Roth Strategies: What You Need to Know

Speaker 1 – 00:00
Welcome to EWA’s FinLit podcast. EWA is a fee only RIA based out of Pittsburgh, Pennsylvania. We hope all listeners
of this podcast will benefit as we deep dive into complex financial topics that we will make simplified for you. And
we hope that this really serves as a catalyst so that you can make the best financial planning decisions for your
family and also save time.
Speaker 2 – 00:28
This week’s podcast joined with Chris and we’re going to dive into backdoor Roth IRAs, mega backdoor Roths and
Roth conversions. So a lot of tax strategies here.
Speaker 3 – 00:40
Yep, let’s do it.
Speaker 2 – 00:41
Chris, give us the lay of the land, of just the tax environment, the tax hood.
Speaker 3 – 00:46
Yeah, that’s a good question because all of this relates back to when you want to pay taxes. We look back
historically of where taxes have been. Right now we’re in one of the lowest rate environments we’ve been at
throughout history. So the highest marginal rates, 37%. But that’s been much higher in the past. So a lot of opinions
are out there on what future taxes will be. Our firm stances that those will be higher, making Roth more attractive. So
sure, we’ll get to that today. But yeah, high level, very low right now.
Speaker 2 – 01:17
Yeah. And so the tax code that was put in place in 2017, believe it took effect in 2018, cut marginal tax rates to what
you just said, the highest rates, 37. That’s set to sunset at the end of 2025. So 2026, if there’s no legislation change,
that top tax rate goes up to 39.6, and then the tax brackets below that go up a little bit too. So all in all, taxes just by
law will be higher. However that was put in place by the current administration now. So most likely, kind of a big
debate in Congress right now and with the government, probably these tax cuts will get extended, most likely
another four years. We’ll see what happens. But one thing to note before, I believe it was in 2021, after the 2020
election, there was a proposal. It’s a big tax overhaul.
Speaker 2 – 02:15
Made it through the House, didn’t make it through the Senate. It would have. One big thing it would have done was
taken Roth away for anybody that made over $400,000 wouldn’t be able to do Roth conversions, which would inhibit
backdoor Roth. Mega backdoor Roth. So why that’s important is our opinion is that this is in place right now, but this
could potentially go away in the future. So all the things that Chris said, taxes going up, potentially Roth could go
away so why Chris, why is it important, you know if taxes go up that you’re planning for Roth now?
Speaker 3 – 02:49
Yeah, that’s every distribution from a Roth accounts tax free. So if we prioritize pre tax accounts, that’s a good thing
while you’re working. So you get a deduction, you can remove those savings from your gross income. So your
taxable income is lower just in the current year, but all of that’s deferred until the future when you’re retired and draw
that money. So if we fast forward whether you’re 10, 20, 30 years from retirement, those are the tax brackets that we
have to try to forecast is what’s that environment going to look like when you’re actually retired. So if we have too
much pre tax on top of Social Security, if you have pensions, real estate income, anything like that, those pre tax IRA
distributions would be added on top of that and could force you into the 32, 35% brackets depending on your
situation.
Speaker 2 – 03:35
So one thing, taxes probably. Well if I was placing a bet, I would say that they will be higher in the future. So number
one, the tax code in general will probably be higher when you’re taking money out. Number two, I think a big
misconception is that I’ll be in a lower tax rate when I’m retired.
Speaker 3 – 03:51
Right.
Speaker 2 – 03:51
Sometimes that’s true. Most of the time it’s not. Especially if you have a higher net worth. For all the reason you just
said Social Security comes in, you know, couple that had max that out when you’re going to retire, that could be 80 to
100,000 a year taxable income, 85% of that’s taxable. But yeah, that could be an income stream. Maybe you’re
working part time, maybe you have real estate income, maybe you have income from different investments and then
the big one is dividends or interest that pay from any non qualified account. So if you’re a high income earner, there’s
limits on how much money you can put into these taxider accounts. So majority of your wealth is going to
accumulate in a taxable investment account.
Speaker 2 – 04:32
Any dividends or interest that get kicked off now or when you’re in retirement gets shows on your tax return as
income. So all of those things you’re already, you know, most likely looking at a couple hundred thousand of income
on your tax return. That’s before you even take any money out. Right. And the other thing too, Medicare costs in
retirement are based on taxable income. So if everything’s taxable, all of those Things plus IRA distributions, you’re
paying pretty high Medicare rates that you could ideally avoid. And then the other big thing is what’s called the
sequence of returns risk. So pre tax IRAs have required minimum distributions. So when you hit age 73, you have to
take a portion of the money out because you haven’t been taxed on it yet and the government wants their tax money.
Roth accounts don’t have that.
Speaker 2 – 05:18
So why that’s good is if the market’s down and you’re forced to take RMDs, you could be forced to liquidate money at
a loss. Whereas a Roth account, you don’t have to take this. You can take the money out whenever you want. If the
market’s down, you can just choose not to take it out.
Speaker 3 – 05:32
Right? Yeah. So your point on the IRA, the RMD, to put it in perspective, if you’re 73 right now, if you have 500,000 in a
pre tax account at 73, you’d have to take about 19 out. If you have a million it would be 37, 2 million 75 or 3 million
113. That’s just in year one.
Speaker 2 – 05:52
But if we goes up, that’s what people understand.
Speaker 3 – 05:54
Yeah. So if we look at, let’s just use the 2 million example. At 73 your RMD would be 75, but by 83, 10 years later that
would go up to 113. So yeah, definitely a big misconception that you’ll be in a low tax bracket just because you’re not
working. So if you have a big retirement savings, that’s probably not going to be the case. So something we’ll talk
about today is Roth conversion planning. So there’s a sweet spot. If you stop working in your 60s before those RMDs
start, we can start recognizing potentially some lower tax rates and flip some over to Roth, which we’ll get into.
Speaker 2 – 06:27
Yeah. So let’s talk about how we do that. So the first one, backdoor Roth ira. Chris, why don’t you give us an overview
of what that is?
Speaker 3 – 06:36
Yeah. So backdoor Roth is a strategy that higher income earners can use to fund Roth outside of an employer plan.
So IRA stands for Individual Retirement Account. Anyone can establish this as long as you have earned income. But
there’s limits where. Do you know the limit offhand?
Speaker 2 – 06:53
It’s like 250 for a married couple.
Speaker 3 – 06:55
Yes. If you make over 250, like if you’re a physician, both physicians, we work with a lot of people in medicine, you’re
probably going to be over that limit. So you can contribute to a traditional IRA on a post tax basis. You can’t deduct
that contribution anyways because it’s the same limit that 250. So step one is you put the money in an IRA, you don’t
get a deduction for it. It’s post tax dollars that you’re using. That’s an important note because when we do step two
and convert that 7,000 to Roth, since those dollars have already been taxed, there’s no liability. So once the money’s
in the Roth ira, it grows and distributes tax free.
Speaker 3 – 07:31
So that’s kind of low hanging fruit that if you have the cash flow to do it, or if you have a brokerage account, we can
just move money that’s already invested on your balance sheet to fund that backdoor Roth and get more money into
the tax free account.
Speaker 2 – 07:43
Yeah. So this is no brainer. If you still have earned income in any capacity, you can fund this. One thing to note is
what’s called the pro rata rule. So if you have an existing IRA balance, let’s say you have a million bucks in an IRA and
you go to do the backdoor roth, you take $7,000, which is the limit. If you’re under 50 in 2025, you do the non
deductible IRA and convert it. This pro rata rule basically says it’s a calculation based on how much money is in the
taxable ira, that then makes the Roth conversion taxable. So the money that goes into the Roth becomes taxable. So
you don’t want to do that.
Speaker 2 – 08:17
The way around that is either number one, convert your IRA to Roth and then do the backdoor Roth or move the ira
into the four into your 401k. Now in the IRS’s eyes, you don’t have an IRA and you can fund the backdoor Roth.
Speaker 3 – 08:28
Yeah, so that’s only for anyone listening. That’s only if you have an existing pre tax traditional IRA balance. That’s
where that pro rata aggregation rule could come into play. You would essentially your $7,000 Roth contribution
would get almost entirely double taxed. It would get taxed once when you earn the money and then secondly, large
portion of that would get recaptured again on your tax return.
Speaker 2 – 08:51
Yep. So okay, so backdoor Roth, that’s easy. Low hanging fruit, no brainer if you’re able to do it. Now let’s talk about.
You can fund Roth also through your employer retirement plan. So whether you have a 403B, 401K the first thing you
can do is we’re going to focus on a mega backdoor Roth. But the first thing you can do is make your salary deferral.
If you’re under age 50, it’s 23,500 for 20, 25. If you’re over age 50, you get a $7,500 catch up. You can make that
contribution pre tax or Roth. So same thing we said, if pre tax deduction. Now Roth after tax basis grows tax free. A
mega backdoor Roth is doing that.
Speaker 2 – 09:32
But then if your employer offers a after tax contribution with the ability to do Roth conversions, you can contribute a
portion into the after tax and automatically convert it to Roth. Chris, why don’t you give us an example? I don’t know,
UPMC is a popular one here in Pittsburgh or ahn, why don’t you give us a breakdown of like specifically how that
works?
Speaker 3 – 09:54
Yeah. So there’s something we need to consider. It’s called the 415C limit. It’s 70,000 total. That can go into a 403
plan or a 401K. So a big misconception that we hear is that the max is 23,500. So that’s the case for most plans or
most people. But again, if you have access to that after tax account, you can fund above that 23, 5 and try to get up
to the 70. So an example would be, so if we have 70 total that can go in, say that you’re a physician and you get a 3%
match that works only the first 350 that you earn. So that match would work out to 10,500 that your employer would
put in for you. Then we have your elective deferral. That’s another 23, five that could go in.
Speaker 3 – 10:39
So just between those two pieces, your contributions and the match, we’re filling up 30 for the $70,000 limit. So we
have 36 left to go. That’s where the after tax contributions would come in. So we would set that up over the course
of the year, 3,000amonth or 36,000 for the course of the year goes into that after tax account. Then we can convert
that internally within the plan to the Roth. So end result is we’d have almost 60,000 between your elective deferral
and those after tax contributions. That’s growing tax free. And then the only taxable portion would be the employer
match. Most 99.9% of employers match on a pre tax basis. That’s still going to grow tax free. But when you pull it
out, it’ll be taxable.
Speaker 2 – 11:24
Yeah. So this is very like plan specific. Some plans allow you to do this, some plans don’t. So important to analyze if
you do have this option, if you do and you’re making enough money that you’re able to fund all this. Another I would
say no brainer while the tax code allows it because potentially in the future you’re not allowed to. And then another
strategy to be able to do this if you have any 1099 income. So let’s say you’re a physician, you have a W2 salary from
the hospital and then you do some, I don’t know, consulting or legal work on the side. You can have another 401
through that 1099 income and you can do the same strategy, make an after tax contribution, convert it to Roth.
Speaker 2 – 12:01
So you know, we have clients that are getting 140, 150,000 a year into Roth through back to Roth IRA, Roth 401K or
403B and then another mega backdoor Roth 401K if they have 1099 income.
Speaker 3 – 12:16
Yeah. Hands down. One of the best things you can do for your planning. The only time we really recommend pre tax
funding is if you have, you know, certain people getting started. Maybe they come out of med school with student
debt and there’s certain repayment plans. If your AGI is lower, it’s more advantageous. But aside from that, or if you
need the extra tax money, like if cash flow wise, you’re really banking on that tax deduction from the pre tax, that’s
the only reason why we’d recommend it.
Speaker 2 – 12:40
Or there’s, I’ve seen like very, a handful of scenarios where people are like going to retire in a year or two.
Speaker 3 – 12:46
Yeah.
Speaker 2 – 12:47
And their income, they’re like peak earning, maybe they’re making you know, 500 to a million. And then when they do
go to retirement, you know, maybe before they’ve turned on Social Security and they don’t have any part time work,
you know, they’re only going to have like 100,000 of income. Maybe we do some deductible contributions and then
just because we know in a year or two they are going to meet a lower tax bracket, that again, very rare situation that
happens. I’ve only seen that a handful of times.
Speaker 3 – 13:16
Right.
Speaker 2 – 13:18
Okay. So the third way is through Roth conversion. So Chris, why don’t you explain this.
Speaker 3 – 13:23
Yeah. Roth conversion planning is just looking at money that’s already in a pre tax IRA and then volunteering to pay
the one time tax to flip it to a Roth ira. So there’s a sweet spot here because we have to look at your tax bracket and
where you’re at. So, for example, say you’re married and between the two of you have about 80,000 coming in with
Social Security. Say there’s pension income of 45 or interest income of 20, and your total income is 150 for the year.
The way that the tax code’s written now, the 22% bracket extends out to 206,000. So we could potentially recognize,
you know, look at doing a conversion for about 50 to 60,000, that would keep you in the 22% bracket and just fill up
those low. We mentioned that sweet spot earlier before RMD start.
Speaker 3 – 14:17
So we would essentially want to volunteer to pay that tax now, get the money to the Roth, which also reduces your
traditional IRA balance. So in the future those RMDs will be lower.
Speaker 2 – 14:26
Basically, you could volunteer to pay 22, knowing that when it comes out with the RMD, you could be paying 35, 37,
or a higher rate of tax code exchange.
Speaker 3 – 14:34
Right? Yeah. This makes a lot of sense. If somebody’s not maximizing their retirement spending, like say they have a
big brokerage account, they’re not maximizing what they could safely take out every year. We could volunteer to pay
that tax from that brokerage account because we’re still staying in a safe withdrawal rate to just use some of that
money that they could otherwise be spending now to make their balance sheet more efficient.
Speaker 2 – 14:55
Yeah, and that’s a good point too. This. So one reason you can do Roth conversion is exactly what you said, to pay a
lower tax rate versus what it would be later. But another good reason is if you know you’re gonna have a surplus, it’s
going to be passed on to kids. Roth accounts pass tax free. I mean, if you’re over the federal estate, the estate
exemption, the estate credit, you’re still, you could still pay an estate tax, but when beneficiaries receive that money,
they don’t pay any taxes when they take out. If your kids are in a higher tax bracket, you know, maybe they’re also
physicians or they’re business owners or something where they’re making a lot of money. You know, they could
inherit that and then pay 37% or higher on it, take the money out.
Speaker 2 – 15:37
So where this is, I’ve seen this really become important if you are over this estate exemption. So right now is $28
million between a married couple probably going to go down in the future. Let’s say you have a $50 million net worth
and a lot of your money is in a pre tax IRA. Some of that could be subject to a 40% federal estate tax plus state
inheritance tax depending on your state. And then when your kids receive the money then they pay taxes again on it
when they take the money out. So I mean those are big, big numbers. But if you do Roth conversions, maybe you still
pay that 40% but then when they take it out they don’t pay any income tax on.
Speaker 3 – 16:17
Could easily be like the federal is 40% here in PA the four and a half percent. So if your kid’s in the 35 or 37% bracket,
we’re losing a lot.
Speaker 2 – 16:28
80% almost.
Speaker 3 – 16:29
Yeah, yeah. So Roth avoids that plus those if you’re inheriting a pre tax account that has to come out over a 10 year
period. So there’s no way to defer that anymore.
Speaker 2 – 16:38
The Roth still has to come out over 10 years if you inherit it, but there’s no taxes. So yeah, if you’re above, if you’re
over that estate exemption, it’s no brainer to do Roth conversion most likely. Yeah. Anything we missed?
Speaker 3 – 16:56
I don’t think so. I think that’s the basics of the Roth planning in general. It all comes down to when you want to pay
the tax. So if you have the extra money, if you’re retired now, might make sense to convert some money. Definitely.
We want to recommend prioritizing funding Roth along the way to avoid a lot of complications later on.
Speaker 2 – 17:14
Let’s talk about to one more thing to add. We get this question a lot. How much is too much to fund a Roth? Yeah, we
would say right now. So general rule of thumb, if you have you get to retirement, whatever your total assets are, if you
have like a third of that in Roth or combination of Roth and taxable account that you’re not paying income tax on, you
take it out. That’s generally good. Yeah, more than that’s good too. Like some clients want closer like 50%. Some
clients want all their money in Roth just so they don’t have to pay any taxes. It we generally want some money to be
pre taxed because when you do retire we do want to fill up those low tax brackets.
Speaker 2 – 17:53
So you know, Social Security, interest, dividends, any earned, any income if you are working part time. But a lot of
times that can be accomplished through what you said, the employer match. Maybe you have a cash balance
pension plan that your employer’s funding or you’re funding yourself. So most likely if you do all Roth funding there
still is going to be some pre tax money to fill up those low tax brackets. But general rule of thumb anywhere between
a third to 50% Roth is kind of the sweet spot.
Speaker 3 – 18:20
Yeah, that’s where it becomes individualized because if you have a lot of pension you could but the sweet spot is 10
12% bracket. No brainer to recognize income there. But potentially 22, 24, 32. Those are the rates that we want.
Speaker 2 – 18:34
To avoid long term or even fill up 22, 24 and then it’s a pretty big jump to go up to 32.
Speaker 3 – 18:42
Yeah.
Speaker 2 – 18:43
So that’s overview on Roth and taxes. Something we’re monitoring this year is if the tax code changes but again
most likely probably will still be in effect for the next few years. But beyond that totally unknown and could go away.
So make sure you’re maximizing it now while you’re able to.
Speaker 3 – 19:00
Yeah, I think a lot of people don’t like uncertainty for sure. So that taxes is a huge question mark in everyone’s plan.
We have no idea what’s going to happen. But the Roth is, you know, we know for sure. Yeah. Takes that away a lot.
Speaker 2 – 19:13
So sure.
Speaker 1 – 19:14
Thanks for tuning in to our podcast. Hopefully you found this helpful. Really hope this is as beneficial and impactful
to as many people across the nation as possible. So hit the follow button, make sure to rate the podcast and please
share with any friends or family members that would also find this beneficial. Thank you very much.