What Your CPA Wants You to Know
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What Your CPA Wants You to Know
109. All about the Backdoor Roth IRA
We break down how high earners can legally fund a Roth IRA using the backdoor method, why it matters for business owners with variable income, and where people go wrong. We share the exact steps, the pro rata trap, and the one IRS form you must not miss.
• difference between Roth and traditional IRA and why Roth can be better for many
• who needs a backdoor Roth due to income thresholds and phaseouts
• step-by-step process to contribute and convert quickly
• role of advisors and importance of coordinating with a CPA
• risks of direct Roth contributions when over the limit
• business owner income swings and AGI versus take-home pay
• the pro rata rule if you hold pre-tax IRA balances
• filing Form 8606 to track non-deductible basis and conversions
• the value of proactive planning before year-end
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I mean, not every CPA or financial advisor is as proactive as we would like for them to be, which is the main point of this episode. I mean, you you should have either a financial advisor or a CPA or both if you're trying to use this strategy, but you might still have to bring it to them in order to make it happen. Welcome to What Your CPA Wants You To Know.
SPEAKER_02:So we've created this podcast to help guide you through it all and make you feel like you have a CPA in your back pocket.
SPEAKER_01:I'm Karsten Stanns.
SPEAKER_02:And I'm Karen Stans.
SPEAKER_01:I'm a CPA with over 10 years of experience helping people start and grow their businesses.
SPEAKER_02:And I'm an MBA with a specialization in marketing and entrepreneurship. Taxes suck, and we want to make sure you don't pay more than your fair share.
SPEAKER_01:We're here to share everything your CPA wants you to know.
SPEAKER_02:In a fun and easy to understand way.
SPEAKER_01:Let's get started.
SPEAKER_02:Let's do it. Let's talk about backdoor Roth IRAs.
SPEAKER_01:No, that's too exciting.
SPEAKER_02:Such an exciting topic today, as always. But this is one that I think most people relate and know what it is, but not enough to like use it. Like they they've heard of it and they're like, oh yeah, that backdoor Roth. But a lot of people need some direction on this. So I thought a whole podcast episode to explain what a backdoor Roth is and how to use it was a good idea.
SPEAKER_01:Yeah, it's one of those things people talk about and then they're afraid someone's gonna ask them a follow-up question. And they're like, oh, hope they don't, because I actually don't really know what it is or how it works.
SPEAKER_02:I don't know all the fine details.
SPEAKER_01:Kind of like when people are like quarterlies, they're talking about quarterlies and they don't really know what quarterlies are.
SPEAKER_02:There's a lot of that with business owners. I see that they say things, but they don't necessarily know exactly what it means. So if you don't, you don't need to feel bad because we're here telling you that a lot of people don't know.
SPEAKER_01:And it is kind of exciting. It says backdoor, it sounds like we're doing something wrong. Yeah, it sounds illegal we're gonna get away with something.
SPEAKER_02:This is not an illegal podcast episode. This is actually completely legal. You do it all the time, but you do need to know all the steps involved and why you would actually use this backdoor option.
SPEAKER_01:I was just gonna say it in this day and age, there's not really that many loopholes left, which are just, you know, things in the tax law that we're allowed to do and kind of take advantage of that maybe that's not the way they were intended, but they're allowed and it's widely used. This is one of them, so some people call it a loophole. And it kind of is, they've been saying they're gonna close a loophole for I don't know, maybe 30 years now, and they never do. So I think the IRS is aware we're doing this, and I guess they don't care.
SPEAKER_02:They're definitely aware, so feel free to use it. This is not something you're gonna get in trouble for, and it's something that you should use if it applies to you. So, first, how about we just explain what is a backdoor Roth?
SPEAKER_01:Okay. So a Roth IRA, which, if you're not familiar, that is when you contribute to a retirement account, an individual retirement account, that you don't get a deduction for it in that tax year, but it grows tax-free. And when you pull the money out at retirement, both the growth and the original contributions are all pulled out of your retirement account without being taxable income. That's different from a traditional IRA where you get a tax deduction for making the contribution and it grows tax-free. But when you pull the money out at retirement, it's all taxable. So we think it's a better plan for most people. And on top of that, uh, some people aren't eligible for a Roth IRA. So that's why we do a backdoor Roth IRA. Um, the backdoor part just means that we contribute to what's called a non-deductible traditional IRA. So it it's it's like that deductible one I was talking about earlier, where you would get a deduction that year and it's taxable when you get to retirement, except for we don't take a deduction for it. And then we turn around five minutes later and we do a Roth conversion.
SPEAKER_02:And wait, let's stop. Okay. Why would someone do this?
SPEAKER_01:So if you make over a certain amount of money, which we'll we can get into those amounts later, and it changes every year. But just know if you're over a certain income threshold, you're not allowed to contribute to a Roth IRA the regular way, where you just put the money directly into the Roth IRA.
SPEAKER_02:And that's just the point I was making. That's the whole point of this episode is that many business owners are out of this threshold. They're making the higher income limits, so they need this. So the whole reason for the backdoor Roth, simply put, is there are income thresholds, and if you make too much money, you can't use it. But this is a way that you can.
SPEAKER_01:Right. And by the time you do all of the steps, it's the exact same result as if you had actually just contributed to a Roth IRA. So why they make us jump through the extra hoops, I don't know. But that's the way that it works.
SPEAKER_02:So if someone's listening to this and they're like, yeah, I fall into this category. How do I set up a backdoor Roth? What are the steps you would take to do one? And who all do you need to talk to? Because I know sometimes there's some miscommunication there.
SPEAKER_01:Well, if you're using a financial advisor, you can just tell them that you want to do a backdoor Roth and that your income is such that you need to do it that way, and they can take care of that for you. They'll tell you what to do. If they don't know what that is, then get a different financial advisor and then tell the new one what you want to do. Now, let's say that you're one of those people that's managing your own retirement. Uh, the way you do it is you first go set up a traditional IRA through Vanguard, Fidelity, Schwab, whoever you, you know, do your self-directed investing through. And then you also set up a Roth IRA, and each year you'll contribute up to the max of the IRA limit into the traditional IRA, but don't deduct it on your tax return. And then you turn around and immediately do a Roth conversion as quickly as possible. Sometimes it takes time for the funding to go through before you can do it. So you might not be able to till the next day. But the main point is you want to do it really before there's much or any growth in that traditional IRA. Because if there's some growth, let's say you put in$6,000 and then it grows by$100. Well, that's fine. You can still do the conversion, but a hundred of that's going to become taxable because that growth of a hundred dollars is taxable. So anyway, you want to do it as quickly as possible. You just go right into each each of those investment platforms has an option to do a Roth conversion from your traditional IRA account.
SPEAKER_02:So let's just say that you didn't know what the income thresholds were and you thought you could do a Roth IRA, but you can't because you make too much money. What happens?
SPEAKER_01:You have to take the money back out and you can get tax and penalty on that. Um, the tax would probably be minimal unless unless there was a lot of growth on there, but you would be penalized on that.
SPEAKER_02:The point I'm making is what if your investment advisor recommends this Roth IRA for you and they don't really check with your accountant or they don't ask you and you aren't eligible for it.
SPEAKER_01:Yeah, that's bad. They they really need to be in contact with your CPA or at least using you as an intermediary to ask those questions of the CPA. And this happens to business owners a lot. You know, with W-2 people, it's not as common because you know, you don't get huge raises in one year a lot of times. I mean, it can happen, but it's more common with business owners because you have a year where you're well under the threshold, and the next year you make twice as much money, which is great, but now you've done something that you're not really allowed to do. So you just need to make sure you take that extra step and do the backdoor Roth.
SPEAKER_02:Yeah, that's kind of what I was getting at. Is I know we've had a few scenarios come up over the years like that, and then some where the investment advisor either didn't know the limits, didn't ask, or third option, the business owner doesn't really know what they make on paper because you know, it's not like they have, oh, you have a set salary, this is how much you make. They know how much they make, but it's it's different on your tax return. You know, it's not very set forward and it's not the same every single year.
SPEAKER_01:Right. And those limits are based on, you know, other complex terms like adjusted gross income or modified adjusted gross income, things like that.
SPEAKER_02:Not what you're actually bringing home. Like they might know that, but it's different.
SPEAKER_01:Right. And though yeah, those terms mean something very specific, and calculating that can be complicated. So if you're close, I mean it can be very difficult to know exactly whether you're over that limit or not without talking to your CPA. Okay, be honest. How's your bookkeeping going?
SPEAKER_02:If you just cringed a little, this is for you.
SPEAKER_01:We created a monthly accounting program where you hop on a one-hour call with us every month to tackle bookkeeping, tax planning, business decisions, basically anything you need.
SPEAKER_02:The best part of this is it's at a reduced hourly rate so you can easily budget for your accounting help. And because we love our clients, we throw in a free annual tax projection so you're prepared every April 15th.
SPEAKER_01:Our clients love this plan. It's perfect if you're doing your own books, but want an expert watching over your shoulder and training you on everything you need to do.
SPEAKER_02:We have all the fine details in episodes 101 and 102 of this podcast if you want to check it out, or just email us at Carson at Sansco.net.
SPEAKER_01:Now back to the show. Okay, earlier I mentioned that I would go over what those income thresholds are, and so I can do that real quick. Right now for 2025, um, the phase out for uh Roth IRA eligibility starts at around$146,000 and it's$230,000 if you're married filing jointly. So if you're anywhere close to those, you do need to get someone to run the numbers and just see if when we calculate AGI, if you're gonna be over those thresholds. Now let's talk about something else that could go wrong. Not everybody can do a backdoor Roth. I know earlier we said that everyone can, sort of, but there there are a few exceptions.
SPEAKER_02:No, really, there's exceptions. Exceptions to the exception. No.
SPEAKER_01:So whenever you there's not an income limit, so that's not a problem. I mean, even if you make$10 million a year, you can still do this. But when you might not be able to, if you have traditional IRA money already out there in some account that you've deducted, now that's a problem. Whether in the past you've been contributing to an IRA and deducting it, or whether it was in a 401k that you left a job and you rolled it into an IRA, you know, now you have a problem because you have a deductible IRA. And when you try to do this backdoor Roth, part of the step is a conversion. Well, you can't convert just the deductible or the non-deductible, it has to be pro rata. In an ideal world, we could. We would go and do a$6,000 non-deductible contribution and just convert that part to Roth. But if you also have$60,000 outstanding in deductible IRA, well, now you're gonna have to do it on a pro rata basis. And so either you're gonna have to convert everything, but that's gonna create a tax event for you. Because if it's a deductible IRA you're converting, now that's taxable. So you just have to be careful. If you have any traditional IRAs outstanding, just please talk to your CPA or tax advisor about whether that's a good option for you. Another thing people do wrong is they think they can just do this and they don't have to file any paperwork. That's another one of the differences between the backdoor Roth and just a regular Roth. If you just do a regular Roth conversion because you're under the income limit, there's not really any forms in your tax return you have to worry about. Whenever you do the backdoor Roth IRA, you have to file form 8606 in your tax return. And that's just a form where you report non-deductible IRA contributions and then reflect that you did a conversion to transfer the uh to to change those into a Roth conversion.
SPEAKER_02:So that was a lot of accounting terms and probably our most interesting episode ever, maybe, or most boring, I don't know. But this is something that many of our clients use. It's very important if you fall into these categories. So hopefully you understand it a little bit more now. But if you listen to Carson talk about it and you're like, I don't know, like I I get the gist of it, but I still need help. Of course you do. Like your accountant's gonna file these forms for you. Make sure that you have a CPA that knows about it and will do their due diligence, and then make sure that your CPA and your financial advisor know what's going on both sides so that you aren't breaking any of the rules and that everything that you need to file is getting done.
SPEAKER_01:Exactly. I mean, not every CPA or financial advisor is as proactive as we would like for them to be, which is the main point of this episode. I mean, you you should have either a financial advisor or a CPA or both if you're trying to use this strategy, but you might still have to bring it to them in order to make it happen.
SPEAKER_02:Yes, unfortunately so. And just like everything else, when you're trying to save taxes, it's all proactive. You can't in 2025 and then in January call up your CPA and say, Hey, hey, how can I save money on my tax return? Everything has been done. So you have to be proactive about all of the things that we share on this podcast, including this. And in two weeks, we're gonna have an episode that's all about things that you still can do right now to help you save on 2025 taxes, because if you wait until the year ends, there's nothing really you can do.
SPEAKER_01:Well, I hope you're all still awake and we're always here with more tax tips. We tried to keep this one short because I know it's not the most exciting topic. So thank you for hanging with us. And until next time, thank you so much for listening to what your CPA is.
SPEAKER_00:This podcast is intended to provide accounting and tax information for educational purposes only. All tax situations are unique and can be handled with the assistance of a tax professional.