February 18, 2024
This Suze School episode is once again on what you need to know about Back Door Roth’s and how the pro-rata rule works.
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Podcast Transcript:
February 18th, 2024. Welcome everybody to the Women and Money podcast as well as everybody smart enough to listen today is Suze School and you need to get out your Suze notebook because this is a Suze school that many of you have requested. Many of you are totally confused about. So we're going to do a Suze school on backdoor Roth IRAs. However, before I do that,
I just want to say, I think it's so fascinating that last Sunday Suze school, we talked about diversification, balance all of those things and how not to put all your money in tech because it's possible that the tech stocks could decrease while energy stocks could increase. And on some level, that's exactly what happened last week.
So it is important for you just to take a balanced approach because nothing goes straight up, nothing goes straight down unless it's a horrific company and you just have to stay put that way in terms of interest rates. We saw that inflation came in a little bit hotter than everybody expected. Ok. It wasn't that big of a deal. Truthfully, many people think that that will mean that the interest rates will stay higher for longer and that the feds will not cut interest rates till later on in this year. There are some people that believe the feds may even raise interest rates, but either way things are staying relatively stable at this point in time. Long term, the market still look good medium term. They're just doing a little bit of consolidation here. So just don't go freaking out. I do think that interest rates may have gone up some, especially in treasuries and they're probably at their top at this point in time, we will have to see.
Let's go to Suze School Backdoor Roth IRAs. And in reality, this really is one of the more confusing topics out there.
The first thing you have to understand happens to be income qualifications for a Roth IRA. And a Roth IRA is simply a retirement account that you open up individually on your own.
You open it up with money that you have already paid taxes on and therefore as it grows and after a certain amount of time and when you go to take it out, if you ever do, go to take it out, it's totally tax free.
But what you're getting confused about is the Roth retirement accounts that you have at work: A Roth 401k A Roth 403b or a Roth TSP.
And you need to understand a Roth retirement account at your employer's has absolutely no income limitations whatsoever. So it does not matter how much money you make, you still can have a Roth retirement account at your employer's place where you work.
You also can have an individual Roth IRA where you contribute money to it every single year. Besides a Roth retirement plan at work, you can have both and you are not limited because you happen to contribute to a Roth at your employers as to how much you can put in to a Roth IRA. Are you writing this down?
So you can fully max out your Roth retirement plan at work in most cases, which is $23,000 if you are under 50 or $30500 if you are 50 or older
And you can have an individual Roth IRA. If you qualify for one where you can max out $7000 a year for 2024 if you are under 50 and $8,000 if you are 50 older, so you very well could max out both. One has nothing to do with the other in terms of how much money you can put in. All right?
What determines however, if you can have a Roth IRA?
It's determined by your modified adjusted gross income.
So, if you are single. That's how you file taxes. You can put in the maximum in a Roth IRA. Regardless of what you've done at work, you can put in a maximum if your modified adjusted gross income is under $146,000
That's what you need to know. Now, the more income you make, the less you can put in into a Roth IRA.
So it actually decreases from like 7000 or 8000 to 6000 to $5000 as your income goes up and once your income as a single reaches $161,000 or more, you no longer are qualified to absolutely even open a Roth IRA for this year
Doesn't matter if you were able to open one for last year or the years before that you get to keep those. But for this year, you would not be able to open up a Roth IRA which allows you to contribute money every single month and all of those things. If you are married finally, jointly, those figures are $230,000. Anything under that, you can max out your Roth IRA and that amount goes down. Once you've reached $240,000 of modified adjusted gross income, write this down everybody, you no longer qualify for a Roth IRA.
Now, the Roth IRA that I happen to be talking about is a contributory Roth IRA which every single year you can put money into it. There are all these types of advantages to it, but it's a contributory Roth where you contribute every single year, as long as you still qualify, income wise. Just know that where all of you are getting confused is with something known as a converted Roth IRA.
A conversion is when you go from a retirement account that you already have, that you have never paid taxes on, that's known as a traditional 401k 403b or TSP or a traditional IRA.
And you decide that the money that you already have in a traditional retirement account, you want to convert to a Roth retirement account.
And when you convert, there are no income qualifications whatsoever. If you had, let's just say $50,000 in a traditional IRA at a brokerage firm held in your obviously individual name and you wanted to convert some of that or all of that to a Roth IRA. You could absolutely do so. Even if you were making a million dollars a year, you could do so
You just need to know any money that you convert is taxed to you that year as ordinary income.
Write that down you can also convert in your employer's retirement accounts from a traditional retirement account at your employer into their Roth retirement account. But whatever amount you convert, you will owe ordinary income taxes on.
But most people who convert a traditional retirement account to a Roth, they are converting money, they have never paid taxes on, do not confuse the two.
Doesn't it matter what other kind of retirement accounts you have? You can convert it and you will just owe taxes on any amount of money you convert.
Let's go to a back door Roth IRA. And why you would do one
You make more than the modified adjusted gross incomes that I told you about and therefore you don't qualify to be able to do a contributory Roth IRA. Government says, sorry, a Roth IRA one that you contribute to every year has so many advantages over any other retirement account out there. We're only going to allow certain people who don't make that much money, relatively speaking, allowed to have one.
But let's say you're making 400,000, 500,000 a year, whether you're single individual, whatever it may be and therefore you do not qualify.
There is a way for you to get money into a Roth IRA and that's by going through the back door.
How do you do that? You do that by opening up an IRA that's called a non-deductible IRA. Remember most of you that have a traditional IRA, you funded it with money that you never paid taxes on.
So money that is in a traditional IRA is money that's known as pre-tax money. Never pay taxes on it To set up a backdoor Roth, you fund it with money that you have already paid taxes on. So it's a non deductible IRA. And that's how you set it up. When you open it up with a brokerage firm, you tell them that this is a non-deductible IRA after it's been in there and many tax people will tell you, let it sit there for six months or so. So it just doesn't look like you did that just to get in to a Roth IRA. But after it's been there for a little bit, you then can convert it to a Roth IRA. Why can you convert it then to a Roth IRA? Because there are no income limitations on conversions, everybody. There are only income limitations on contributory Roth IRAs. Please understand that difference.
So if you have money that you've already paid taxes on in a non-deductible IRA and you convert it to a Roth IRA. Now you have gotten money into a Roth IRA regardless of the income that you make, that's called going through the back door.
Here, however, is what you have to understand if you happen to have an individual retirement account, whether it is a traditional IRA, a SEP IRA for small business owners, a simple IRA, whatever you happen to have outside of work, what you have at work makes no difference. If it has the letters IRA on it, you own it outside of what you have at work. Listen to me closely now and it is obviously funded with money that you have never paid taxes on. It is not a Roth, it is an IRA that you have funded with pre-tax money and you do a backdoor Roth IRA.
You are going to owe taxes according to what's called the pro rata rule. Write that down - on the amount of money that you converted to your backdoor Roth with money you have already paid taxes on. So I am going to repeat what I just said. So there is absolutely no confusion on this point whatsoever.
Before you ever do a backdoor Roth IRA, you have got to make sure if you have any money in a traditional IRA or any account outside of your employer. And it wouldn't have the words IRA on it if it were at your employers, by the way, an IRA is an individual retirement account that you set up by yourself.
Any account that has the three letters IRA that has been funded with pre tax money, which most of them have now recently, they're going to be coming out with Roth, SEP IRAs . And so, but then it would say Roth. So if it doesn't say Roth on it, and it simply says IRA of any kind and you do a backdoor Roth, you are going to be subjected to the pro rata rule. So this is how the pro rata rule works. Let's just assume that you have $30,000 in a SEP IRA. Just let's assume that that is true.
And you decided to do a backdoor Roth IRA. So you deposited at the beginning of January $8000. And then a few days later, you converted that $8000 to a backdoor Roth. And you think everything is fine
But it's not ok because you have $30,000 in a pre-taxed SEP IRA. So to put it simply what that means to you is you now are subject to the pro rata rule and you need to know how to calculate the pro rata rule. So this is how you would do it in this particular example:
You have $8000 that you just put in to a backdoor Roth IRA.
You have to add that $8000 to the $30,000 that you have in your SEP IRA. So now you have a total of $38,000 in all your individual retirement accounts. You then have to divide $8000 the amount of money you put into your backdoor. Roth IRA by that $38,000 figure.
And what you would find is that is 21%.
Next, you have to multiply 21% by the $8000 that you put in to your backdoor. Roth. And that will give you $1680. And it is that amount of money that is tax free of the $8000 that you put into your Roth backdoor. That means that $6320 is the amount of money of that backdoor Roth that is going to be taxable to you. That is how you figure out the pro rata rule amount.
So I hope this has cleared up any confusion that you have about backdoor Roth IRAs.
Next Sunday is going to be another podcast kind of like this, but it's going to focus on when it might make sense for you to actually change your tax filing status from married filing jointly to married, filing separately, in specific situations.
So don't miss it because you may be in the situation that I'm going to be talking about on next Sunday's Suze School.
So it's an important one as they all are to tune into
Until next week, there's only one thing that I really want you to remember when it comes to your money and it is this people first. What do I mean by that at this point in time? Yeah, I mean, you better know exactly what you can and cannot do with your money. You better know exactly why you are doing what you are doing with your money.
You better know exactly when it makes sense to get life insurance and when it doesn't, you need to know things about your own money because what happens to your money directly affects the quality of your life and nobody else. So people first then money, then things now you stay safe and unstoppable.