Greetings Wela family,
We hope everyone’s summer is off to a great start and that you’re staying cool with the blistering Texas heat in full effect! It is hard to believe that we are more than halfway through the year.
With a new month comes a new installment of the monthly financial planning newsletter. This month’s emphasis is on “Backdoor Roth Contributions and Roth Conversions.” We will dive into the intricacies of how to properly execute a backdoor Roth contribution, when it makes sense for a household, and other items to consider before implementing. As always, please let your dedicated service team know if you have any questions regarding the material within this newsletter.
To start off on the right foot, let’s define a backdoor Roth contribution and the conversion element. Simply put, a backdoor Roth contribution is a tax loophole for taxpayers who have been phased out of the income limits to contribute to a Roth IRA on a traditional basis. A Roth conversion is the second part of the phase, where you take traditional IRA monies that have either never been taxed or have just been contributed as a non-deductible contribution solely for the purpose of converting to a Roth IRA.
After successfully completing either strategy, you are left with a more diversified tax allocation. For taxpayers uncertain about future tax rates due to potential law changes, backdoor Roth contributions can be an excellent tool to get money into a tax-free bucket now before possibly facing higher tax brackets in the future. If you forecast higher future tax rates, then a backdoor Roth contribution is a great tool to consider implementing.
Properly executing this strategy involves several steps. It’s important to keep accurate tax records and ensure the process is correctly reflected on your tax returns. Let's discuss a simple example. Assume Bob and Patty make above the annual Roth IRA limitations ($240,000 for 2024) and have determined with their Wela advisor that a backdoor Roth contribution makes sense for their financial plan.
1. Establish Traditional IRAs: They will establish traditional IRAs and make non-deductible contributions. Let’s assume they will max fund their traditional IRAs up to the 2024 limit of $7,000 each, totaling $14,000 of non-deductible traditional IRA monies.
2. Fill Out IRS Form 8606: Bob and Patty will need to each fill out Form 8606 to attach to their 1040 during tax time. This form will carry the contributions they made as a non-taxable conversion. By contributing as a non-deductible contribution, these funds in the eyes of the IRS are after-tax dollars that have already been taxed and did not receive the up-front tax benefit you would normally receive in a traditional IRA. When they each fill out their 8606 forms, they will need to fill out line 1’s amount to reflect their respective contributions to their own traditional IRAs. The result of completing this form accurately will carry the contributions they made to the bottom of Form 8606 as a non-taxable conversion on Part ll of the form since they initially elected to make their contributions on a non-deductible basis. Once the form is completed, Bob and Patty will not have an impact on their taxable income, but they still must report the conversion amounts as a “distribution” on line 4a of Form 1040 while zeroing out line 4b to confirm no tax implications. It's advisable to execute this strategy on at least two different statements whenever possible for clarity in case of an audit.
Implementing backdoor Roth contributions can become complicated if taxpayers have more than one traditional IRA. This is where the IRA Aggregation Rule comes into play. The IRS requires values of all traditional, SEP, and SIMPLE IRAs to be factored into the non-deductible contributions. This could result in a portion of the conversion being taxable. If we revisit Form 8606, on line 6 the IRS requests values of ALL traditional, SEP, and SIMPLE IRAs to factor into the non-deductible contributions that have been made. When more than one IRA exists outside of the non-deductible contributions account, the IRS will deem any conversions made as part of the backdoor Roth strategy as a distribution of taxable (tax-deferred) monies and tax-free basis (non-deductible contributions) on a pro-rata basis across all the client’s IRAs
Let’s revisit Bob and Patty and assume they have $100,000 of existing traditional IRA monies outside of their non-deductible contributions. Bob would now have to fill in line 6 on Form 8606 with $100,000 and determine the non-taxable portion of his distribution as well as the taxable amount. This would result in what was originally a tax-free execution becoming a distribution of $7,000 that has $455 being tax-free and the remaining $6,545 becoming a taxable distribution that shows up on line 4b of Bob’s Form 1040.
Before implementing this strategy, consider other factors such as impending retirements later in the year that include rolling over plan assets or access to Roth options at your current employer. It’s a nuanced process, and we’re here to help you navigate it.
We hope this month’s newsletter provided insight into the intricacies behind properly executing a Backdoor Roth Contribution and Roth conversion. If any of this material seems relevant to you or is something you would like to discuss in more detail, please reach out to your team at Wela. We’d be happy to continue this conversation. We wish you all a joyous upcoming 4th of July and will be back next month with more financial planning content!
We hope you had a great 4th of July!
Warm regards,
Your Wela Financial Advisory Team
Brent Forrest & Associates LLC. dba Wela Financial Advisory is a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and, unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.
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