The 2-Step Roth IRA Loophole the Rich Use at Any Income

There is so much misinformation out there. It is incredibly shocking how many registered investment advisors, financial planners get it wrong. They tell wealthy clients they cannot put money in a Roth IRA. They're wrong. It's misinformation. And as soon as they figure out, holy crap, my broker-dealer has been misleading me. So today you're going to get the truth about the IRA limits and what's called the backdoor Roth IRA.

I think this backdoor Roth IRA is the number one most used tax loophole out there, because this is a little bit of a loophole, but it is so widely used. I use it, Mark uses it, we've had thousands of clients use this. You can do this with your Roth IRA at Directed IRA, you can do this with your Roth IRA at Fidelity. Okay, and so if you're someone that thought, I make too much money, I can't do a Roth IRA, we're going to break it down, tell you why that's wrong. and show you how you can use this super powerful tax-free advantaged account that Congress said is so powerful we don't want the wealthy to use it. We're going to show you the loophole and how you can actually get it.

Okay, and I'm going to break it down. And who doesn't like a loophole? We all love loopholes.

Yeah, yeah.

Loopholes are awesome, right?

Yeah.

Okay, so here's the rule. I'm going to give the 2 rules, and then Matt, you can explain— start the path of how to utilize this loophole. The first rule is if you are single and you make over $168,000 AGI, you cannot put money in a Roth. That's the front door. If you are married filing joint and make more than $252,000, you cannot go in the front door and come to the Roth party. Now, there's a little phase-out of about 10 grand or 20 grand in, in that There starts to phase out at $153,000 and $242,000, but the key number is $168,000 and $252,000. The second rule you need to know is that if you want to convert money to Roth, there's no limit. There's no limit to converting to Roth, but there's a limit to contribute to Roth. Matt, what do we do with this information?

Yeah, this is the interesting part. I'm going to go do a little history lesson. Mark's going to be like, move it along, Matt, but I think this is interesting.

Okay.

When Roth IRAs were created, they put an income limit on the contributions and an income limit on anyone that wanted to convert from traditional to Roth. They put an income limit on both. And the theory was, hey, wealthy people, we don't want them to use these tax-free accounts. If you're over these income limits, they think you're wealthy and they're already making enough money. We don't need to give them more advantages. This is meant for the middle class.

Yeah, the Roth is too sexy.

Too sexy. It's too great. Let's, let's not let everybody have it. The rich people, they're already rich. Let's not let them have it.

Yeah.

And so, and that's where these income limits came about. That was like the logic behind the law when they created Roth accounts. Well, about 15 years ago, they changed the law and they removed the income restriction on Roth conversions.

That's weird. Why would they do that?

Well, Congress wanted to raise money and they said, hey, if these people have traditional accounts and they want to convert to Roth, Let's let them do that now because they have to take that into income and they pay tax on a Roth conversion. And what can we do as Congress? We can spend that money. We don't want to wait until they're 60 and they take traditional distributions later down the road. That's somebody, some other senator or congressman that gets to spend that money. I want to spend that money. I'm in Congress now, maybe. Okay, seriously. Okay.

Um, little did they know they created the loophole.

Exactly. Magically, the loophole. And us tax lawyers, we're like, bingo. All right, so here's what's happening now. I want to do a Roth IRA. I'm over these income limits. What can I do? Well, you put the money in a traditional IRA, which can have some income limits too, by the way, if you have a 401 at work or something. But what you're going to do is you're going to make your annual contribution, $7,500. into your traditional IRA is a nondeductible contribution. And we can come back to what that means. Basically, it means you don't take a deduction.

Okay.

Yeah.

In fact, Matt, let me give the rule on that. Ironically, it's pretty much the same. A non-participant in an employer plan. So I don't have a 401 at work. I phase out of a traditional IRA contribution at $252,000. So it's kind of the same rule. If you make more than $252,000, you can't get a deduction to put money into traditional and you can't put money into the Roth. So your house, if you have a 401, it's even lower because they're saying, hey, you got to be in the 401 at work. So if you want to put money in an IRA and get a deduction, you can't do it either. So they're screwed. But so why would they put money in this IRA if they don't get a deduction?

Yeah, because, because that, well, that other rule was just about whether you take the deduction or not. So I can still put the $7,500 in a traditional IRA. I just don't get the deduction. But I don't care about the deduction if I'm going to do a Roth conversion on those dollars, that $7,500, I'm going to convert to Roth. Now that that $7,500 is in a Roth account, you might be asking, Matt, you just converted $7,500 to Roth. Do I have to take that $7,500 into income and put it on my tax return? I get a 1099. It's taxable for $7,500.

Well, it sounded too good to be true, Matt. I guess the sleuth holes fake.

Yeah, that's— well, we got good news. There's actually good news on this. Because you didn't take a deduction on that contribution, you do not have to pay tax on the conversion. Now, if you invested those dollars and they grew, you'd have to pay tax on the growth. But generally, when you're doing the backdoor Roth IRA, you're not investing it. You're just putting the money in the traditional, again, non-deductible contribution. You claim this on your 1040, and then you're going to get a 1099-R from your IRA custodian that says, hey, you did convert $7,500. But when you put that 1099-R on your 1040, You're going to check the box that says not taxable because you didn't take a deduction. So in the end, we have the exact same outcome of I have $7,500 in a Roth IRA.

Boom, bada-bang. Now I want to hit— that's it, people. Spoiler alert. I mean, we can't make it any more exciting than that. No matter how much money you make, you can put money into a Roth IRA. By using this 2-step method. Put it in the traditional, don't get a write-off, convert to Roth, don't pay tax. You're right back where you started. You're in the party. Can't go in the front door, just got to go through the back door. That is, my friends, the backdoor Roth. Now, I want to give you guys another tip here. This is the close sister or brother to this strategy. I don't know if it's a sister strategy or brother strategy. I guess they call them sister strategy.

Sister strategy.

This is the sister strategy.

Who is they?

Well, you know, some people. There's some people, you know, there's people, there's people out there. Okay. These people, you can call them what you want. When I'm done with my example, these people will say, oh, Mark, oh, Mark, you don't, you don't know what you're talking about. You, we want a traditional deduction. You want to put money into an IRA and get a traditional Tax deduction because you are going to be into a, a lower tax bracket later in life. So take the deduction now. Don't do the Roth IRA. Mark and Matt are crazy. The Roth IRA is not that great. Yes, you get tax-free growth and tax-free withdrawals, but you don't get a deduction on the way in. And I know many of you listening to us have heard this rhetoric, and I call it rhetoric because they say when you compare A rate of return of 7 or 8% over time. And if you hold your tax bracket constant as well, the issue is it's the same whether you get the deduction in the front or Roth tax-free on the way out. If your bracket is the same and your ROI is the same, it's a neutral strategy. And so they go, Obviously, your bracket is going to be lower in the future because you'll be retired. Well, newsflash, people. Mark Kohler here. I'd like to have more income in the future. I'd like to retire with more money. I plan on being in the same damn tax bracket or better if things go well, because right now I can generate a lot of write-offs. In the future, I'm going to be sitting on a beach somewhere sipping a margarita. My bracket will probably be higher. That's what I want the Roth IRA. Sorensen.

Yeah, totally agree. And, um, not to get back to the politics, but do you think it's more likely that tax rates are going to go up versus down, even on your same income level? I think it's more likely tax rates are going to go up than down in the future. Um, who knows, who knows on that. But, um, but I agree too. I think my perspective on that is, and I think a lot of people who are good savers and investors Um, is I'd rather have some short-term pain for long-term gain. The whole point about setting money aside and investing it for later is about delayed gratification now. And that's kind of what the Roth is. You're willing to say, I will pass up the tax deduction now so I can have tax-free income later. Even if it is a wash, like you can run on a spreadsheet where tax rates are the same now versus in retirement, you say it's going to wash. You're gonna say, yeah, but I'd rather push that value and benefit to when I'm 60, 70, 80 years old living off of that money rather than take it now when I'm 40, 50 years old, you know, and, and, and building, earning, working. So if it is a wash, the whole point of saving money for later is to have it for later. So like, it, it, it almost doesn't make sense to say, well, then you shouldn't do it. So, um, Anyway, anyhow, well, let's—

I've got some other points I want to pop in though. Yeah, I've got a banger of an argument here, Matt, and I want to see if you're on board. Here it is. Let's say I've got this $100,000 sitting in a traditional IRA. It's from an older 401. I worked at this job a few years ago, yada, yada, yada. And I've got this $100,000 just sitting in this Merrill Lynch account, whatever, some broker-dealer account. I'm getting an 8 to 10% return if I'm lucky after costs, ETF, mutual fund, whatever. And you say, is it worth it to convert this to a Roth? I'm going to have to pay tax on $100 freaking grand. I don't know if it's worth it to convert to Roth. Well, my friends, I have a, as I called it, a banger of an argument here. And that is, if you're going to invest that $100 grand, and let's say self-directed and maybe do some hard money loans, buy some real estate, buy some crypto, buy into a startup or a syndication and make maybe a 10%, 15%, 20% return because you're going to invest in alternative assets, not what your broker-dealer gives you at their annual convention on their flyer in the lobby of the hotel. You're going to invest in something you know more about. If you're getting a 20% return, holy crap, that money is going to double in approximately 3 to 4 years. And now, would I rather pay tax on this bigger chunk of money that I went and self-directed, or would I just like that $100 grand, rip the Band-Aid off now and never pay tax again? So in 10 to 12 years, when I'm sitting on over a million bucks, well, let me see, we're going to have to do the math. It's about 15 years I'd have a million. I'm going to do the math, but I think the Roth pays off, Matt. I think especially when you self-direct.

Yeah, that's the— would you rather pay tax on the seed, the smaller amount now, or would you rather pay tax on the harvest after it's grown and everything? I mean, that's what you're doing with a traditional is You're getting the deduction now, but you're gonna have to pay tax on the harvest as this thing grows and comes out later. So, um, yeah, so I, I, you know, and this is of course, you know, we're talking about just the Roth conversion here in general now for a second. We took a little, a little side route here on the backdoor Roth IRA, uh, because remember on the backdoor Roth IRA, just so you know, when you're putting that $7,500 in every year or $8,600, if you're 50 or older, that's a non-deductible contribution. And when you convert that, there's no tax on it. All right, so that's just going right in to the Roth account, the same as if you just put $8,600 or $7,500 in directly to a Roth. But I want to hit 2 things you should know though.

Okay, by the way, I did the math, Matt. I did the math. You're going to hit $1 million on that $100 grand around 13 to 14 years. I'll have $1 million on that seed Of which I paid tax on, but not the harvest of $1 million. There you go. Okay, 2 more tips. You said 2 more rules.

Yeah, 2 more tips. And I think these are important on the backdoor Roth IRA. First is if you have traditional IRA dollars where you did take a deduction, maybe this is an old employer 401, you rolled to a traditional IRA, or you just did regular traditional contributions and took a deduction over time. So you've got what are considered traditional deductible dollars. And now you're trying to do the backdoor Roth IRA where you're putting $7,500 into a traditional IRA with no deduction on it because it's non-deductible. Well, when you try to do the Roth conversion, the IRS is like, wait, wait, wait, you can't just pick the $7,500 of non-deductible dollars. If you have deductible dollars in a traditional IRA, you must convert a portion of those too. Just so you know, there's something called this pro rata rule. It kind of muddies the water on the backdoor Roth IRA when you have traditional IRA dollars where you took tax deductions to get the dollars in. There's a couple workarounds around that, but I just want to raise that issue first.

Okay.

And I'll say it doesn't apply to traditional 401 dollars. So if you have a solo 401 or you got a 401 from an old employer or a current employer that's in traditional 401 dollars, don't worry about that. It's just traditional IRA dollars. could include a SEP IRA, that if you took deductions on, you have to convert a portion of those as you're doing the backdoor Roth IRA.

Love it. Well, my last point is another strategy that many, many, many of our clients use once they catch the magic of the Roth IRA. And that is, if you're going to convert some money to Roth, you have to look at How much am I converting and what tax bracket will I be in at the end of the year when I do convert it? And we want to be strategic there. And so we've coined the phrase chunking at my Roth IRA. I want to chunk in pieces. This does refer to Chunk in the infamous movie Goonies. Thank you, Steven Spielberg, 1981. But chunk very pivotal character in the show.

Yeah.

Uh, I want a chunk of this traditional IRA. I want to move it to my Roth in pieces based on what bracket I'm going to be in. So I've got my sweet spot brackets and I don't want to overdo it and fall into a bracket unwaringly or unwittingly, however they say it. And so we love being in the 24% bracket. Before I have this huge jump to 32%. And I'd like that space. I think that 24% bracket, 22% bracket, all in there is where we want to play when it comes to Roth IRAs. And it's true, if you're going to live in the 35% or 37% bracket, maybe it's just time to rip the Band-Aid off because you know you're sitting on a big investment opportunity. So rip it off, but if you can chunk at it, think about it.

Yeah, when Mark says rip it off and when we're thinking about Chunk, another way to think about it is you're going to do what's called the Truffle Shuffle. Okay, which is, which is the dance move that Chunk performs in the movie Goonies. It's the Truffle Shuffle.

So good, Truffle Shuffle, very good.

Yeah, it's a good pull, you know, it's a good pull. Um, all right, well, the backdoor Roth IRA, let me just say, if you Want to execute on this? We do this every day at Directed IRA. So we have a backdoor Roth account strategy application where we open the traditional, we open the Roth, we do the conversion all in one. So just know if you're into self-directing, we're doing this every day at Directed IRA. Mark mentioned some of the powers of self-directing, being able to invest in other assets. So check us out at directedira.com. And of course, our lawyers at our law firm, KQS Lawyers, are advising clients every day. On a myriad list of tax strategies, which one of which could be how to be doing the backdoor Roth IRA. If you got a spouse, they should be doing the backdoor Roth IRA. All these other tax-advantaged accounts and tax strategies you should be implementing, whether you're a W-2 employee or a self-employed person, business owner, we have a lot we can do to help you. So you can book a call at KQS Lawyers for that, and we'd love to be of service to you there.

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