President Biden’s Budget Proposal’s Impact on Backdoor Roth IRAs

Hey everybody. So by now you probably read in the news in a variety of places that President Biden's new budget proposal has a limitation in there that they want to get through Congress where you can no longer do a backdoor Roth if you're a high income earner. And what I'd like to explain today is why this really doesn't matter. There's so much better way to get money over to tax free accounts without buying products or changing advisors or anything drastic like that. So first of all, let's start with what is a backdoor Roth? Well, if you don't qualify for a regular Roth contribution, you can actually contribute to a traditional IRA and then you immediately convert it over to a Roth. But it really doesn't matter. It's a much more cost effective and financially beneficial to do a Roth conversion instead of a backdoor Roth. I know, I know you maybe been doing backdoor Roth for 10 years and you love them and you, and I think that's great and you read all about them. But really this is no big deal. In fact, there's such a better way to do that. Let me explain. So let's say you could do an $8,000 IRA contribution. So in a backdoor Roth, what you're doing is you're making that contribution, then you're turning right around and you're converting that same $8,000 into a Roth. So let's follow kind of what happens here. You take $8,000 of your money and at the end of the year you end up with $8,000 in a Roth by way of a backdoor transaction. Instead, let me suggest that you do something totally different. Use that same $8,000, but use it for taxes, and you use it for taxes to pay for conversions. So if you had $8,000 in cash, and let's say you're at the 24% tax bracket, that means you could actually convert about $32,000 of your existing IRA account. This also applies if you're like in your last few years of working and you're contributing to a 401k. We recently had some clients that came in and they were both still working, they were both maxing out all their 401k contributions, getting all the catch up provisions. I mean, they were laying it in, man. So they were each putting about $40,000 into their company, 401k. Let's use the same logic and let's say, well, what if they just reduced their 401k contributions down to just the amount that the employer would match so they get the matching and then they redirect all the other money over to pay taxes to do conversions. So let's assume in this illustration that they don't have very much money sitting out in regular assets or savings or money markets or anything like that. So they have to find ways to raise cash to be able to do conversions. A lot of people come to us and they think, gosh, I shouldn't do any conversions because I don't have any money outside my company plan. Well, that's absolutely false because there are ways you can make it happen. And like in this case, they took that same 30,000 that they were contributing to the 401k and instead used it to pay taxes. They could convert, say $120,000 of their existing IRAs and 401ks, use the same 30,000 that they were going to put in the 401k to pay taxes. And now at the end of the year, instead of 30 or 40 in a 401k, now they have 120,000 in a in a Roth account. And a lot of the company 401k plans allow you to convert internally. So if your plan has a Roth 401k option, you ought to give them a ring. Find out online whether or not they allow an in plan conversion, which means you can take money from your pre tax over to a Roth 401K. But regardless, what I'm trying to show you is that this backdoor Roth thing potentially going away for high income earners probably doesn't matter. In fact, if you're a high income earner, it makes no sense at all to play the backdoor Roth game. There's just so much more opportunity for you in doing conversion. So some people that are high income earners, they typically have larger 401k and IRA balances too. And so their pushback is, gosh, I'm already in such a high tax bracket and if I just wait a few years, I'm probably going to be a lot better off to do that. And that's actually, while it's logical, by the time you do the math on it, you're just creating a bigger problem. Let's say you have a $2 million sitting in your 401k, you're going to wait four years before you retire. That $2 million could easily be what, 2.3, 2.4 million in four or five years from now. So now all you've done is you've increased that contingent tax liability on that 3 or $400,000 of gain. On that 2 million, all because you wanted to avoid a little bit of incremental tax this year. And I've found that most people who retire at a lower income aren't necessarily at a lower tax bracket, maybe a little bit, but not significantly. So. So if you're kind of thinking about this Roth, this backdoor Roth thing, what should you do next? What are some of the steps and the things you ought to be thinking about? Well, first thing is you need to know how much pre tax you really have. And while you may be the person who knows to the penny every morning because you look it up and put it into a spreadsheet, there are a lot of people we deal with who they really don't remember. All the orphaned IRAs and 401ks and stuff. So get it all together and figure out how, how big of a problem you're going to have. What I mean by how big a problem you're going to have is all those pre tax assets are one day going to grow to a dollar amount and you're going to have to start taking required minimum distributions. So you want to know how big the problem is. It's going to grow and create a different set of problems in those excessive required minimum distributions. The next thing that you want to do is figure out how much of the total of your pre tax should you convert. There's no rule that says you should convert all of it. You need to look at your age, your income, your needs or expenses, what you want to give to charity, what you want to leave to your heirs. And all these things kind of go into a pot and you stir them up really good to come up with what the right answer is, how much tax you're going to have to pay, how much Medicare premiums maybe are out there in the future. All those things go into determining what the right solution for you is when you do conversions. And then I guess the third thing is you need to figure out what's the optimal time period over which to do conversions and what tax rate you want to do conversions at. And, and my guess, in fact, I'll bet you a donut today that you should, your optimal tax rate is going to be higher than what you think it is. And the time frame over which you should do your conversions is probably much shorter than what you think. In order to get to the gold, in order to get to the real tax avoidance that's available, you simply have to get to higher tax brackets, which means you convert over a shorter period of time than what you think that you probably should be doing. But we're all, we're all conditioned to avoid tax. And I'm, I'm considering that you want to avoid tax, but at this stage in your life, you have to do it in a little different way. I mean, good for you. You've got a large IRA because you've used tax deferral for a long time. You know, the average million dollar IRA or 401k, you maybe have got 200,000 of your own money in it and the rest has been through tax deferral. And you've been smart in that you save taxable, just continue to be smart. And I know that the way that you save tax and avoid tax over the rest of your life, this next quarter that you're entering into in your life, you have to be willing to pay the tax on the front end under your own terms, your own amount, and you control it instead of just being subjected to whatever the IRS tables are when you start hitting required minimum distribution. So I hope some of this was a little bit of help to you. We do a podcast every so often that we have got up on our website. Go to Craig Weir w-e a r.com look at the podcast page and there's all kinds of stuff in there. But one of the things that I'd encourage you to check out in there is a podcast I did that was entitled supercharging your Roth conversions through donor advised funds. So if you are somebody who you have charities that you like to give to your church for five 1C3s, there's another strategy out there that maybe allows you to convert less and to get bigger tax deductions, pay less tax along the way. Also, we have a YouTube channel. Feel free to check that as well. I hope this has been a little bit of help to you and we can help in any way. Please reach out.