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Roth Conversion vs. Backdoor Roth IRA – Episode 355

Adam Talks

In this episode of Adam Talks, IRA Financial’s Adam Bergman Esq. discusses the differences between a Roth conversion and the Backdoor Roth IRA strategy used by high-income individuals.

Roth Conversion vs. Backdoor Roth IRA

Hey everyone, and welcome to another episode of Adam Talks. I’m Adam Bergman, tax attorney and founder of IRA Financial, and on today’s episode, the Roth conversion versus the Backdoor Roth IRA. Are they the same? Are they different? What’s the deal?

So, I wanted to do a podcast on this because technically, everyone can do a Backdoor Roth IRA and I get this question often where clients are confused, like, hey, Adam, I want to do a Roth conversion. Is that a Backdoor Roth IRA? Is a Backdoor Roth IRA different than a Roth conversion? What’s the deal? Super confusing. So, I’m going to “unconfuse” everyone right here.

So, let’s start with the premise. Before 2010, you were limited in terms of who can do Roth conversions. Essentially, if you made more than $100,000, you were not able to do a Roth conversion. That changed after the financial crisis, in 2010, the law changed to encourage taxpayers to do Roth conversions; I’ll explain why in a second. Essentially, a Roth conversion is when you move your pretax IRA, whether it’s a traditional IRA, a SEP IRA, or pretax 401(k) to Roth. You are required to pay income tax on the amount, the fair market value of the cash, or the asset you convert. So, yes, you can convert an in-kind asset, like a house a cryptocurrency, a piece of gold, or a private equity investment. You would need to essentially get the value of that in-kind asset, the fair market value, not what you paid for it, the fair market value; you should have a third party opine on that value, you don’t need a $40,000 opinion letter, but someone should at least provide you a value.

For real estate, it’s easy. There are online sources. You can get a realtor to provide some type of letter indicating the value, or you just use tax records. But you essentially want to have it confirmed by a third party because it’s a taxable event, you are subject to income tax on the amount converted, the fair market value. It’s subject to ordinary income tax, essentially added to all the income you have from your compensation from other sources, and it’s added to your 1040 and you pay ordinary income tax on it, not capital gains. But, there is no 10% early distribution penalty, just income tax. So, that’s a Roth conversion.

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And since 2010, there are no income limitations. Why? Treasury loves conversions. Because what is a conversion? You are paying tax prematurely, right? If you didn’t do a Roth conversion and you had a traditional IRA, we would not have to start taking distributions until you reach the age of 72, when the required minimum distribution rules would kick in. So, what you’re doing, if you do a Roth conversion at age 52, you are accelerating the amount of tax or accelerating the timing of your tax payments which the Treasury loves, even though long term, maybe it doesn’t make a lot of sense, because if you waited, maybe your IRA would be more and then they would get a larger ordinary income tax crack at your IRA versus doing a conversion and then you now have a Roth; and once you’re 59 and a half and the Roth’s been open at least five years, it’s all tax-free. But, as I mentioned quite frequently on this podcast and other videos, governments think in four to eight year cycles because that’s when they generally are elected for, and that’s generally when the budgets have to be proposed for. They’re not worried what’s going to happen in 20, 30 or 40 years. That’s someone else’s problem. Short sighted approach, yes, but that’s just the way politics work. So, they encourage Roth conversions because it accelerates the amount of tax revenue Treasury has to do all kinds of important stuff, like pay for our military and our streets and our schools and medical and all that important stuff. So, they love that stuff.

Related: Benefits of a Roth Conversion

As a taxpayer, Roth conversions are also super valuable because if you do it right and you can time the value, meaning, let’s say you do a Roth conversion on cryptocurrency when it’s dropped 60%, or Tesla stock or Netflix stock has dropped 70%, or maybe you selected real estate that has dropped 40%, like 2010 or ’11; if you can lock in your gains at a low price and then wait your 59 and a half, and the Roth been open at least five years, bang, it’s all tax free. That’s the difference between a pretax IRA and a Roth. A pretax IRA, you get a tax deduction when you make the IRA contribution; in 2022, it’s $6,000, $7000 if you’re over 50. You have to take requirement and distributions at age 72. If you take a distribution prior to the age of 59 and a half, you have to pay income tax and 10% early distribution penalty. But, if you wait until you’re 59 and a half, you just have to pay income tax, ordinary income tax on what you pull out.

Whereas, a Roth IRA, you do not get a tax deduction. So it’s an after-tax account, but if you can wait till 59 and a half, the Roth’s been open at least five years, it’s all tax free. Plus, there’s no RMDs for Roth IRAs, so you can keep those funds growing, tax shelter them for a lot longer, and hopefully have a very large tax-free retirement account. So, there’s obviously a big incentive to get to Roth. The tax, the toll, is sometimes too expensive for some taxpayers. But, you can do Roth conversions over a period of years, right? Let’s say I own 100 shares of Tesla, you can do 20 shares a year for five years, and eventually you’ll get everything to Roth. Now, obviously you need to make sure you can pay the tax. It’s a gamble, right? Because let’s say you did a Roth conversion on Enron stock or Lehman Brothers or on Bitcoin when it was at $60,000 and now you pay tax at $60,000 and now Bitcoin’s at $19,000. You may not be super thrilled, right? You just gave Uncle Sam a lot more tax revenue than it would be entitled to if you just did a distribution today based off fair market value. So, there is a gap.

Now, that’s what a Roth conversion is. No limits. It’s pretax to Roth. Okay? Remember that: pretax to Roth, you pay ordinary income tax. A Backdoor Roth IRA; again, has now been made possible since 2010. It’s a type of conversion. The main difference between a Backdoor Roth IRA and a Roth conversion is Backdoor Roth IRAs are after-tax IRAs to Roth. Not pretax IRAs, but after-tax IRAs to Roth. That’s the big distinction. They’re both deemed conversions; on the regular Roth conversion, you’re going to pay tax on the value of what you convert: cash or in-kind asset. On the after-tax Backdoor Roth IRA, if you do it well, and you do it right, there’s not going to be any tax.

So, this is how the Backdoor Roth IRA works. Essentially, in 2022, if you make more than $214,000 and you’re married filing jointly, you cannot do a Roth IRA; you’re not allowed to. But since 2010, as I mentioned, you’re able to do Roth conversions. So, the Backdoor Roth IRA was born in 2010 and essentially all you need to do is do an after-tax IRA, not a pretax IRA contribution, an after-tax, which still is at $6,000 or $7,000 if you’re over 50, but you don’t claim a tax deduction for it, it’s an after-tax IRA. And this is the only time you would do an after-tax IRA is if you want to employ a Backdoor Roth IRA strategy. There’s no reason to just do an after-tax IRA contribution randomly if you still can do a Backdoor Roth or you have the opportunity to do other types of transactions because there’s no point. The Backdoor after-tax Roth IRA is in no man’s land. You don’t get the tax deduction, and the earnings on it will be subject to tax, so you don’t want to be in the after-tax world. You either want to be in pretax or Roth. Pretax – you get that tax deduction and Roth, so long as you’re over 59 and a half, the Roth’s been open at least five years. It’s all tax free.

So, the only reason to do the Backdoor Roth IRA is you do the after-tax conversion to Roth; if you do it right, there’s no tax, right? So, if you put $6,000 in, let’s say, I don’t know, September 15 into an after-tax IRA, and on September 16, that money is just sitting in an account, you just convert it to the Roth. There’s no tax right? Because there’s no earnings on that $6,000; just sat in a bank account. So remember, earnings would be subject to income tax. So, if you waited till January of the next year and you invested in Tesla stock and it went up 30%, you would have to pay tax on the earnings on that after-tax.

So, the way to do a Backdoor Roth IRA is you literally do it the next day or the same day. Add $6,000 or $7,000 to an after-tax IRA and then immediately convert it to Roth. Again, the only time you want to do this is if you make more than $214,000 married filing jointly and you cannot do a Roth IRA, you want to do the Backdoor Roth IRA and then immediately convert it to Roth so you can get into the Roth IRA.

So in other words, anyone now could set up a Roth IRA by using the Backdoor Roth IRA. Warren Buffett, Elon Musk, Jeff Bezos, you and me, we all can do it even if you make more than $214K because you just do the Backdoor Roth IRA. Pretty easy workaround.

So, one other thing to keep in mind. Not on Roth conversions, but on a Backdoor Roth IRA there’s a pro rata formula. It kicks in if you have other pretax IRAs out there. So, let’s say you had a pretax IRA from 2015 and $5,000, kind of sitting out there. And now you want to do a Backdoor Roth IRA in 2022 of $5,000. You can’t convert the five automatically to Roth because you have another pretax IRA out there. So, you have to use this formula where you add all your IRAs together. Five and five is ten. And now you want to do the backdoor of five out of ten, which is 50%. That means 50% of the $5,000 you want to do in an after-tax IRA to Roth in 2022. $2,500 can only be converted to Roth. The rest would stay in after-tax. That formula does not apply to Roth conversions. It only applies to Backdoor Roth IRAs which means when you’re converting after-, not pretax, but after-tax to Roth and that only is an issue if you have other pretax IRA funds. If you don’t have any other pretax IRA funds, you could just go backdoor after-tax to Roth with no tax consequences.

So, there you go. The main difference, keep in mind, in backdoor is, backdoor you do after-tax to Roth. You only do that if you make more than $214K married file jointly and you want to do a Roth IRA. If you do a Roth conversion, it’s pretax to Roth, which is subject to income tax on the cash or the fair market value of the asset diverted. That’s it. They’re both different types of conversions. They’re both conversions. One is pretax, which is the Roth conversion. The Backdoor Roth IRA is an after-tax to Roth which, if you do it correctly, would not be subject to any tax.

So, there you go. Hope you guys enjoyed today’s podcast. Hopefully now you understand the difference between the Roth IRA and the Backdoor Roth IRA. Both superb, exciting strategies but solve different problems. One is obviously getting your pretax traditional or 401(k) funds into Roth. So, as long as you are 59 and a half, the Roth’s been open at least five years, you can lock in your tax-free gains. And then the other is the after-tax where you can move into a Roth IRA and make Roth IRA contributions even if you exceed the Roth IRA income limitation of $214K married file jointly in 2022.

So, really cool strategies that help people in different ways; even can help the same person depending on what that person wants to do. So there it is, another episode in the bag. I appreciate you guys spending some time here today. I hope you enjoyed today’s podcast. If you are watching on YouTube, thank you. Don’t forget to subscribe. And if you are listening, remember it’s a weekly podcast that drops every Wednesday and you can pick up the podcast anywhere you pick up your podcast: Apple, Spotify, SoundCloud, wherever, you will be able to find it.

So, thanks again for spending some time with me. I really appreciate the support. Have a great day and I’ll talk to everyone again next week. Take care.


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