. They can actually cut you a check for the after-tax amount. Not the earnings, just the after- tax contribution amount. Okay. That’s one thing you can do. The second thing that could happen to that after-tax piece, it could actually go directly into a Roth IRA. 

Speaker 2: (15:19) 

Hmm. Okay. So let’s put some numbers to it. So let’s say you work at a company for, let’s say for 10 years. And during that time you put in more than the $19,500, you put above and beyond that, let’s say you put in an extra $5,000. So over that 10-year period, you’ve got $50,000 of after-tax money as your contribution basis. Right. And let’s just say that grew to $75,000 total over that time, just as an example.

Speaker 2: (15:42)

So when you roll it over, what happens to the two buckets of that $75,000? 

Speaker 3: (15:47)

All right. So again, the distinction there is contribution versus kind of the growth on that. The contribution can move directly into the Roth. The growth on the extra $25,000 then would be combined with the pre-tax money. 

Speaker 2: (16:06)

Okay. Got it. So now that you’ve described that, so the $25,000 of growth is still quote unquote pre-tax. So it couldn’t go into the Roth, that total money of the $75,000 or so needs to be broken into two. So the mega backdoor Roth conversion strategy, it just allows for that growth, that $25,000 potentially in this example, to be inside the Roth ahead of time so that you get the benefit of that tax-free growth. So, you know, certainly it’s a small strategy out there. It can be really cool to execute if you’re in the right situation where you’re a high-income earner or working at a Fortune 500 company that makes us available, but it’s a pretty neat strategy. So Matt, thanks for joining me today, to be able to talk about the ins and outs of Roths and IRAs and 401(k)s and some distribution planning for the future. I appreciate it. 

Speaker 3: (16:57)

Happy to be here. Thank you. Bye.

Speaker 4: (17:00)

Thanks for tuning in to the John Chapman show. Be sure to subscribe on iTunes, Stitcher, or Spotify, we encourage your questions, comments, and feedback for additional information. Check out the John Chapman show.com or look for John on LinkedIn and Twitter. See you next week.