A sneaky-but-legal way to save for retirement

September 14, 2022 • Issue #160

Hi y’all —

Harry Styles is wrapping up his residency at Madison Square Garden, which means I’m wrapping up my residency at Madison Square Garden.

After several shows, I’ve got it down to a science: He goes on at 9:06, so I leave my apartment in Brooklyn by 8:15 p.m. I pregame on the subway to avoid paying for drinks. I shop early for merch to avoid lines, use the bathroom during “Matilda” and leave just after The Whale so I can beat the crowds to the train.

These life hacks serve me well. They allow me to accomplish the same thing as everyone else (thirst after him have a great time) while skipping certain pain points (like drowning in a sea of feather boas). My methods may be sneaky, but sometimes you have to get creative to achieve your goals — like with backdoor Roth IRAs.

It seems messy, but let’s make like Harry and jump in: How do backdoor Roth IRAs work? Should I get one?

I’ll start with the basics. An IRA is an individual retirement account often funded by pre-tax contributions, and a Roth IRA is a specific type of IRA generally funded by after-tax contributions. These aren’t workplace plans; I open them separately from (and often in addition to) my job.

One of the perks of Roth IRAs is that they offer “tax-free growth on each deposit for many years to come, which is a great feature, so people want to contribute to one,” Patrick Simasko, elder law attorney and financial advisor at Simasko Law in Michigan, tells me via email.

The only problem? Not everyone is eligible to do that.

IRS rules dictate that single filers with an modified adjusted gross income of $144,000 or more (and married couples with MAGI of $214,000 or more) in 2022 don’t qualify to contribute to a Roth IRA. They can only contribute to traditional IRAs, meaning they’re losing out on Roth-only benefits like tax-free withdrawals later in life.

Enter the backdoor Roth. John Bergquist, president of Lift Financial in Utah, says it’s a way for folks to put dollars into a Roth IRA even if their income level is too high.

As you might expect from the word “backdoor,” it’s not something I can simply order off the menu. I have to do a conversion, which involves depositing non-deductible, after-tax money into a traditional IRA and then immediately making it into a Roth.

“There are no current income limitations on doing a conversion, so backdoor Roths use this to their advantage to get around the income limitations and still get funds into a Roth,” Bergquist says.

Converting my IRA this way is a taxable event — there’s actually a specific form I have to use to tell the IRS about it — but it can be a useful tactic for high earners, says Jason Noble, a certified financial planner in South Carolina.

“It will allow the money to grow, and when withdrawn over the age of 59.5 or five years from the conversion, the withdrawal is 100% tax-free,” Noble adds in an email. “If you believe taxes will go up in future years, a backdoor Roth is a viable solution as you pay the income taxes now and avoid them in the future.”

Alas, IRA conversions are kinda complicated. In particular, I need to watch out for the pro rata rule, which Bergquist says “is a big challenge to a backdoor Roth — and one that can definitely get you in trouble.” Basically, the IRS won’t allow me to dictate which specific funds in my combined IRAs I’m converting, so it treats the balance as one big sum for tax purposes. 

Bergquist gives this example: Say I’ve got a traditional IRA with $94,000 and a non-deductible IRA contribution of $6,000 that I want to backdoor into a Roth. But the way the IRS sees it, I’ve got $100K in IRA money; I can only convert 6% from the after-tax dollars, meaning 94% of my conversion will be taxable.

This can result in a big surprise bill if I didn’t plan for it. It also gets more complex when growth and withdrawals are involved.

The pro rata rule, and other quirks like the step transaction doctrine, are best handled by a professional, so I should definitely get in touch with a financial advisor if I’m seriously considering a backdoor Roth.

But, in all honesty, I probably don’t need to.

Simasko says that if I’m under the Roth income limit — which I am — I should just make a regular Roth contribution and avoid the hassle. (I could also put the IRA money into my 401(k), then funnel it into a Roth, but that’s a whole other story.)

THE BOTTOM LINE

(but please don't tell me you scrolled past all of my hard work)

Backdoor Roth IRAs are a way for people with high incomes to get around IRS rules. They involve a conversion and are somewhat difficult to do, but they’re totally legit. (At least for now — Congress has tried to close the loophole.)

Because my MAGI qualifies me to make normal Roth IRA contributions, I personally don’t need to worry about this. But if you’re interested in a backdoor Roth IRA, Simasko urges you to not to go it alone.

“Work with a planner who can help you make a non-deductible traditional contribution, then convert it to a Roth IRA, then make sure it is treated correctly on your tax return,” he says.

VIA GIPHY

RECEIPT OF THE WEEK

check out this wild celebrity purchase

VIA INSTAGRAM

Philanthropist MacKenzie Scott (formerly Bezos) recently donated her $55 million complex in Beverly Hills, California, to charity. The organization plans to sell the compound — which includes 13 bedrooms, 14 bathrooms, a pool and a tennis court — and put the profits toward “affordable housing projects and an immigrant integration program.” That’s what I call Prime real estate.

INTERNET GOLD

five things I'm loving online right now

1	I wouldn’t say I’m a *fan* of the British monarchy, but I do love to follow the news around the royal family — which means I’ve been absolutely eating up the coverage of the queen’s death. That includes this incredible Twitter thread about how a team of volunteer editors changed her Wikipedia page last week…
2	…and this story about how mourners are being asked not to leave corgi toys, stuffed animals or any non-floral items at memorials for Queen Elizabeth II. “Feel free to bring flowers, but maybe don’t bring any more Paddingtons or marmalade sandwiches for now,” added one news anchor.
3	Also cool: Starting on Sept. 26, the flowers for the queen are going to be composted and “used on shrubberies and landscaping projects across the Royal Parks.”
4	OK, moving on. Watching a COVID-stricken John Green — y’know, a best-selling author — narrate a series of increasingly unhinged cars-versus TikToks is an amazing way to waste time, if that’s something you’re looking for. Just sayin’.
5	Teeny tiny cat teefs.

401(K)ITTY CONTRIBUTION

send me cute pictures of your pets, please

VIA Leslie Lewis

Meet Flynn, an orange cat who was tired yesterday and now is clearly re-tired.

Brb, going to Harry’s house.

See you next week.
 

 
P.S. Have you ever converted your IRA? What’s your favorite Harry Styles song? If you had to donate your house to charity, which would you choose? Send contributions to julia@money.com or @SuperJulia on Twitter.

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