“Simple doesn’t mean easy.”
I went fly fishing a few weeks ago. I practiced in my yard before the trip and threw that fly flawlessly. There was no wind and no pressure.
It was a different story when it was game time.
When I was on the boat, the guide would say, 10 o’clock’ thirty feet, and I would throw it to 2 o’clock and ten feet. I got my right and left mixed up when I saw those fish. I could feel the guide shaking his head in disappointment at me as that big fish would swim by—a very humbling experience.
Sometimes, things can seem easy, but they aren’t.
When you look at your investment statements, all the numbers don’t mean the same thing.
Said another way, $1,000,000 in a Traditional IRA is not the same as $1M in a taxable account or $1M in a ROTH IRA.
Why?
Traditional IRAs and 401ks have an “IOU” attached to them. The IOU is taxes yet to be paid to the IRS.
This is why your dollars in a ROTH are worth so much more. Your future qualified distributions from your ROTH will be tax-free.
So, how do you get more money into ROTH IRAs?
You can do ROTH conversions or a Backdoor ROTH IRA Contribution.
In this issue of FFF, we are going to discuss the latter.
A Backdoor ROTH IRA is a way of getting money into a ROTH when you exceed ROTH IRA contribution limits. If you make over $161,000 if single or $240,000 Married Filing Jointly, you cannot directly contribute to a ROTH IRA.
Those same limits don’t apply to Traditional IRA contributions, so you can still contribute to a traditional IRA and then convert it into a ROTH IRA even if your earnings are beyond the limits mentioned above.
The conversion must be done in a two-step process:
- Contribute to IRA: It could be tax-deductible or not, then wait for an unspecified amount of time. Some people say a few days, and some say a year. My recommendation would be to wait at least one month so that you can reference two separate statements.
- Convert to ROTH IRA
Seems simple, right? Yeah, it’s just like throwing a fly in my yard…
Many reporting requirements can make these two steps very complex.
If you have a non-deductible IRA contribution, you need to file IRS Form 8606, which keeps track of your cost basis. You use this cost basis to offset distributions from your IRA, which is reported on 1099-R Forms. Many of the 1099-Rs have a notation that says, “taxable amount not determined.” Your CPA uses your 8606 to determine the taxable amount.
By the way, why would someone want to do a non-deductible IRA contribution in the first place? It would grow if they did not convert, and the earnings would be tax-deferred. But the main reason is to convert to ROTH, in my opinion.
Adding to the complexity is aggregation rules when converting. The IRS has a specific stipulation under IRC Section 408(d)(2), stating that when determining the tax consequences of an IRA distribution, including a Roth conversion – particularly the “pro rata” rule under IRC Section 72(e)(8) and also the early withdrawal penalty under IRC Section 72(t)(1) – the value of ALL IRA accounts will be aggregated together for the purpose of any tax calculations.
For example, let’s say you make a non-deductible IRA contribution of $7,000 and have a pretax traditional IRA of $100,000. You can’t just convert your $7,000 to the ROTH and pay zero tax. You would need to do some math… (This math is required regardless of whether this non-deductible 7k is going into an existing Pre-tax IRA or a new IRA that is entirely separate from the already existing pre-tax IRA)
$7,000 / $107,000 = Only 6.5% of the $7,000 conversion would be tax-free (basis), and the rest would be taxable. Your conversion is “pro-rata,” and you had to “aggregate” all your IRAs, SEPs, and Simple IRAs to get the total.
That is one of the many reasons I encourage clients to consolidate all assets when working with us. ANY IRA ANYWHERE affects the calculations.
I have seen people who are not following the steps correctly. While others are not accurately using the aggregation rules.
Another mistake is losing the cost basis.
When you make a non-deductible IRA contribution, you need to file 8606, as previously stated. What if they don’t convert it? Or no one told them they should? Often, there could be an incorrect assumption that ALL the IRA is pretax and 100% of the withdrawal is taxable. In this case, the person would pay tax on the money twice once, when they made the non-deductible contribution. The second time, when they withdrew the money and got the 1099-R and had no basis reported.
How could you lose cost basis?
Form 8606 is only required when there is activity to report. You could have reported the 8606 correctly a decade ago, then forgotten you have a basis when you withdraw the money. Heck, I had a client forget he had an old 401k from 20 years ago, let alone basis in an IRA. Read about found money here.
If you have any questions, please email me at Jeremy@Riverbendwm.com, call 843-970-1049, or click here for a phone appointment.
On the lighter side, I did catch a few fish after catching my pants and shirt about a dozen times. It was indeed a comedy of errors. I could have probably caught more fish with regular fishing tackle, but the reward would not have been as great.
I ate with a friend at Jimmy B’s in Marion, SC. This plate was only $10, and the peach cobbler isn’t in the picture!
I hope all is well with you and your family,
Jeremy
Finger Financial Five – 5 points in 5 minutes or less – is intended to provide you with a weekly shot of useful financial information. My intention is to share principles so that you will have more clarity, more peace, and make better financial decisions.
Investment advice offered through Stratos Wealth Advisors, LLC, a registered investment advisor. Stratos Wealth Advisors, LLC and Riverbend Wealth Management are separate entities. This content is developed from sources believed to be providing accurate information and provided by Riverbend Wealth Management. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. Stratos Wealth Partners and its affiliates do not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal, or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.
