Ep 25: Q&A | Roth IRA 101, Backdoor Roth IRA Contributions, Lifestyle Creep

Jess: You're listening to Market MakeHer, the self-directed investing education podcast that demystifies the stock market from her perspective.

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Jess: Today's question comes from TikTok, from hello2jojo, who asks, how do I do a backdoor Roth IRA contribution? And she also stated that she was rolling over a 401k to an IRA.

Jessie: But this is a great question because this is something that I literally have no idea about.

Jess: I've heard about backdoor IRAs, and that's the extent.

Jessie: I didn't even go to research it.

Jess: Like I do not know anything about backdoor IRAs or how they work.

Jessie: So I'm excited for this question.

Jess: Yeah.

Jessie: So this goes back to that analogy of rooms, the IRA rooms.

Jess: There are rules that the IRS puts in place on who can go in and out of those rooms.

Jessie: That's the taxable events, is adding money to retirement plans and then taking money, aka distributions, from retirement plans.

Jess: So the IRS is the bouncer at the door of this backdoor.

Jessie: Well, there's a backdoor.

Jess: Yeah.

Jessie: The IRA, the bouncer.

Jess: That's the secret.

Jessie: The secret room.

Jess: It's like a speakeasy.

Jessie: In it.

Jess: You got to have the password.

Jessie: I like where this is going.

Jess: So if you cannot contribute to a Roth IRA, it means you make too much money.

Jessie: That's a good problem to have.

Jess: Right.

Jessie: There's contribution limits in general, but there's income limits to be able to contribute to a Roth IRA.

Jess: There are no income limits to contribute to a traditional IRA.

Jessie: It's just the income limits decide if you can mark your contribution as tax-deductible or not.

Jess: Right.

Jessie: That's step number one.

Jess: Because the Roth IRA is taxed up front, right? That's right.

Jessie: It's after-tax dollars that are going in, and so when you pull the money out, it's not taxed.

Jess: And there's also a five-year rule with that.

Jessie: Okay.

Jess: Whereas the traditional IRA, if you're a higher-income earner, within those limitations, that may help you tax-wise, but you may make too much money, and the IRS is like, no, you can go in this room, but we're not giving you a tax deduction.

Jessie: So this is where we want to talk about something called the IRA aggregation rule.

Jess: So say you're in this house where there's all these rooms, and each rooms have different rules.

Jessie: The IRS looks at your traditional IRA accounts as one account.

Jess: That's important to know.

Jessie: Yeah.

Jess: When you make a conversion, that means you're converting funds that are in the traditional IRA into the Roth IRA.

Jessie: It's the back door.

Jess: You're going in through the traditional IRA door, and that traditional IRA door has this conversion speakeasy where you open up the telephone booth, and you're like, yo, I made a non-deductible contribution.

Jessie: I would like to get in, and they're like, boop, boop, boop, okay.

Jess: That's how you do the conversion, but it doesn't necessarily make sense to do that sometimes.

Jessie: You may want to get in that room because the Roth IRA sounds so illustrious, but it actually may not make sense for you, and that's because of the account aggregation rule that we need to break down.

Jess: Tracking so far.

Jessie: What's a non-deductible contribution again? How does that happen? So you have to know what you put into your IRAs.

Jess: So you have a deductible contribution where you can deduct it from your taxes, as in it reduces your taxable income, but if you make too much money, then you can make a non-deductible contribution where you don't get those tax benefits.

Jessie: So even though they say it's pre-deck tax contributions into a traditional IRA, it's not always true.

Jess: It could be non-deductible contributions that are there.

Jessie: This is what makes it a little bit tricky, depending on your situation, especially with this question very specifically that started with, I want to roll over my 401k into an IRA and then convert.

Jess: I would not do it in that order.

Jessie: Here's why.

Jess: So you have the IRA aggregation rule, also known as the pro-rata rule.

Jessie: And this is totally something that applies to me.

Jess: I am a very privileged person, and I'm in this situation right here, but I have had old 401ks, and they are all rolled over into IRAs.

Jessie: So I have a lot of IRAs, and those were actually deductible contributions at one point.

Jess: So the IRS is going to look at all of my IRAs, say I want to convert to a Roth IRA, and they're going to say, okay, well, hypothetically, this is not the real numbers, but let's say I have $100,000 altogether, just for easy math, across four different accounts.

Jessie: And 90% of that was deductible contributions, but 10% was non-deductible.

Jess: So $90,000 was deducted from taxes at some point, 10,000 was not.

Jessie: If I want to convert into a Roth IRA, that's going to create a tax event, because now I'm going through this back door into this room, but because I'm going through rooms, I'm generating a tax event, and 90% of that is going to be taxed as income.

Jess: So I just add it on to my income.

Jessie: And remember, if I'm in this situation, I already make too much money, which means I need to work on reducing my tax bill.

Jess: Right.

Jessie: Yes.

Jess: Okay.

Jessie: So making a backdoor Roth IRA conversion may not be a good idea if you already have this huge tax liability, if you're just trying to get it into the Roth IRA.

Jess: And there are better ways to do that.

Jessie: Like what? So it's such a great question.

Jess: Think about what the intention of the Roth IRA is.

Jessie: If you're first starting out and you're on a lower tax bracket, it makes sense for you to max out and contribute to the Roth IRA, because you want those after-tax dollars.

Jess: But that can also work in reverse.

Jessie: So ideally, when I retire, I'm going to have the lowest amount of income.

Jess: And let's just say everything stays exactly the same as it is today.

Jessie: It's $24,000 if you're filing joint, where you don't have to pay taxes on your first $24,000.

Jess: Because remember, the way that the tax system is, is all that step up, right? Yeah.

Jessie: Say I am way forward in my life.

Jess: I have this traditional IRA that I've grown and contributed to, I then at that point would do up to $24,000 every year and convert it to the Roth IRA.

Jessie: And then that wouldn't be taxed, because it would be up to the limit, like depending on my whole situation.

Jess: And to really simplify that.

Jessie: Do you get what I mean? Don't convert into a Roth IRA and add to your income if you're in a high tax bracket.

Jess: Do that when you're in a lower tax bracket.

Jessie: Right.

Jess: OK.

Jessie: It used to be, back before 2017, you could do something called a recharacterization, where you'd be like, actually, whoops, I don't want to do that.

Jess: Now Roth conversions are permanent.

Jessie: You go in that door, it's there.

Jess: You're not getting it out.

Jessie: There's no way to undo it.

Jess: I understand the benefits of having a Roth IRA.

Jessie: Do you make a lot of money and you have an IRA? Is there a benefit to trying to do a backdoor to get a Roth? It's just because you don't want to pay taxes on it later? Yeah.

Jess: The whole point of the Roth IRA is when you pull the funds out, you're not taxed and you're going to be in a lower tax bracket at that time.

Jessie: But you have to remember the IRS always has its handout.

Jess: They're going to get their money somehow.

Jessie: So traditional IRAs, there's something called a required minimum distribution, where you reach 70 and a half.

Jess: That's actually a minimum amount that you have to take out of your IRA.

Jessie: Because the IRS is like, whoa, this was your pre-tax funds that you've grown.

Jess: Now you're going to take it out.

Jessie: You need to pay your taxes now, dude.

Jess: Roth IRAs don't have that because you don't pay the taxes.

Jessie: So it's beneficial and it's just, again, goes into personal finance or investing is personal.

Jess: Where do you think you're going to be at age 70 or whatever age? Exactly.

Jessie: What's going to be going on in your life? And hopefully you don't have a bunch of income.

Jess: That's the goal and that's the intent.

Jessie: But also think about the traditional IRA.

Jess: If you're contributing to that while you're in a higher tax bracket, get those benefits from your 401k plan.

Jessie: But then when you're older and you start withdrawing from that traditional IRA, hopefully you're not in that super high tax bracket anymore.

Jess: The idea is when you're retired and you're not working anymore and you have no other sources of income coming in, then you don't want too many taxes taken out because you want all that money to live off of, right? Yeah, exactly.

Jessie: And it's taxes income because this is your income.

Jess: Your retirement is your income.

Jessie: So retirement's like your job you have that you don't have to work at that you saved up for not having to work but still having a monthly income.

Jess: Yeah.

Jessie: Your money got a job and now your money has grown up and you're reaping it benefits.

Jess: Yeah, exactly.

Jessie: That's totally the intent.

Jess: But just doing a Roth conversion for the sake of the illustrious Roth IRA doesn't always make sense.

Jessie: And also not a tax advisor in the slightest, never have been, but have worked in finance for almost 15 years and talked to a lot of clients about this.

Jess: And also told them I wasn't a tax advisor.

Jessie: Right.

Jess: Neither am I.

Jessie: But lots of information on this.

Jess: We'll link the IRS.gov notes about the account aggregation rule.

Jessie: Just remember the intent of you doing a backdoor Roth IRA contribution or putting anything into a Roth IRA.

Jess: All of this is for tax benefits.

Jessie: Yeah.

Jess: So when would it make sense to do a backdoor IRA though? What were these backdoor things made for? So you can convert it over into a Roth IRA.

Jessie: You could do that conversion at any time.

Jess: So it's just because like, oh, at the time when I set up this retirement account, I wasn't allowed to do a Roth.

Jessie: I had to do an IRA.

Jess: But now I'm in a place where I do qualify to have that Roth.

Jessie: So I'm going to just backdoor my IRA into a Roth account.

Jess: This amount of money going forward can go into the Roth IRA.

Jessie: Yeah.

Jess: And that's called a conversion.

Jessie: The proper term is I'm going to convert my IRA into a Roth IRA.

Jess: That's not a rollover.

Jessie: Not a rollover.

Jess: Okay.

Jessie: It is a conversion.

Jess: But it would make sense if you're in a lower tax bracket because it could have tax consequences.

Jessie: Or in this person's question, if you have no other traditional IRA assets or all of your traditional IRA assets are non-deductible, well, then it's not going to add to your income there.

Jess: So that's what you have to think about, is the account aggregation role.

Jessie: Obviously, you can always call your brokerage firm and they will help you with this.

Jess: But I'm going to have to do that because I'm realizing I had a 401k that I got laid off from my company and rolled it over into a regular IRA.

Jessie: But now that I'm freelancing and definitely making less than I was, I'm wondering if that's something I should be considering.

Jess: It may make sense.

Jessie: When we do our taxes and you find yourself getting back a hefty refund, then it might make sense.

Jess: Which I doubt.

Jessie: That's what I would.

Jess: Yeah.

Jessie: I mean, who knows? The universe.

Jess: Give me that refund.

Jessie: That'd be great.

Jess: Think about things positively.

Jessie: I haven't had a refund in a long time.

Jess: I would really like one.

Jessie: I got one last year, but it was like, you know, nothing.

Jess: But I would love...

Jessie: If it was a dollar, I would feel better.

Jess: Something.

Jessie: Yeah.

Jess: Anything.

Jessie: Yeah.

Jess: You're right.

Jessie: Check.

Jess: Yeah.

Jessie: I definitely had to do that when you're freelancing.

Jess: Ugh.

Jessie: No fun.

Jess: Anyways, a couple of things to be aware of if you are doing a Roth conversion.

Jessie: Roth IRAs have a five-year aging rule.

Jess: Have you heard of that before, Jessie, actually? I've heard you say that before, but I don't think we followed up on it.

Jessie: Because it's after-tax dollars, you can also remove your contributions tax-free, but it has to be in the account for five years.

Jess: Your contributions have to be there, meaning that there's also a five-year waiting period for your conversion.

Jessie: So if you were to take a conversion from your traditional IRA or the source was that pre-tax 401k, you are under 59 and a half, and you want that benefit of withdrawing from the Roth IRA, you still have to wait five years before you can do that.

Jess: Okay.

Jessie: You're like trying to retire a little earlier.

Jess: You might not want to do that.

Jessie: That's right.

Jess: But that's also a benefit of a Roth IRA, is you can withdraw your contributions after they've been aged for five years, and then you could retire earlier without incurring that 10% penalty that you definitely would get on the traditional IRA.

Jessie: That's interesting.

Jess: Mm-hmm.

Jessie: Wait, so with the Roth IRA, that five-year rule, you said you can borrow against yourself from your retirement accounts if you really need that money, or is that just a 401k? As long as your 401k plan allows it, you could have a longer period, like over a year.

Jess: Technically with an IRA, you have 60 days, but you're only limited to do one every rolling 12 months, so meaning you can take money out of your IRA, but you have 60 days to put that money back without it being taxed as income and incurring a penalty.

Jessie: It's not that long.

Jess: What's a rolling year? Today is February 7th.

Jessie: You have until technically February 7th of next year, rolling 12 months.

Jess: Oh, okay.

Jessie: Yeah.

Jess: So, wait, but you said 60 days to pay it back.

Jessie: I can do that one time within that year, so I can't borrow money against myself for another whole year, starting from the day, like today or whatever day I'm taking it out, but I have to pay that money back within 60 days.

Jess: Yep.

Jessie: Otherwise, that bouncer's coming for you.

Jess: Yeah, you're getting kicked out.

Jessie: You are going to get some penalties.

Jess: Yeah.

Jessie: Okay, good to know.

Jess: I really like this analogy of the bouncer, because the broker, IRS cares what goes in and out of that room.

Jessie: If you find yourself in a situation, though, financial advisor and tax advisor, you'd want to have that conversation.

Jess: And again, you can always call your brokerage firm.

Jessie: They will talk to you for free.

Jess: You can ask them some questions, just to make sure you're doing the right thing.

Jessie: Just say, hey, I just need to make sure that I'm tracking this correctly, and this is what I was thinking.

Jess: Is this allowed? Does this make sense? And they'll tell you.

Jessie: We also, Jessie, had a lot of comments about people who are starting their first salary job, and I love Gen Z.

Jess: I'm so proud of you.

Jessie: You're just going to be great.

Jess: All the information and resources you could ever need get you going in the right direction.

Jessie: Yes.

Jess: And for your 401k contributions, there's always an option in there.

Jessie: Increase it by 1% per year.

Jess: Just do that anyways.

Jessie: Yeah, definitely.

Jess: You won't even notice it.

Jessie: You can get a raise.

Jess: I know companies aren't really doing raises anymore.

Jessie: Maybe again, it'll happen, where you get a raise.

Jess: They let you do a 401k adjustment, or if it was like 2% or 3%, do you want to contribute that to your 401k? So that's something to keep in mind, because it's money that you're not already seeing.

Jessie: You can maintain on what you've been making, and you can put that extra 2% or 3% into the 401k.

Jess: Then you're not really missing it.

Jessie: Think about that as you continue in your career.

Jess: Think about it that way when you're saving.

Jessie: That money doesn't really exist until you really need it.

Jess: It's a good tip, Jessie.

Jessie: Keep it out of your line of sight.

Jess: Oh yeah.

Jessie: Skits.

Jess: Don't make it an easy app to open on your phone.

Jessie: Don't make it an easy thing to access.

Jess: Oh.

Jessie: Keep it out of sight, out of mind.

Jess: Love it.

Jessie: Pay yourself first.

Jess: I like it.

Jessie: And the little things, like this has helped with my shopping problem.

Jess: I really love nice bags, and they're an investment.

Jessie: I am only allowed to buy a bag if something monumental has happened in my life.

Jess: I named that bag, like my most recent is called Mary, because that's a talent executive over at CNBC.

Jessie: That was a monumental moment in my life, and I was able to buy that bag because it represented something.

Jess: But now every time I wear it, it's not just an accessory on my outfit, it reminds me of something I've accomplished.

Jessie: Yeah.

Jess: And that's a good way to look at it.

Jessie: I like that idea.

Jess: It's just a way to not have lifestyle creeps.

Jessie: And you know, you can buy Louis Vuitton stock, LVMH.

Jess: Yeah.

Jessie: I wish they still made stock certificates, because that would be a cute one to have framed or something.

Jess: Yeah, I don't want a framed LVMH stock certificate.

Jessie: The Disney ones used to be so cute, like I used to love when people would bring them in, they got it for their kids, it had all like little Disney characters on it.

Jess: Okay, well, there you have it.

Jessie: Sometimes it doesn't always make sense to do the thing that investment gurus say.

Jess: And if you have questions, let us know in the comments.

Jessie: And like we said, you can always ask your brokerage firm.

Jess: So true.

Jessie: Also, no, we accept challenges.

Jess: I would love a hard question, please and thank you.

Jessie: Yeah.

Jess: Did you know someone blocked me on Instagram once because of that? Because you know my specialty is derivatives.

Jessie: And then he asked a question about gamma in a bull call spread.

Jess: And then I sent him like a novel.

Jessie: And he was like, subscribe.

Jess: He was so mean.

Jessie: He's like, well, you could have just copied and pasted that from the internet.

Jess: And I'm like, well, I didn't.

Jessie: And I'm like, well, I didn't.

Jess: I actually took the time out of my day to answer your question.

Jessie: And with all due respect, if that was copy and pasted from the internet, I probably wrote it.

Jess: This still bothers me, obviously, if you can tell.

Jessie: Stuff like that.

Jess: I get so petty.

Jessie: So petty.

Jess: He did ask a question that should be hard.

Jessie: This is like action.

Jess: Everyone, if you're asking a question, be prepared to get a very detailed answer.

Jessie: That's right.

Jess: And remember, keep building knowledge.

Jessie: Keep breaking those barriers.

Jess: Remember investing involves risk.

Jessie: There is always potential to lose money when investing in securities.

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Jessie: We are not registered financial advisors and do not provide personalized investment advice.

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