Transcripts Including Tag: rothbackdoor

Description: Tax Optimization :: Roth Backdoor

These are the transcripts that include the tag rothbackdoor.

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026: Physician on Fire Jonathan Mendonsa Right. That's a great summary in fact we've actually covered a lot of those topics one by one and I think you just pieced it together. You know I think a pretty easy to understand way. So one of the things that I know a lot of high income earners look at in fact there's some concerns that maybe down the road it may not be there is the backdoor Roth do you want to unpack that idea for us.
026: Physician on Fire Milo "Physician on FIRE" Andersson Sure. I've been doing the quote unquote backdoor Roth for four or five years. And what that is is a way to get some money into a Roth IRA for people that earn too much to be eligible to contribute directly. And for couples that are married filing jointly I believe the cutoff is about 180 or $190000. And so once you're above that MAGI I think it is then you have to look at a non traditional way of doing it which is by making a nondeductible contribution to an IRA and then subsequently converting that to Roth IRA. So you accomplish the same thing as a direct Roth IRA contribution which you're not allowed to do but by doing it in two steps. And so that's why they call it the back door. And as you mentioned that that could go away at any time. So I always take advantage of that right away in January every year and you can do it for yourself and you can do it for your spouse even if your spouse doesn't earn an income because you can start a spousal IRA.
026R: The Friday Roundup Paul Case Study Final Wrap Jonathan Mendonsa Okay. And then there's one other thing that I thought was really cool he was the first one to talk to us on this show about the back door Roth and that is a very cool idea. It is one that we are going to really explore in a future episode but I won't go super far into it today. But what's really interesting for this particular framework the high income professional these people are making 250 300000 400 500000 plus. What's great about this is they don't have to choose which one of the buckets that they use. Obviously they're going to throw as much as they can into tax deferred if they have access to an HSA they're going to use that if they have a 457 they can fill up that so that they've already fill up all their tax deferred and they have plenty left to go ahead and invest in taxable funds for them. There's absolutely no downside to go ahead and take advantage of this backdoor Roth. And it's it's a tax diversity play. So I know there's a lot of controversy out there about when it comes down to the wire and you have to pick between putting $5000 in a Roth versus $5000 in taxable. What should you do and I think there's a lot of value there. And if you listen to our episode 18 and 18 R when we talk about capital gains harvesting I think we kind of explore that idea a little bit and that's a great conversation to have. But for the high income professional there's really no downside to go ahead doing both because they can. Why not go ahead and take advantage of the backdoor Roth and then if the capital gains laws change down the road and they raise the rate or change something else about it they have this play and then the Roth which we'll explore more has some additional features especially when you look at doing a inheritance for your kids. There's some really cool features about the Roth that are worth exploring. So I like that he got a chance to really talk a little bit about the backdoor Roth with us.
026R: The Friday Roundup Paul Case Study Final Wrap Jonathan Mendonsa Yeah absolutely. And you know we talked about those different scenarios. I think at some point me and you will be forced to come to the conclusion that there's maybe six to eight different scenarios that are very distinct and you and everybody that's listening will find themselves identifying with one of those different scenarios and then being able to model it to their own purposes. The backdoor Roth people are going to be very interested in that once they're in that I think probably. I want to say 150 to 200 thousand range and then higher. That really starts to look more attractive as as an option. So alright guys let's go and take a pivot here and just take a few minutes to highlight what's going on in the community this week. Brad where should we start.
043: Drawdown Strategy Retirement Manifesto Jonathan Mendonsa And I know nothing about the mega backdoor roth I've read Mad Fientist's article three times it literally doesn't make sense to me after hours of looking at it. So if you have a simpler way of distilling that this would be the first time I'd be introduced on the show that you really cool.
043: Drawdown Strategy Retirement Manifesto Fritz "Retirement Manifesto" Gilbert I've done a Mega Back Door Roth for the last three years. I'm a huge fan so I can talk about that for a whole podcast if you want.
043: Drawdown Strategy Retirement Manifesto Brad Barrett So for everyone out in the audience who has never heard of this mega back door thing like what is this. I thought the Roth IRA limits where fifty five hundred dollars a year and only certain people with certain incomes could put money in. So what the heck is this frankly like why are you allowed to put in you know the difference between your 18000 contribution and your to your employer deferral for your 401K. And this. $53000 limits or $35000 a year in what seems like a gimmicky way like. How on earth is this possible. And also like are there certain mechanisms you have to do. Does everyone's company allow this. Talk us through how this is even plausible.
043: Drawdown Strategy Retirement Manifesto Fritz "Retirement Manifesto" Gilbert That's right. And you know if you think about the tax logic and again this is all part of the withdrawal strategy theoretically you want it you want to have stuff count as income when you're in your lower tax years. So conceptually doing it now. When I'm at my peak earning years doesn't really make sense right. Financially it's probably not optimized but to me the value of having as much roth as possible in my drawdown strategy is worth taking a potential financial hit to get it set up. You know that's that's that's the thing you should do a Roth when you're younger in your career and you're not in the higher tax brackets max them out right. If any of your listeners are making less than 50 60 grand a year. A hundred percent in the Roth don't even think about it because as your income grows you're into a higher marginal tax bracket that's when you want to do for tax contribution and then wait until retirement to pull that money out and have it counted as income. That's the that's the traditional way of doing it. But this mega back door has so many other attributes that are attractive about it that I'm kind of going against the grain of how you normally fund a Roth.
043R: Mega Backdoor Roth Jonathan Mendonsa Now what's really cool about this is Seonwoo who is the moderator in our Facebook group now he is a pure ultra optimizer in every way shape or form and he writes over a FI by 40 dotcom and he says I completely disagree with the Social Security discussion on today's episode guaranteed 8 percent return by delaying Social Security. The problem with that argument is that the Social Security payout tables are actuarially fair and what he means by that is when you take into account the lifespan of the average person the average person will get the same lifetime lifetime pay out regardless of when they start claiming benefits. The difference is going to lie with the widow or benefit so when someone dies his or her spouse is entitled to the deceased benefits. So if the higher earner is older it's statistically better to delay taking Social Security benefits. So here's a back and forth of that. If you delay till 70. Yes Fritz is completely right. You're going to get that increase in pay out year over year so it's a guaranteed rate of return. But the but practically speaking every single year you delay is a year or less that you're probably going to get this because most of us Tim Ferriss aside don't have 120 130 years in the bank. Most of us are going to probably cap out right around 95 unless the robots take over our organs for us. So you can see how yes the math says you're going to get this guaranteed rate of return. But if now you're only able to use that for 10 years instead of for 16 or 17 years. Seonwoo is saying that may not be a great choice. With the exception of thinking about your surviving spouse that is what you're going to have to weigh. And I don't think I can give you the one size fits all answer in this episode but I can say that when you're building your drawdown strategy that is what I would be considering. Is your spouse significantly younger than you than you. Then there's a case that they would have a much longer timeline to be drawing down on that money for. And I think those are the the key points you have to think about when determining what to do with this. And then the last point that we wanted to talk about from Danny was this idea of keeping money in your taxable account to can to cover the Roth conversion tax cost especially in a market downturn. You should get aggressive on the conversion. You also need to fund living expenses as well. So I wanted to spend some time on this because Brad I think some people do have a tendency to confuse the Roth conversion with the mega backdoor Roth. And I'd love to get your take on that.
043R: Mega Backdoor Roth Jonathan Mendonsa And then I wanted to say that there is a distinct thing called the mega backdoor Roth and I'm going to let Brad kind of introduce this concept as well. But before I do that I wanted to talk about one point which is in that episode Fritz says that in order for you to be able to do this your H.R. department has to allow in-service withdrawals and the only reason I say that is I think some people took that as a mandatory requirement for H.R. departments and I wanted to stress that unfortunately it is not mandatory. He was saying that in order for you to be able to do it your H.R. department will need to offer this now they don't they don't have to they're under no requirement to and in fact many businesses don't. But if you're lucky enough to work for an employer that is H.R. department does allow in-service withdrawals then you should be able to do this. And so it's worth going to your H.R. department to ask them whether or not they make that allowance.
043R: Mega Backdoor Roth Brad Barrett Yeah and that's built into the 401k plan so it's not just like on the whim of like the V.P. of H.R. it's what does your 401k plan allow. And yeah the two keys to be able to do the mega backdoor and I will explain that a little further in-depth in a second but the two keys are that they allow after tax contributions and in-service withdrawals. OK. So those are the two absolutely essential points so when you do talk to your H.R. department and ask them about the rules of your particular 401K. Those two things have to exist in order for this mega backdoor to work. All right. So just reading that mad Fientist article Jonathan that you quoted in the Fritz episode there are many people in the comments who are saying oh this sounds great in theory but my company doesn't allow for it. I don't I don't know what percent of companies do 10 20 percent or something like that it didn't seem like an significantly large percentage but that's just anecdotal obviously. So the only way to know is to ask your H.R. department it's simple as that.
043R: Mega Backdoor Roth Jonathan Mendonsa So I want to go and start off the segment on the mega backdoor Roth by playing a voicemail that we got from ViShal. He has access to the mega backdoor Roth and he is going to quickly take a few minutes and walk us through how it would work practically.
043R: Mega Backdoor Roth Jonathan Mendonsa That was a very thorough walkthrough and then just to our audience for those of you that are interested and getting a little bit more of a tutorial on this. Vishal shared with us a post that he wrote specifically because we brought this up he got a lot of value from that episode but he really wanted to highlight that. I think that Mad Fientist did a pretty decent job talking about it. But I think there's definitely room for another article on the mega backdoor Roth and so we're going to put a link to this in the show notes Vishal writes over at. Everything about education dot net. And this was a great walk through on how to tackle the mega backdoor Roth I highly encourage you to check it out. It'll be in the show notes. On today's episode and before we move on Brad did you have any final thoughts on that. Anything else that we should clarify before we keep going.
043R: Mega Backdoor Roth Brad Barrett Yeah the mega back door and this is kind of a bizarre thing and we and we laughed about it on the episode because it seems like such a gimmicky loophole that like it's hard to even imagine this exists. It's just allowing you to put in in some cases up to $35000 in money into a Roth IRA each year even if you're excluded normally based on income limitations from like a regular Roth IRA. So that's why it's called this backdoor Roth. So what's happening is you actually have a $53000 limit. I think it's increased in 2017 to 54000. But I know in 2016 it was definitely 53000 So we'll go with that. And you can put in $18000 of employee deferrals to your regular 401k. All right. And we always talk about you want to max that out right because that's that's what lowers your tax liability. That's a tax deferred item. All right. So we highly recommend maxing that out. But the cool thing is you have that total $53000 limit. So we're getting the 35 as you just take the 53 back out the 18000 that you put in. And that's $35000. OK. So that's the potential additional amount that you theoretically could contribute to your overall 401K. Now what does include in that is your employer earns contributions or matches or whatever so that all gets added together up to this maximum $53000 limit. But just for back of the envelope math will say there's no employer match you've put in 18000. You still have that $35000 limit. And now if you're fortunate enough to have a 401K your company that does allow for after tax contributions and in-service withdrawals then you can put in up to that 35000. You don't have to put in 35 Obviously whatever you have extra lying around that you want to get into a Roth if you put that money in as an after tax contribution and then you have to actually mechanically make an in-service withdrawal. And that money then goes as as I understand it it goes to a Roth IRA of your own. OK so that's hence the in-service withdrawal you're actually withdrawing that money from that after tax account in your company 401K into a an actual Roth IRA account. All right. And it is as simple as that. That's that's the crazy part about this is why this exists how this exists is beyond my comprehension honestly and I can't imagine this will last forever. But again if you have those two things you can do this and then it is a Roth IRA forever and it's tax free forever even when you pull it out 50 years from now. All right so that's the beauty of this. And of course since this is an after tax contribution that money is taxed currently. All right it's just as if it was going to go into your regular savings account. You just decided to put it into this after tax contribution in the 401K. And then do this in service withdraw to get it to turn it into a Roth IRA. So that's just a decision you're making obviously with the money you have left over. So that's why I say like it's not a slam dunk to put in thirty five thousand dollars because then it's it's in your Roth IRA. Right so that's a decision you have to make but mechanically that's how this works. So Jonathan does that does that make sense.
043R: Mega Backdoor Roth Jonathan Mendonsa And the other thing you'd have to look at really to round that out when you're making your choice depending on where you live and the state that you're in. Some states have thresholds for where those tax brackets actually start. So going back to our first case study where the person was making $25000 a year they could by funding that 401k they could potentially drop themself below that threshold in which case they would only be subject to just that federal tax and so it's a very very obvious play. Well I hope you found that helpful. Especially having me and Brad squirm our way through that hot seat question there at the end in my mind this episode accomplished three or four different things. One for those of you that were trying to figure out how the mega backdoor Roth worked practically speaking they should lay the groundwork for that. And should be a great reference for you going forward two. So for the parents that are trying to help their children tease out whether or not that first investment vehicle should be a 401k and then whether or not they should be putting money into a Roth IRA or a traditional IRA. This episode should clarify that decision three for that single path to fi or for that first job. Those early years this should clarify how to approach those early investment strategies. Very comprehensive. Probably going to be an episode you're going to need to listen to a few times and. I think it's just an extremely valuable conversation that kind of gets glossed over. Because Brad and I find ourselves talking many times about the married couple with one child that's 10 years or 15 years into their journey. So hopefully for those of you that are in this season of life you'll find this a very useful episode. We like to close every show by doing a giveaway for a book that we have found useful and traditionally we do. JL Collins book the simple path to wealth and we do. Dominic Quartuccio's book design your future for this will be the last week we're doing it and then we actually are going to be featuring a new book. But for that for one more week we're also doing Tim Ferris's book tools of titans and that's one that both Brad and myself have read and found extremely useful and it's just the tactics routines of millionaires billionaires and high performers. And I think it's one that both of us have found extremely useful and insightful and we just wanted to share it with our audience so if you're interested in that and you want to participate in this give. All you have to do is go to choose FI dot com slash iTunes. Follow the instructions there. Leave us a short written review and then send us an e-mail to feedback at Choose FI dot com letting us know that you left the review and what screen name you left it under and will enter you in the drawing. We give away one book for every five written reviews that we get and we would love to include you in that. Brad how many winners do we have today.
046: Our Next Life The Reveal Tanja "Mrs. Our Next Life" Hester Yeah I know we're we're total weirdos in that regard. And it's not to say we're never going to do a single dollar in back door Roth conversion but we're planning as much as possible to leave that money alone for a bunch of reasons like one. We feel like right now while we're still young we can travel in a little bit more rugged fashion if we're staying in hostels on squeaky rubber coated mattresses like it's not the end of the world will be fine. So we can travel a little cheaper. We also feel like right now we're still healthy so while of course some crazy freaky health care thing could come around it's less likely now just statistically than it is after 60. So we want to make sure that we have like a big hefty fund sitting there for our later years. And so that's just been part of our underlying philosophy all along is like you know let's treat yourself but like 60 year old us not us now. And obviously we're lucky and actually get to pursue that strategy that doesn't work for everybody else like we've been able to have max out our 4:01 case and save a ton in taxable so that we have this early retirement cushion. But the other thing I'll add that I think is a real benefit of the two phase approach is it creates a whole other safety net where like even if we completely mismanage our money for the first 18 years between Mark being 41 and 59 we still have this other whole pool of funding to fall back on. So we just have to make sure that we can cover our expenses and like earn enough that we can pay our property tax so we don't get our house seized by the state or something like that and then we're going to be OK and we'll have money for later. Like that just to me is something that gives me enormous peace of mind and helps me sleep at night. And I recognize not everybody is a worrier like I am and not everybody needs that. But for those who do I think it's yet another bit of freedom to fail where we can fail at early retirement and it actually doesn't jeopardize our traditional retirement that will still be intact.
046: Our Next Life The Reveal Tanja "Mrs. Our Next Life" Hester So the way that the exchange based plans work is you have to either sign up during open enrollment which is each fall and heads up to folks who are thinking of signing up for next year that the open enrollment period has been shortened this year. And also they're going to do maintenance on healthcare.gov on Sundays. So you have many fewer days than usual you have to sign up by December 15th. So don't forget really important. So you either have to sign up during open enrollment or if you lose your job mid year then that's considered a qualifying event just like it would be for any health care. And then you can sign up at that point. But the way that the system is built under the Affordable Care Act for as long as it survives until the next thing comes is that you project forward. So you have to guess what your income is going to be in the next tax year. And if you lose a job mid-year you have to figure out like make a guess for what your income will be for that whole year. And it's based on AGI which is adjusted gross income. It's essentially everything minus any IRA or 401K contributions but it doesn't take into account standard deduction it doesn't take into account mortgage interest charitable. Any of that stuff. So it's like the whole deal everything that counts is taxable income and then you get your health insurance based on that. They just essentially tell you based on what your taxable income is what your subsidy will be. And then you can choose if you want like a high deductible plan a lower deductible plan gold plan Bronze all that stuff. Silver plans are the most heavily subsidized so those are a good bet to go with for early retirees or really anyone who is going to get a benefit of help with their premium. And then at the end of the year when it's tax time then you square up and reconcile so like if you earned more than you thought then you have to pay a little bit of that subsidy back. But if you hit it right on the nose then you don't. And that's where early retirees are in a really good position because most of us know exactly what are our taxable income is we know the dividends we've gotten. We know how much we've taken out and how much capital gains is there. And so I suspect a lot of us who are going to be doing this approach will each December be looking at OK how much have I earned. Do we have a little bit more room in the cap that might be a place or redo a little bit of backdoor Roth conversion just to make sure that we get all the way up to that level and take advantage of every penny and then you know if you have a year where you earn a little bit of extra aside income like I consider that a good problem to have I would rather pay some of that money back but have extra money that we've earned. So you know I know some folks out there are hardcore tax avoiders we are not we believe in taxes so we don't mind if we end up having to pay some of it back. But I think the whole thing just makes it so much easier to budget for us so it's worth doing some of that gaming things out before you proceed.
046R: Selectively Hardcore Jonathan Mendonsa Alright guys we'd like to take just a couple minutes and point out I guess the corrections or maybe adenomas to a past episode so an episode 43 we talked about a little bit about the mega backdoor Roth and then in the following episode 43 R we really broke that down in detail and we have two points of feedback one of feedback and one correction that we wanted to go ahead and address today let's go ahead and talk about the feedback first and that is on the mega backdoor Roth. And after we published that episode it came to our attention that practically speaking there's actually two ways to do that mega back to a Roth and I thought this was very interesting because until we published this episode it was more or less just taken at face value that there was just one way and different people talked about the one way that they never put them side by side. And I think it's worth mentioning and highlighting this potential second avenue depending on which one you had already heard of. So this this feedback is from William and I should point out that we had a couple of other people messages about this alternative route as well so. But I think William did a great job piecing it together and I'm just going to read this. Read this e-mail. He said this is my third year of doing the mega Roth and it's the second year of mmaxing it out 2 important addendums about who all can benefit from the strategy first. Not only will inservice distribution's get money into a Roth structure but if your 401k plan supports a Roth 401k option it's become increasingly common for the 401K plan to support a feature known as the Roth 401k conversion. Much like the Roth IRA conversion process the 401k Roth conversion takes some money out of one sub account and deposits the money into a Roth 401k and come tax time. You'll owe taxes on that converted amount and similar to the standard back to a Roth IRA if you do a conversion of the after tax contributions to the Roth 401k the tax liability will be strictly against the growth or earnings from the after tax 401k contributions. You'll end up with Roth 401k funds which will eventually be able to be rolled into a Roth IRA. Secondly the mega Roth can actually be used and be beneficial even if you can't immediately do an in service rollover or an unplanned Roth 401k conversion. Basically the whole conversion to Roth funds can occur even with an out service. For example after employment has been terminated rollover the benefit of this is that you get up to thirty six thousand dollars of additional Roth funds per year eventually even if you work for a company for five years or so the growth from those funds that you'll owe the taxes on will be far out dwarfed by the size of the contributions. So my takeaways here just for those of you that are listening. Many of you may have access to a Roth 401k as well as a 401k and you have the choice between the two. And what I came away with is that for people to have that plan option instead of having after tax contributions in their 401k in many cases the provider of those accounts will often just take any amount that would be considered after tax contributions and just put that into the Roth 401k. And then this process might follow a more predictable path from there. So just for the record what we said on the show talking about the mega backdoor Roth in episode 43 R is accurate but there are nuances that may be specific to your situation and just wanted to let you know that if you have access to a 401k or a Roth 401k you may have a play there as well. That wasn't strictly laid out with the path that we talked about in that previous episode.
046R: Selectively Hardcore Brad Barrett And I think the fundamental takeaway is you should always get in touch with your H.R. department at your specific company and find out what the plan allows and what the rules are. Of course we could talk about this on the podcast ad nauseum and keep coming up with different addendums but it ultimately matters what your 401K plan says. So we've armed you with a bunch of information here of potential different options and go out and figure out what works for you. So it's very exciting to have these different options. And Jonathan One other thing I wanted to touch on and I know Keith from the wealthy does listen to the podcast so I'm curious to hear his take on this but one thing that's always stuck in my mind since we've had him on and we've actually had a bunch of people kind of write in to us about this specifically was we were talking about the backdoor Roth and he used that as I think that was his quote the back door Roth. And he said that he thought that that was going to go away imminently and now I think this was also a scenario where it was we were potentially conflating the Roth IRA conversion with this mega backdoor Roth. And I don't want to put words in Keith's mouth certainly but I agree with him if he's saying the mega backdoor Roth is going to go away like that seems like such an absolute ridiculous gimmick and I can't believe that it exists at all. Now less should exist going forward. So I believe that's what Keith was talking about when he was talking about the back door. But I think in the context of the conversation with Keith we were talking about the Roth IRA conversion and I think the implication was that that was going to go away. And that seems less clear to me just from like a public policy standpoint because the Roth IRA conversion. Now for most people outside the fi community obviously who are trying to do this only when their tax rate is very low or they can do this at a 0 percent tax rate. But for most people if they're making a Roth IRA conversion that is a taxable event. And again it goes on people's tax returns as income and it's tax revenue to the government in the current year. So from like a policy perspective I don't see that like being something that Congress or the IRS is going to try to get rid of immediately. And I know Keith kind of quoted something like it's costing the Treasury billions of dollars. But like that didn't square up so that that's actually why I'm bringing this up now like it didn't square with what the reality of that Roth IRA conversion once which is again a taxable event in the current year which brings tax revenue to the government in the current year. So I can't believe that there are enough people in the FI community who are making these conversions. At like a zero percent tax rate that is costing the Treasury billions of dollars like he mentioned so I believe he was talking about the mega backdoor Roth which again is a total gimmick and probably will and should go away. So I did want to clarify that and that's based on my own understanding of how this works. But just applying some logic to the situation so I did want to clarify them.

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