Ep 39:Unlocking the Backdoor: A Guide to Roth IRA Contributions
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We discuss the intricacies of Backdoor Roth IRAs, a popular strategy for high earners to contribute to Roth IRAs despite income limits.
We explore the mechanics of the Backdoor Roth and the Mega Backdoor Roth, including eligibility, contribution limits, and tax implications.
We also cover the importance of understanding 401k options, the pro rata rule, and key considerations for executing a Backdoor Roth conversion effectively.
We address work visa considerations when looking to complete a back-door role or a direct contribution.
We help you think through whether this is for you or not based on your work visa, your country of origin, and where you are likely to be when you finally withdraw the money.
We finally address the biggest mistakes we see when people DIY backdoor roth and the tax preparation that comes after that.
Episode Links & Resources
Are you Tax-compliant With Your Overseas Assets? - Free Guide - Scroll to the bottom of the page.
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The speakers' views and opinions discussed in this episode should not be considered financial, tax, or legal advice. Consult your advisor for any legal, cross-border tax, and financial advice.
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Speaker 1 (00:01):
<silence> Welcome to the International Money Cafe Podcast, the show where we filter out the noise on cross-border taxes, finances, and life in the us. I'm your host, Jen Ham, certified financial planner, founder and owner of Elgon Financial Advisors.
Speaker 2 (00:21):
And I'm your host, man Nadik, enrolled agent, owner and founder of AM and Tax and Business Services. Join us on this journey as we explore the unique challenges faced by inbound outbound families and businesses on taxes, compliance, and financial planning. Let's get to the show.
Speaker 1 (00:43):
We are back with another, what I think is gonna be a pretty cool episode. So man and I have been talking a lot about backdoor frauds and what has happened is man has been collecting a bunch of questions that her clients are asking kind of things we are seeing online. So in today's episode, we are just going to attempt to answer some of man's questions on the backdoor road. We'll see what questions she asks and we go from there. Man, how does that sound?
Speaker 2 (01:15):
Absolutely amazing. 'cause I love to ask you questions, <laugh>. Okay. All right. Like you already said, this is a popular strategy for high earners and there's a lot written out there in the internet universe on backdoor rots. People come back to us wanting to know whether this is a good strategy for them in order to be able to do this. Who would you think would qualify for a backdoor Roth IRA and why do you think this is a popular strategy? Jane?
Speaker 1 (01:56):
Okay. No, that's a fantastic question. So with a typical Roth IRA, you are able to make a direct contribution if you are modified adjusted gross income is 150 K in 2025 or 236 if married, filing jointly. Once you go over that number, the IRS code does not allow you to make a Roth contribution. So this strategy, the backdoor Roth has sort of come in and even though it backdoor sounds kind of weird, it is legal that allows you to still be able to make a Roth contribution despite your high income. And of course, the whole reason why you want a Roth or why people want a Roth IRA is because we know the money grows tax free. And once you get to retirement age, this is one account where RMDs are not required. RMDs are required distribution because when you do traditional retirement accounts, so we are thinking, let's say IRAs 4 0 1 Ks at some point 'cause the account grows tax deferred, IRS comes in and says, Hey, we wanna get our share of this. They wanna get their taxes, which forces you to start taking out some of that money, hence the required minimum distribution. Does that answer your question, man?
Speaker 2 (03:29):
A bit, yes. But if you can maybe share a quick example of who you would think would be an ideal candidate for a BDO Roth.
Speaker 1 (03:43):
Okay, absolutely. Let's talk about, we'll use John. John has a great income. His family is making, let's say about four or 500,000 per year. They are not allowed by tax court to be able to do a Roth contribution. John and his wife, we're assuming this is a married couple, they've been contributing to their 4 0 1 Ks and they've actually maxed them out. They've already contributed to their kids 5 29. They have some good amount of money in taxable account. They have no debt and they really want to save more for retirement. Now at their income level, when I've looked at, let's say their 4 0 1 Ks and their IRAs, they have a pretty high balance, which tells me at retirement time the required minimum distributions are gonna be pretty high, which means they are likely going to be in a pretty high tax bracket. So in this case, to help them start growing some money or start accumulating so many in tax free growth, I would help them do the backdoor Roth just like I described. Does that make sense?
Speaker 2 (05:04):
Absolutely, yes.
Speaker 1 (05:06):
Okay, cool.
Speaker 2 (05:06):
Now that we have an ideal candidate who mm-hmm
Speaker 1 (05:10):
<affirmative>.
Speaker 2 (05:11):
You would select for a backdoor rot. So now I have maybe a different candidate who comes and says, Hey, I've heard of backdoor rots, but mm-hmm <affirmative> what is this mega backdoor Roth? And how do I find out if I qualify for that? Okay. Would you be able to help us out with that, Jane?
Speaker 1 (05:36):
Yes. I love the name Mega Backdoor Roth. What has happened once, of course, all these things have to be allowed by IRS. Some companies will allow their employees to contribute extra to their retirement accounts. Again, it has to be allowed by the company. So let's say company, maybe I won't use specific company names. Let's say X, Y, Z company has created this option in the retirement account. The way it works is you max out, let's say your 401k contribution, which is around 23 500 this year. And then you can do what's called an after tax contribution into the same account. Obviously they're going to separate the buckets where this works and where the magic happens is where as you contribute your after tax contributions, they go immediately and convert this to a Roth, which is fantastic when you think about it. Now, if your company is not doing the conversion immediately, we might wanna talk about that a little bit. But really for it to make sense, you make the contribution and immediately this gets converted to a Roth, hence the mega back door Roth. And the reason for the wide mega, because I was looking at the numbers and I think this year you could potentially go up to 70 K of retirement contributions using this strategy. Does that explain how the mega backdoor Roth works and why it's such a great tool if you have access to it and if it makes sense for your situation?
Speaker 2 (07:30):
Definitely, Jane, and while we are talking about mega backdoor Roth conversions, so in case if that is your plan, it is important to keep money aside to pay for taxes.
Speaker 1 (07:45):
Right. But actually when you do the mega Roth, remember you are using after tax money, right?
Speaker 2 (07:53):
Oh, I see.
Speaker 1 (07:54):
You've already done the pre-tax, which is the 401k, and then you take your after tax money and you put it into this. As long as the company allows you to do the conversion immediately, you don't have to worry about taxes ever. And this is why it's such a popular thing. And like I said, it's not all companies that are willing to offer it, but if your company offers it, it's definitely worth having a conversation. Part of it is there's no income limit as to who can contribute to this or not.
Speaker 2 (08:28):
Okay, that makes sense. But let's stay here for a little bit because I am based in the metro Detroit area. I have a lot of people who ask me these questions working for the big car companies here. Now let's say you did not have after tax dollars in a 401k or that's sort of an employer plan. Let's say you were actually looking at the, in your traditional 401k, so to speak, and your employers allowed you to take that and put it into the Roth 401k. Would that be considered a mega backdoor Roth conversion and would that be a taxable event? Hey dear I'm C listener. Let me tell you a little story. Coincidentally, when I started my practice, it was the same year in which FATCA was passed into law. FATCA stands for Foreign Account Tax Compliance Act. The government started to crack down on those who had financial assets overseas and were not compliant in disclosing these funds to the US government.
Speaker 2 (09:45):
The SEN fbar filing requirement has been around since 1970, since the Bank Secrecy Act was passed. Well, even though it has been more than 10 years since these laws were passed, we still have many, many US taxpayers who may have a filing requirement but are completely unaware of it. <laugh>, I'm talking about that joint account with your dad with over 10 K back home. So this is in fact our most frequently asked question. We've put together a comprehensive free ebook, which goes over the most important compliance requirements for overseas financial assets. And we want you IMC listener to have this ebook completely free. All you need to do is go to our website, www the i am cafe.com and scroll to the bottom of the homepage and enter your first name and email address and you will be able to download this handy ebook. Now, hurry, go get your free and fabulous download
Speaker 1 (11:04):
With a 401k. You have two options, right? You have what's called the Roth 401k, and you have the pre-tax 401k. Let's go back to John. Let's assume his company offers the 401k and as part of that, they say you can do it pre-tax or you can do it after tax. John has the option of saying, out of my 400 whatever K income, I want to reduce my taxable income for this year. In which case he'll just go the traditional 401k route. So that's one. On the other hand, he may say, I'm not too concerned about reducing my taxable income this year. I'm going to take up the option of the 401k Roth contribution. Right? In which case he's gonna be taxed first and then he can put in his contribution into the Roth 401k. These two have nothing to do with the mega back door Roth. This is another option on top of all these are the retirement options. Does that make sense?
Speaker 2 (12:16):
What you're saying is one, the employer should have these options first of all,
Speaker 1 (12:22):
Yes, yes.
Speaker 2 (12:24):
For them to be able to do this. And then secondly, when they are making these different contributions, they have to take into account what their cash flow is going to be for the Oh,
Speaker 1 (12:36):
Absolutely. Absolutely.
Speaker 2 (12:38):
When maybe it's not that big a deal for those who are in the high income bracket to think about cash flow. But if you are not, then that would be an important thing.
Speaker 1 (12:50):
Let me add one more thing because of you're talking about the cash flow. So think about the money that's going into the after tax account, which becomes the mega back door Roth. This is money. You would probably, if you didn't have that option, like for the people who come to me and they don't have that option and they wanna save more, we end up putting it into a taxable account.
Speaker 2 (13:14):
Mm-hmm <affirmative>.
Speaker 1 (13:15):
The thing to keep in mind as far as your cash flow, it can't be money that you need because there's another little IRS thing that says, with the mega backdoor Roth money, you cannot take it for at least five years. So you kind of have to keep that in mind. So anybody that's looking to do the mega backdoor Roth, which again we are assuming the company's offering, they need to know that they can't really touch this money for at least five years. And the assumption we are making is, this is money you are probably saving for retirement. Does that answer the question though?
Speaker 2 (13:52):
Yes. Yes.
Speaker 1 (13:53):
Okay. It
Speaker 2 (13:53):
Does. Okay, cool. One last question on this one though. When you have multiple 4 0 1 Ks, such as the pre-tax and the mm-hmm <affirmative> or the traditional and the Roth 4 0 1 Ks, when you have these, what are the limits on how much money you can totally put into these 4 0 1 Ks contributions in a year? Mm-hmm <affirmative>. And can you also do a Roth IRE contribution outside of this?
Speaker 1 (14:25):
That's a good question. So how much you can put into both the pre-tax and the Roth 401k, I think they year it's about 23 500. The pre-tax, whether it's pre-tax or whether it's already being taxed, which is the Roth, it's up to 23 500. That's one with the mega backdoor Roth I was doing the month the other day, I don't remember the exact numbers, but I in total you can go up to 70 K. So you can do the math, which is something like, like I said, up to 70 K, take 70 K minus the 23 500 that you already contributed, and then minus what you employer is gonna match you. I'm gonna assume your employer is kind of generous. So let's assume if those two numbers add up to something like 30 K, then you can put in 70 minus 30, close to 40 K into this account. Now here's the beauty of this whole thing. These are still considered employment retirement accounts. If you qualify, actually in this case, we know you don't. You can still do a Roth, in this case, a backdoor Roth outside of the 4 0 1 outside of the company's retirement plan. Does that make sense?
Speaker 2 (15:47):
Yes. Yes.
Speaker 1 (15:48):
Okay, cool.
Speaker 2 (15:49):
Coming down to this and knowing like we are talking here about a lot of money, cash flow Sure. And all that, there are sometimes people will come to you, they've already sort of di wide this backdoor rod themselves. But not to go too much into detail because I always tell people not to and to work with a financial planner that they have or they want to make a backdoor Roth conversion or an IRA contribution. Very high level. Jane, would you be able to highlight what are the three important things to remember if you wanted to execute a backdoor Roth ira?
Speaker 1 (16:30):
Okay, this is great. I like to describe this as a two step process, assuming no complications and we'll talk about the big complication that comes in. Essentially we know you don't meet the income limits, which is fine at a very high level. You'd go ahead and open a traditional IRA and then you make a non-deductible after tax dollars contribution to the traditional IRA that you just opened. And then ideally you wait a while like so the separation of transactions, don't wanna invest the money yet and then at some point come back and do a Roth conversion. So the money goes from the IRA, the traditional IRA into the Roth IRA. At that point you can actually start doing the investment when it comes to these contributions and conversions. The thing I always say to people is do not mix these monies with other, let's say IRAs or other accounts you may have had the cleanest way of doing this is open a brand new empty traditional IRA and a brand new empty Roth IRA.
Speaker 1 (17:52):
Although I think with the Roth you can use an existing Roth since the money's coming in. But definitely open a clean traditional IRA and kind of just use that as this is my tool for doing the conversion. So that part is really, really key and really important. The part that I now see people missing and messing up a ton, which is sad Ashley to say there's this thing called the pro rata rule. What happens is RS looks at all your IRA account outside of the retirement account. When you do the conversion IRS looks at all this and says, oh wait a minute, you already have a another traditional IRA that we see over there and you have another traditional IRA that we see over here. What we are gonna do, and I'll give you a specific example to show you how the math works. We are going to tax you on all these IRAs. So the whole event ends up being not tax free. Let me walk you through an example and you see what I mean. Let's go back to John.
Speaker 2 (19:08):
Mm-hmm <affirmative> I'll let you give the example but I have a quick question once you have.
Speaker 1 (19:13):
Okay. So John has a traditional IRA, let's say he had retired, he had switched jobs at some point and he did the rollover 'cause he wanted to take the IRA with him, the money with him. Remember this whole prorata aggregation rule does not apply to 401k. So he's John, he's got this old IRA somewhere. Let's say he's already over 50 so we know he's able to contribute eight K, not seven to do the backdoor Roth. Right?
Speaker 2 (19:50):
So with the catchup, yeah.
Speaker 1 (19:52):
Yes, with the catchup there's a catchup. If you are over 50 now remember this eight K has already been taxed. So this would be a non-deductible. IRA, let's assume he has this old IRA and to make the month easy, let's assume his pre-tax IRA is 90 2K. He then brings the eight K. So in total he now has a hundred K IRAs outside. If he goes ahead and does the conversion of the eight K, this is how the tax bill is going to look like. Okay? One think of the non-deductible portion, which is the eight K divided by the total IRA amount, which is now a hundred K. And that portion is what's going to be the non-taxable piece. The second part of the equation looks like this think amount to be converted. So the eight K times the non-taxable percentage that we just calculated above and that's the amount of after tax funds to be converted to the Roth. So using this example, remember it's eight K, right? 8% and hope I'm keeping the numbers right of the hundred thousand K is non-taxable. The converted amount is going to come from 92% of the pre-tax funds and only 8% from the eight K contribution. It means he's gonna be paying taxes or 92% of this, which is 73 60 instead of not being able to pay taxes. So far so good.
Speaker 2 (21:51):
Jane, that was a great example. But here's my question. Is there anything else that they need to be concerned about the 73 60?
Speaker 1 (22:01):
Oh yeah. Because it now means, think about it, the 73 60 of the original after tax contributions is still mixed with your original pre-tax amount, which makes future accounting and contributions even more complicated in the future, especially if we plan to keep doing this. One way to try and avoid this is actually making sure that you don't have any pre-tax IRAs before you attempt the conversion. And in John's case, the 90 2K he has in the IRAI would have him do a rollover to his 401k and just make sure by December 31st he has no IRAs anywhere apart from all the 4 0 1 Ks. Does that make sense?
Speaker 2 (22:56):
Yes. Yes. Okay. A lot of things to consider here.
Speaker 1 (23:00):
Mm-hmm <affirmative>.
Speaker 2 (23:01):
One is that you don't have a pre-tax IRAs at all. Mm-hmm <affirmative> before you even think of making a back to Roth ira. And secondly is to know what these IRAs are that go into this pro ratta bucket. When we are talking about that, Jane, would you be able to go into a little bit about, okay, what goes into this bucket when we are saying IRAs mm-hmm <affirmative> are these just the traditional IRAs that he has made or will this also include the rollovers maybe that this person has from maybe a previous 401k that he has now rolled it over into this? Yeah,
Speaker 1 (23:45):
Good question. So this aggregation rule applies to all IRAs that you have. So let's assume to your point, like the example we used at the beginning. He had worked at another job, he had a 401k and he did the roll into an IRA that will apply if he has a SEP IRA. We've talked about SEPs in a previous episode. If he has a simple IRA, so basically any IRAs apply to this bucket. And again the easiest way I explain this to clients is make sure if we are gonna do this, let's say for this year, by December 31st, all your outside IRAs need to be completely empty. Otherwise we are gonna fall into that whole aggregation pro ratta rule, which is a real pain. And I know a lot of CCPs don't even wanna have to deal with it
Speaker 2 (24:41):
With I know. And this is where your, the connection between your financial advisor and your tax advisor keeps coming back and we bring it up over and over again. But another thing also, Jane, is maybe we should talk a little bit about this, is the timing aspect of making these decisions about backdoor Roth. Whether it is a mega backdoor contribution or a backdoor Roth contribution is when, does this make sense to you?
Speaker 1 (25:14):
You mean like the timing of the year or?
Speaker 2 (25:17):
Yes, the timing of the year itself. Mm-hmm <affirmative> but then also how much money you have in this bucket, which will push you into the pro rata rule, but also the fact that now you have money that you are adding into your taxable income possibly when making these conversions, especially with the mega backdoor is what I'm talking about.
Speaker 1 (25:42):
The good thing is, like I said with the mega backdoor Roth, because this is after tax contribution, you don't have to worry about taxes as long as you're able to do the conversion. So basically you now have a giant pile of Roth money growing.
Speaker 2 (25:58):
Yeah.
Speaker 1 (25:59):
If we take care of the pro rata rule, the aggregation rule, which is why I say the timing, the date that's critical is December 31st. You don't have to worry about taxes impacting whatever you are doing. But in terms of when you can contribute, remember to be able to do the mega backdoor Roth, you need to max out your retirement plan. So let's say the 23 500. So, and the money by the way comes out of your paycheck. So it's not something you can go back and do retroactively. What I'll say is if we are planning on maxing out your retirement account and doing the mega back door Roth, then we can't be putting in a hundred dollars at the beginning of the year. Ideally you spread it out throughout the year, you need to do a bigger chunk and we can do the math. That's pretty easy to do to ensure that you hit the numbers by the end of the year.
Speaker 1 (26:55):
As far as the back door Roth, outside of work, we just need to finish the contribution by the tax deadline. So in 2025 you can contribute money to your non-deductible, your traditional IRA up until next year, April 15th. The conversion can happen later, but the contribution needs to happen before April 15th. But again, the key thing is you cannot have any IRAs outside of work by December 31st. Otherwise we are gonna run into these aggregation rules in cases where we are not able to take that IRA money out, my suggestion at that point is probably hold off until the following year 'cause you really don't wanna get into that whole mass calculation kind of thing. Does that answer your question?
Speaker 2 (27:53):
Yes. Okay. I guess also then, Jane, maybe we should clarify mm-hmm. That for in order to not have the pro rata rule apply to you, if you decide to first convert your pre-tax IRAs to Roth IRAs, then that is something that you have to work with the financial planner. And if somebody came to you with that and asked you for options, what would you tell them as far as planning that? And I know it would be very unique to each individual, right?
Speaker 1 (28:36):
Yeah. But the thing I say, because I know clients sometimes tend to procrastinate things happen. What I say is let's not attempt this backdoor Roth conversion until I know for sure that all UI arrays are empty. And the reason I'm saying that, 'cause remember we have until April 15th mm-hmm <affirmative> to do the contribution and we can do the conversion anytime after. So let's not risk it. 'cause sometimes we never know how long the rollover is gonna take, so let's not risk getting into that mess. My advice to them is obviously let me know what are the IRAs that you have, let's figure out how to empty them then and only then can we talk about doing the backdoor rock conversion.
Speaker 2 (29:28):
Yeah, that was pretty intensive. We really pull that apart. I think that's good because these are common pitfalls and we do need to talk about how to avoid them as far as backdoor Roth. So let's say, and this happens to me from time to time when somebody will come to me and say, Hey, I want to make a backdoor Roth because they're not eligible for any other way of getting money in there, but they have forgotten or they have not kept track of previous IRA contributions or previous Roth IRA contributions that they may have made. And at that time I do tell them that this is something that they would have to go and track back and get all the basis of all these contributions that they have made. And that's when it's really important to make sure that they have filed that form 8 6 0 6 when making these contributions so that at least you have one way of getting back into it. You could go back 10 years to the IRS's uh portal and grab your transcripts for the past 10 years, but that's all you can go to and not the ones before that. So another thing, just wanted to put that out there. Moving on though, in a cross border context, and we keep coming back to this because this is our audience now in a cross border context, what is the backdoor Roth, would that be applicable to people who may wanna move out of the US sometime down or are not able to stay on?
Speaker 1 (31:20):
Yeah, so I've seen a couple cases where somebody will come in and say, oh, I have the option of the mega actor Roth. And I'm like, great, let's investigate that. But for us to really truly investigate whether this makes sense for you or not, I need to understand your immigration status now I need to understand or at least have an idea of where you are going to be when you retire. Basically I wanna understand where you are going to be when you start taking money out of the Roth or the mega back door Roth money out. What happens is we talk a lot about tax treaties. A lot of tax treaties do not recognize the tax advantage option or the tax advantage status of the Roth account. And partly because I think we said this in another episode, the Roth account only came into existence around 98 I think, which is way after Mana and I had actually come to the us.
Speaker 1 (32:27):
It's not included in a lot of these tax treaties. So the thing, first of all I want people to understand is the Roth account or versions of Roth account is a US IRS tax code option has nothing to do with the other countries. So that's the first thing I want them to understand with other retirement accounts, let's say like a 401k or traditional IRA or those can sort of come into how other countries define pensions. And as soon as you say pensions in other countries, they sort of kind of get it, this is money you're gonna get after a while and we know the money's gonna be taxed. That kind of thing. So if you are planning for one on retiring in a country where your country and there's only maybe six or seven countries doesn't recognize the tax status of the Roth, what's gonna happen is the minute you leave the US and you start filing taxes in the other country, one, the other country is gonna start taxing you on this Roth account.
Speaker 1 (33:36):
'cause to them it's just a foreign taxable account. That's one. Also, by the time you come to take money out, they are going to tax you, which means you kind of lose all the tax benefits that you'd accrued. Okay. When you put money into it. So that's the one thing I always say, let's consider the country that you're gonna be retiring to. We're then gonna dig into the tax treaty and manas and I'd love to do that to see if the account is mentioned in any way, shape or form. If that's the case, then I'll be like, okay, don't worry about it. I know we have the option, but the taxable account is still a good option for you. You don't always have to have the Roth account. Does that answer the question?
Speaker 2 (34:24):
Absolutely it does. And the backdoor Roth IRA could be a great option for investments, but it will not be a great option for everybody in the cross border context.
Speaker 1 (34:38):
Exactly, yes, yes.
Speaker 2 (34:40):
Also, like you just mentioned about treaties, it's important to see if any one of these have been updated to include the Roth. I think that maybe there are governments now that are kind of doing that, but not that we have seen many so far.
Speaker 1 (34:57):
I think one of the few that kind of calls it out is the UK tax treaty does call out the Roth account. The Canadian tax really also allows the Roth account, but I actually worked with a client the other day that was moving to Canada. You have to make a special election for it to be allowed to continue being a Roth account. So yeah, I think the key thing is let's talk, let's figure out where you're gonna be and then we can figure out if it makes sense or not, which is where we keep going back to. It may be good, but it may not be good for everybody. Financial advice, as we keep saying, is really needs to be customized. It has to make sense for your situation. Yeah, absolutely.
Speaker 2 (35:45):
Oh for sure. And there are very specific windows as well that people need to remember. To your point earlier about the Canadian tax treaty, there's a very small time period within which that election needs to be made. I understand. Yes. Oh, so do you have anything else to add, Jane? I thought this was a great episode. We had some technical glitches in the middle, which you wouldn't know about dear listener, but we made it and yeah, did you have anything else that you wanted to add, Jay?
Speaker 1 (36:18):
I think I've answered a lot of questions on this. So what I'm gonna say is if people have other questions, send them to us and we are happy to do a part two of this if they are more questions on the back door, Roth or Roth's account or any retirement account. So yeah, I think that's it and thank you for asking some of those deep, deep questions. Melissa, <laugh>, <laugh>.
Speaker 2 (36:42):
Yes. I enjoyed being the questioner this time. So yes, <laugh> and just like Jane said, if you have more questions, definitely please reach out to us. You can go to the website and sign up for a newsletter. We will have your email or just drop us a note and we will try and answer all those questions we get on a future episode. So thanks for listening. Take care. Bye.
Speaker 3 (37:12):
Thank you for listening to the International Money Cafe podcast. The content is for informational and educational purposes only and should not be used as a substitute for professional advice. Seek the advice of your qualified service provider with any questions you may have regarding your cross border finances and tax needs.