Roth IRA

YFP 401: Ask YFP: Roth IRA Eligibility & Estimating Life Insurance Needs

Posted on by YFP Media

Tim Ulbrich and Tim Baker tackle questions from the YFP community on life insurance needs for expectant parents and eligibility for direct Roth IRA contributions.

Episode Summary

On today’s episode, YFP Co-Founders Tim Ulbrich, PharmD and Tim Baker, CFP tackle two important questions from the YFP community.

First, they dive into how to project your life insurance needs when welcoming a new baby into the family and then Tim and Tim break down how Modified Adjusted Gross Income (MAGI) is calculated to help you determine if you’re eligible for direct Roth IRA contributions.

If you have a question you’d like featured on an upcoming episode, visit yourfinancialpharmacist.com/askyfp or email [email protected].

Key Points from the Episode

[0:00] Introduction and Episode Overview
[00:54] Question 1: Life Insurance Needs for Expecting Parents
[01:33] Tim Baker’s Advice on Life Insurance and Retirement Plans
[09:17] Question 2: Calculating Modified Adjusted Gross Income (MAGI)
[09:34] Understanding AGI vs. MAGI
[14:33] Conclusion

Episode Highlights

“Having a baby tends to lead to some reflection about a lot of things, including finances, you know, savings, life insurance, disability, estate planning, education planning, all those things kind of come to mind.” – Tim Baker [1:39]

“ If you’re talking about the retirement plans, when a spouse dies, their assets essentially transfer to the beneficiary. Most of the time it’s going to be you as the surviving spouse.” – Tim Baker [3:23]

“One of the things to remember with Roth IRAs is that you can typically take out your basis or what you can contribute without penalty or tax.” – Tim Baker [4:24]

Links Mentioned in Today’s Episode

Episode Transcript

Tim Ulbrich: Hey everybody, Tim Ulbrich here. Welcome to this week’s episode of the YFP podcast, where we strive to inspire and encourage you on your path towards achieving financial freedom today. YFP co founder, COO and certified financial planner. Tim Baker joins me to answer two questions from the YFP community.

Tim Ulbrich: One on projecting life insurance needs and another on how modified adjusted gross income is calculated to know whether or not you’re eligible to make Roth IRA contributions. If you have a question you would like for us to feature on an upcoming episode, head on over to your financial pharmacist.com/ask yfp to record your question or send us an email at [email protected].

Tim Ulbrich: And before we get started, I wanna let you know that we’re now publishing the podcast in video form on YouTube. If you wanna watch this [00:01:00] episode, make sure to subscribe to the Your Financial Pharmacist YouTube channel where we’ll publish. New shows each week. All right, let’s jump in with our first question, which came to us via email.

Tim Ulbrich: And that question is. My wife and I are pregnant and are reviewing our life insurance policies. If one of us passes away, does the other spouse have early tax free access to use the deceased spouses Roth IRA 401k SEP IRA or solo 401k, or would the spouse still have to wait until they are retirement age, typically 59 and a half.

Tim Ulbrich: To access. We’re trying to determine how much more life insurance we need to buy with a new baby on the way. My wife and I are in our thirties. Tim Baker, what are your thoughts on this?

Tim Baker: Yeah, so first of all, congrats on on baby coming. Um, that’s uh, that’s monumentous. I feel like Tim having a baby tends to lead to some reflection about a lot of things, including finances, you know, savings, life insurance, disability, [00:02:00] estate planning, education planning, all those things kind of come to mind.

Tim Baker: Um, you know, I think. If if I’m, if I’m answering this question, I separate these things in terms of, like, life insurance versus, like, you know, um, retirement plans. Um, because I think, especially when you’re young, you know, spending some money on a, on a fairly inexpensive term insurance to keep those.

Tim Baker: Retirement plans, um, unadulterated is worth it. Um, because, you know, 1 of the misconceptions is like, when you retire. You, your expenses are going to be, I wouldn’t say they’re going to be the same as if there’s 1 person versus 2, but it’s going to be, you know. It’s going to be pretty expensive. So like, I, I wouldn’t look at that as like, as insurance.

Tim Baker: So I think I would look at it in, in the, in the confines of like, okay, this is for the purpose of retirement. And this is the purpose of, you know, insurance. [00:03:00] So there are different rules for different types of accounts, um, and different types of beneficial, uh, different types of beneficiaries. So. Um, you know, if you’re both in your thirties, you’re having a baby, if you’re really healthy, I would look at term insurance.

Tim Baker: You know, I always kind of talk about the rule of 30, which I have to look at, but basically, uh, to see if that still holds Tim, but the rule of 30 was you could buy a half a million dollar term insurance policy. Um, 30 year policy. If you’re in your 30s for about 30 bucks a month. Right? So I’m sure prices have gone up since I’ve been talking about that.

Tim Baker: So I have to, I have to make sure

Tim Ulbrich: Sounds about right. Yeah.

Tim Baker: I think that is important to understand. So, um, but when, if you’re talking about the retirement plans, when a spouse dies, each. their Their assets essentially transfer to the beneficiary. Most of the time it’s gonna be you as the spouse, um, the surviving spouse.

Tim Baker: So there’s really five options with, with these types of IRAs. Now, 4 0 1 ks and 4 0 3 Bs will be a little bit different, but I’m gonna speak specifically about IRAs. [00:04:00] But first option you can do is you can keep the IRA so a beneficiary can withdraw the funds even if they’re younger. Then 59 and a half 59 and a half without paying a 10 percent early withdrawal penalty.

Tim Baker: If the deceased has already started taking distribution. So in this case, that wouldn’t be that wouldn’t be it because you’re younger. Um, a surviving spouse, a minor child or disabled person is required to take what’s called RMDs required minimum distributions based on the deceased person’s age. Rather than the beneficiary, if the, if the air is not a spouse and there’s different rules.

Tim Baker: So there’s, there’s kind of spousal rules and non spousal rules. One of the things to remember with, with Roth IRAs is that you can typically take out your basis or what you can contribute without penalty or tax. Right? So that’s important to know off, off the rip. The second option is, Roll over the IRA.

Tim Baker: So beneficiaries can roll assets into a personal IRA without paying income tax or early withdrawal penalties, unless they are 59 and a half. So a rollover [00:05:00] into an inherited IRA does not incur penalties. If the assets have been in the accounts for 5 year, 5 years. Um, and this option Tim is only. Uh, open to our surviving spouse who must transfer to the same type of account.

Tim Baker: So traditional to the traditional or Roth to Roth. Um, the third option here is to convert to a Roth IRA. So that in this case, you know, we’re talking about a Roth IRA. You could also disclaim part of the assets. You say, I don’t, I don’t want it or cash out the IRA. So in most cases, what I would say from a planning perspective, um, what I would say is Don’t think of your spouse’s, um, retirement house assets as a form of insurance.

Tim Baker: I would say by the insurance, but if you do get into a pinch from a, from a cashflow perspective, you can access those funds, especially, um, if you are the spouse and if you’re looking at basis without taking the penalties. So there’s, there’s a few different layers of sorts that I would go through before.

Tim Baker: You know, get into a point where you can [00:06:00] completely cash out the IRAs. But is, this is just like a, um, this is typically just like a. Um, like a backdoor Roth conversion, the flow chart on this can be very complicated in terms of, okay, when did they start distributing it? Did they not? How old’s the, the, the deceased spouse?

Tim Baker: How old’s the surviving spouse, et cetera. So it can be very complicated. So I think if I’m in my thirties, I’m basically layering a little bit more. Uh, term insurance where I feel comfortable and I’m, I’m treating that, um, deceased spousal IRA or 401k as if it’s, you know, my own retirement plan and not, you know, not an insurance, um, bump, so to speak.

Tim Ulbrich: Yeah. Tim, I like how you’re separating out these two things. And I do love the question, right? Because there’s a, there’s an intentionality and I can tell some in depth analysis going on that we’re not just applying blanket rules of how much term life insurance do I need, but actually trying to get to the question, which needs to be answered when it comes to buying term life insurance, which is what do I [00:07:00] need this policy to replace?

Tim Ulbrich: And in this question, there’s some background questions of, Hey, well, if there are retirement Will those be accessible or not? I’m with you, right? If someone’s in their thirties, you know, not advice for them, but I would think of it the same way you are. If I’m in my thirties, babies on the way, assuming relatively healthy, inexpensive term life insurance policy.

Tim Ulbrich: If I’m looking at these two things, just to put some numbers to this, and I’m looking at, Hey, maybe I’d need a million dollar term policy versus a one and a half or 2 million. If I were to exclude these, uh, retirement assumptions, when you consider the cost of these policies, again, we’re making some assumptions of health and other things, but based on age, like that feels kind of like a no brainer, right?

Tim Ulbrich: In terms of keeping it clean separation of these two things and relatively inexpensive, assuming that the monthly budget can handle the extra, whatever it’d be, you know, 20, 30 bucks a month to add on to the term coverage. So, um, I like that because I think sometimes we can make these things maybe overly complicated and, uh, you know, [00:08:00] I, I like the intent of the question, but, but I also like thinking of these buckets separately in there.

Tim Ulbrich: And there’s a peace of mind component here too, knowing that, Hey, we’ve got the life insurance piece that’s purely for the sake. Hopefully we never use it, but if it’s, if it’s there, you know, we have access to those funds.

Tim Baker: Yeah. And there, and there are other things that I would potentially pull levers before I would even look at retirement plans that could be. You know, leverage in debt or other things, you know, like, uh, a HELOC or something, I think, even before I would, I would start cashing in retirement plans. So, again, I think it’s, uh, all the reason to have, you know, this is about planning, not a plan, you know, all the reason to have a planner to kind of work through life events and hopefully nothing like this ever happens.

Tim Baker: But I think it’s a great thought experiment to kind of go down

Tim Ulbrich: One last thing I’ll say on this before we move to our second question is for those listening that maybe don’t have term life insurance or wondering about, you know, what’s all involved in a term life insurance policy. How do I begin to think about and evaluate what the [00:09:00] need is? Or if you have a term life insurance policy, uh, wondering if, if that coverage is appropriate, or maybe you just have an employer.

Tim Ulbrich: Policy and you’re wondering about your own policy. We’ve got a very comprehensive resource life insurance for pharmacists the ultimate guide Uh that will give some great background educational information on this topic We’ll link to that blog article in the show notes so you can read more and learn more on that Tim said you mentioned backdoor roth.

Tim Ulbrich: We got it. We got to go there, right? So

Tim Baker: my

Tim Ulbrich: your favorite topic. Yeah, so our second question Our second question is also came into us via email. How do you calculate? Modified Adjusted Gross Income to know if you’re eligible to contribute. To a Roth IRA. What, what are your thoughts on this one?

Tim Baker: Yeah. So a lot of us use magi and AGI synonymously. So modified adjust, just to adjusted to gross income is not the same as adjusted gross income. Um, although we, again, we use them the same. So to [00:10:00] determine, so just to kind of throw out some numbers, um, if you are filing single and you’re modified, adjusted gross income is.

Tim Baker: 150, 000, we’ll say it’s 150, 000, 165, 000, once it gets to 165, 001, the door for you to be able to, um, Contribute directly into a Roth IRA shuts. So once you make a, once your magi is $165,000 and 1, you can no longer make a direct contribution. So this is where you have to contribute to traditional, go through a bunch of steps and then, and then move it over to

Tim Ulbrich: Are you talking about for individuals or joint filing?

Tim Baker: That’s that’s for single file and for, for Mary phone jointly, the phase out is phase out is 236, 000 to 246, 000. So once you make 246, 001 dollars, you cannot directly put, you know, contributions into a Roth IRA. So how do [00:11:00] we get this number? The modified adjusted gross income. Um, so really what you want to do is you want to actually start with AGI.

Tim Baker: So AGI, I believe is line 11 on form 1040.

Tim Ulbrich: Nailed

Tim Baker: Um, awesome. So then you have to add back in. Certain deductions, um, to get your magi. So these would be things like student loan interest deduction, which, you know, a lot of people aren’t getting that because they make too much money, um, tuition and fees deduction.

Tim Baker: If that’s available IRA contributions, deduction, um, if you’re contributing to a traditional IRA and taking a deduction. Also, typically not available. It could be rental losses. If you’re, if, uh, the rental losses are subject to pass passive activity, uh, loss limits. Um, other things could be, uh, excluded foreign earned income.

Tim Baker: excluded employer adoption benefits, half of self employment tax deduction, any passive loss or passive income interest from series E savings bonds used for education. [00:12:00] And finally, losses from publicly traded partnerships. So once you add back these deductions, that gets your Modified adjusted income, and that’s, um, gross income.

Tim Baker: And that’s essentially the number that you use to say, okay, can I make a contribution directly into the Roth or do I have to do a backdoor strategy to go from a traditional into a Roth? Um, that’s Magi. So it’s often the case for a lot of people that they don’t have a ton there. So that’s why we kind of use it synonymously.

Tim Baker: But, but there is slight differences in that AGI and MAGI number.

Tim Ulbrich: Tim, I think this is a really good question. Not, not only from the Roth contribution, but you’re starting to dissect. The IRS form 1040 a little bit, right? As you’re talking through the different things, when we look at, you know, the terms we throw around income and gross income and adjusted gross income modified, adjusted gross income, understanding what are the above the line deductions, other deductions, credits, et cetera.

Tim Ulbrich: [00:13:00] Here, we’re talking of things that are above the line that you were, you were listing off. But the reason I’m going there and I’m not suggesting we need to go down the tax rabbit hole, but the more we understand. Okay. Thank you. Kind of the flow of dollars from a tax standpoint and what these terms mean.

Tim Ulbrich: We start to see some of the levers that we could potentially pull from a tax optimization standpoint, as well as being able to answer questions like this one, which is like, Hey, can I make direct contributions to a Roth? Do I phase out? Do I need to consider it back to a Roth? And then if so, you know, what does that look like?

Tim Ulbrich: And how do I make sure I’m doing that correctly? We’ve addressed that on the show previously as well.

Tim Baker: yeah, I’ve talked about this with tax. It’s like, you know, understanding the 1040 kind of gives you not the answers to the test, but you can kind of start to see visually how the form is populated. And then I think it can ultimately affect your behavior and how best to optimize. Again, I sometimes people do some crazy things just to get a tax benefit, which doesn’t [00:14:00] necessarily work.

Tim Baker: You know, fit with their overall financial plan. So it’s kind of just doesn’t make any sense. But I think if you understand the construct of, you know, the, the tax code and the tax form, then you can, you know, your, your behavior can then be, you know, slightly altered to, to optimize your tax situation.

Tim Ulbrich: Yeah. And if you’re listening, you know, here in some of these terms wondering what, what are these guys talking about in terms of, you know, a backdoor Roth versus a direct contribution, we actually talked about this recently on an RX money roundup, episode 18. And we answered the question, can I do a backdoor Roth IRA myself?

Tim Ulbrich: That’s why I was joking with Tim that it’s his favorite, favorite topic to talk about. So we’ll link to that in the show notes, make sure to check that out. And, uh, you’ll, you’ll find a good resource there that will help you, uh, in your own. Planning as well. Thanks again to the two questions that we had submitted, uh, this week.

Tim Ulbrich: And, uh, if you have a question as you’re listening that you’d like to have us feature on an upcoming episode, head on over to yourfinancialpharmacist. com forward slash ask YFP. You can record your question there, or [00:15:00] you can send us an email at info. At your financial pharmacist. com. Thanks again for listening.

Tim Ulbrich: If you like what you heard, please do us a favor, leave us a rating and review on Apple podcast, which will help other pharmacists find the show. And finally, an important reminder that the content in the podcast is provided for informational purposes only, and is not intended to provide and should not be relied on for investment or any other advice information in the podcast and corresponding materials should not be construed as a solicitation or offer to buy or sell any investment or related financial product.

Tim Ulbrich: For more information on this. You can visit yourfinancialpharmacist. com forward slash disclaimer. Thanks so much for listening and have a great rest of your week.

[END]

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Why Most Pharmacists Should Do a Backdoor Roth IRA

Posted on by yfpadmin

Why Most Pharmacists Should Do a Backdoor Roth IRA

*Disclaimer – The following post is not tax or investment advice. It is meant to provide education on the subject matter covered and the ultimate decision to make any changes should be determined only by you and your designated financial professional(s).

Invest for retirement in tax-favored accounts. It’s one of the core financial recommendations you’re probably familiar with. While the 401(k), 403(b), or TSP is one of the best ways to do this, your contributions are limited to $19,500/year (for 2020). And if you’re someone looking to build a stellar retirement portfolio, that may not be enough to hit your goals.

As a pharmacist, you may have been told you make too much money to contribute to one of the best retirement accounts available, the Roth IRA. While that may be true, you may not have to settle for a traditional IRA or park your cash in a taxable brokerage account just yet.

That’s because there’s a legit strategy to work around this known as the “backdoor Roth IRA.”

While this retirement saving strategy does require a few extra steps, the ability to invest thousands of dollars with tax-free withdrawals can be well worth the effort. Plus, Roth IRAs have some other awesome benefits that are not available with traditional contributions.

When you’re eligible to take distributions at age 59 ½, you won’t owe any taxes on that growth.

Also, unlike a traditional IRA, there is no required minimum distribution and at any point you can withdraw any of your contributions you’ve made if needed tax free. Plus, if you have held a Roth IRA for at least 5 years, you can make early withdrawals on the earnings without penalty for a first time home purchase up to $10,000.

*Please note that the 5 year rule is different for a Roth conversion which allows you to move funds from your traditional IRA and place them in your Roth IRA. The 5 year holding period restarts for each conversion and any withdrawals during this time frame will result in a 10% early withdrawal penalty if you are under 59 ½.

Let’s go through why backdoor Roth IRA can be a great option and then how to actually do it.

The Issue with a Traditional IRA

IRAs or Individual Retirement Arrangements, are retirement accounts available to anyone who earns an income in addition to non-working spouses (covered later). No matter what company you work for or retirement plan they offer, you have the opportunity to contribute to an IRA. This is something you set up completely outside of work and can be done in addition to your 401(k).

Like your 401(k), IRAs also come in two flavors: traditional and Roth.

Contributions to traditional IRAs can lower your taxable income today with the amount growing tax-deferred resulting in you paying taxes at the time of withdrawal. However, because of the income limits to get the deduction, most pharmacists will never get this benefit.

Now the rules get a little tricky here because these limits are determined by whether you and your spouse have access to a retirement plan at work. But assuming you do, the ability to deduct traditional IRA contributions phases out completely at $75,000 if you file single and $124,000 if married filing jointly for 2020, hence excluding most pharmacists working full-time.

With this in mind, there is really is no question on whether a traditional or Roth IRA is better since there won’t be any benefit with the former. Therefore, either contributing directly to a Roth IRA or using the backdoor strategy will be your best move.

Roth IRA or Backdoor Roth IRA?

With the median pharmacist salary around $126,120, it’s very close to the income limits before you’re restricted from making standard Roth IRA contributions.

But rather than an all or nothing situation, the IRS begins phasing out your contribution limit once your modified adjusted gross income (MAGI) exceeds a certain threshold. These thresholds are listed below and depend on your filing status (single or married) and the tax year (2020 or 2019) you’re submitting your return for.

Single Taxpayers and Heads of Household

Single filers can make regular Roth IRA contributions when their income falls within these ranges for tax years 2020 and 2019.

One perk of being married is higher income limits to contribute. If your household income is below the amounts listed below, you can make Roth IRA contributions for tax years 2020 and 2019.

Married, Filing Jointly and Qualified Widows or Widowers

Before you think the backdoor Roth is your only option, glance at the income limits to see if you qualify to contribute directly to a Roth IRA first. No need to put in the extra work if it’s not necessary!

Even if your annual income falls within the IRS income phaseout range, you can still make partial backdoor Roth contributions. For example, if you’re a single taxpayer with a MAGI of $125,000, your maximum Roth contribution is $5,600 in 2020 and $4,800 in 2019.

This means you can contribute $5,600 directly to your Roth for tax year 2020 and the remaining $400 with the backdoor method to still contribute $6,000 annually. If you are able to make partial contributions and want to determine your limit, check out the IRS guidance for 2020.

Roth IRA Contribution Limits

The amount you can contribute to backdoor Roth is the same as the standard Roth IRA before the IRS phaseouts start applying.

You and your spouse can contribute up to the following amount to your Roth IRA:

Tax Year 2020: $6,000 ($7,000 if you’re 50 years or older)
Tax Year 2019: $6,000 ($7,000 if you’re 50 years or older)

To maximize your peak earning years, the IRS lets you contribute an extra $1,000 annually once you turn 50, something known as a catch-up contribution.

These are also the same contribution limits if you fund a pre-tax traditional IRA. Keep this in mind as you will need a traditional IRA to make valid backdoor Roth IRA contributions.

Make sure you only contribute up to the annual limit to your Roth IRA. In 2020, that’s either $6,000 or $7,000 per person. For non-backdoor Roth contributions, you can request a refund to correct the problem. If you don’t correct the excess contribution, you will pay a 6% penalty on the excess amount.

Open a Spousal IRA

If you file your taxes under married filing jointly (MFJ) and your wife or husband either earns a small income or doesn’t work, you can consider opening a spousal IRA to double your annual contributions. As long as your earned income is equal to the amount you contribute to your IRA and your spouse’s IRA (at least $12,000 if you each contribute $6,000), the spousal IRA contribution is valid.

In 2020, having a spousal IRA lets you and your spouse both contribute $6,000 ($7,000 if you’re 50 or older). That’s up to $14,000 of cash that grows tax-free until you withdraw it. Pretty cool right?

In order to take advantage of the spousal IRA option you will need to open up both a traditional IRA and and a Roth IRA in the spouse’s name. After contributing the annual contribution to the spouse’s traditional IRA you will then convert the balance to the spouse’s Roth IRA.

A Step-by-Step Guide to Making a Backdoor Roth IRA Conversion

Ok. We’ve gone through the benefits of a backdoor Roth IRA, why it’s a great move, and the contribution limits. Now let’s go through how to make this happen step-by-step:

via GIPHY

1. Make Nondeductible Traditional IRA Contributions

The first step is funding your traditional IRA with nondeductible income. If you’re making this contribution before April 15, you can either date it for last year (2019) or the current year (2020).

After the federal tax filing deadline (April 15 for most years), your only tax year option is the current year.

You’ll be completing an extra form, but this step is like making regular post-tax Roth IRA contribution. These contributions don’t reduce your taxable income for the current tax year.

The best way to fund your IRA contributions is from the checking account you use to deposit your paycheck. You must then decide if you want to make a lump sum conversion or dollar cost average as money becomes available.

Lump Sum Contributions

If you have $6,000 in idle cash and are close to the deadline for making your contributions, lump sum is the best option. With this strategy, you only have to make one contribution each year and your tax implications will be minimal if you make the conversion relatively quickly.

Dollar Cost Averaging

If you can’t max out your IRA at once or prefer to take advantages of changes in the market, you can also considering dollar cost averaging. With a $6,000 annual contribution limit, you can contribute $500 a month if you want 12 equal monthly payments but you could also come up with some other schedule.

Besides doing this out of necessity, there are other benefits with this technique. By contributing an equal amount over a period of time, you will naturally avoid trying to time the market. You will buy more shares when the market is down and fewer shares when the market is up.

Where to Set Up Your IRA

You have a lot of options on where to fund your IRA including banks, brokerage firms, and mutual fund companies. Companies such as Vanguard, T. Rowe Price, or Fidelity allow you to open accounts without any fees or commissions but there may be a minimum initial amount depending on the investment you choose.

Now, when you make your contributions, you will have to decide how you actually invest the money. Remember, the IRA is not the actual investment but rather a tax-advantaged vehicle or shield for your money.

You will have thousands of options here and how you invest will depend on your goals and your risk tolerance.The one point to keep in mind will be to minimize the fees. Many index funds and ETFs exist with expenses ratios as low as 0.03-0.08.

However, keep in mind that by subjecting your contributions to market fluctuation, you could actually lose money prior to making your conversion. Therefore, the conservative approach would be to keep contributions in a money market account or other low-risk investment with little to no volatility.

2. Make a Roth IRA Conversion

Your next step is to convert your contribution amount into a Roth IRA. It can take several days for your traditional contributions to settle before you are able to convert them but by having your Roth IRA with the same broker, you should be able to easily schedule the conversion.

When making the backdoor Roth IRA conversion, your broker will ask if you want to withhold any income for taxes. Since you made a nondeductible contribution in the first step, don’t have your broker withhold anything.

Potential Tax Implications for Lump Sum Contributions

You will be responsible for any taxes when you file your return, but the amount should be minimal if the cash doesn’t sit in your traditional IRA long enough to significantly appreciate in value. This is your most likely tax situation when you make lump sum contributions and you don’t have an existing balance in your traditional IRA that converts first.

Potential Tax Implications if You Dollar Cost Average

If you convert money that has appreciated in value, let’s say 30%, you pay taxes on those gains. For example, let’s say for 2020, you contribute $500/month to get up to the max contribution of $6,000. But, because the market was on fire, you actually have $7,800. You would be responsible for paying taxes on the $1,800.

How Long Should You Wait Between Traditional Contributions and Roth Conversions?

One of the questions that commonly comes up when making the Roth conversion is how long to wait. Technically, as soon as your account is funded with your nondeductible traditional contributions, you can make the move.

However, doing this could cause some issues with something called the step transaction doctrine. It has to do with the overall result of a series of transactions where the IRS could essentially penalize you with taxes because you are exploiting a loophole.

There is controversy by financial experts on what the best waiting period is. Some advocate for one month while others recommend waiting a full year before making the conversion.

3. Report Contributions and Conversions on Your Tax Return

When filing your federal return, report the nondeductible contributions and Roth IRA conversions. Your broker will send you the necessary tax forms each year to properly report the information to your accountant or online tax prep software.

Although you’re contributing to a traditional IRA first, you will make nondeductible transactions. You will need to complete IRS Tax Form 8606 to report your total traditional IRA contributions for the current tax year. This lets the IRS know you’re not funding your backdoor Roth with tax-deferred contributions.

4. Repeat as Necessary

Follow the same steps if you have a spouse as you can each do a backdoor Roth IRA every year.

Backdoor Roth IRA Tax Implications

I discussed earlier that you likely won’t have to pay taxes on your traditional IRA contributions when you make the conversion assuming there is no growth during that time frame. However, in that particular case, it assumes this is first time you are doing a backdoor Roth IRA and that you only have other existing Roth IRAs.

It gets a little more complicated if you have existing funds in nondeductible traditional IRAs. Because of the IRS aggregation rules, they look at everything you have contributed in the past, not just what you contributed for the current tax year and it all becomes “aggregated.” Therefore, if you have a large existing traditional IRA balance, it may negate the benefits of the backdoor strategy.

If you are in this situation, you could roll the existing IRA balance into a 401(k)-type account if your employer allows. This can either be your employer 401(k) or a self-employed 401(k). This way you can fund your backdoor Roth with the income you earn in the current tax year and have a starting traditional IRA account balance of $0 and avoid a potentially hefty tax bill

When your current traditional IRA balance is small or doesn’t have large investment gains, it might be better to pay the taxes on the amount you convert instead of rolling it into a 401(k), especially if you have limited investment options or high fees.

Conclusion

The backdoor Roth IRA is a legal and easy way to maximize your retirement savings and can be a great option for pharmacists given many will not be able to directly contribute to a Roth IRA because of the income limits.

If you haven’t filed your 2019 income taxes yet, you have until April 15, 2020 to make IRA contributions. You also have all of 2020 and until April 15, 2019 to make the tax-advantaged contributions we’re discussing today.

If you need help doing your conversion or want some guidance on how to invest the funds within your Roth IRA, you can schedule a free call with our financial planning team to see you’re a good fit.

Also, If you’re looking for other ways to reduce your taxable income when investing, IRAs aren’t your only option. I recommend listening to this podcast episode to help determine your priority of investing.

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Episode Summary

Key Points from the Episode

Episode Highlights

Links Mentioned in Today’s Episode

Episode Transcript

Why Most Pharmacists Should Do a Backdoor Roth IRA

Why Most Pharmacists Should Do a Backdoor Roth IRA

The Issue with a Traditional IRA

Roth IRA or Backdoor Roth IRA?

Roth IRA Contribution Limits

A Step-by-Step Guide to Making a Backdoor Roth IRA Conversion

Backdoor Roth IRA Tax Implications

Conclusion

Compliance/Legal

Disclaimer and Disclosures

Firm Brochure (ADV Part 2)

Brochure Supplement (ADV Part 2B)

YFP Planning CRS

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