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Demystifying Backdoor Roth Conversions

The Discerning Investor by by Julie Jason
by Julie Jason
The Discerning Investor | July 10th, 2020

Last week, we talked about this year’s July 15 deadline for 2019 IRA contributions. July 15 is also an important date for “backdoor” Roth conversions for people who don’t qualify for Roth contributions.

That is, if you haven’t made your 2019 IRA contribution, and you don’t qualify for a Roth contribution due to income limits, consider doing a backdoor Roth for 2019 and, while you are at it, do one for 2020. That way, you can contribute a maximum of $6,000 ($7,000 if you are 50 or older) for each tax year, for a total of $12,000 ($14,000).

When you convert, you will have to pay taxes on the amount converted, except in a special situation that I’ll describe shortly.

What’s “backdoor” about the conversion?

If you earn over a certain dollar amount, you cannot make a direct Roth IRA contribution. The back door is a contribution to a traditional IRA followed by a conversion to a Roth.

What are the income limits that prevent a direct contribution to a Roth? That depends on your filing status.

For example, if you are single with a modified adjusted gross income (MAGI) of $137,000 or more (2019), then no Roth contribution for you. The max for 2020 for single filers is $139,000. The limits are higher if you are married and filing jointly ($203,000 for 2019 and $206,000 for 2020).

Limits are published in IRS Pub. 590-A, which you can read online at irs.gov/pub/irs-pdf/p590a.pdf.

Why would you want a Roth? Roth IRAs are tax-free, not tax-deferred. There are no required minimum distributions (RMDs) during your lifetime. And when you withdraw the funds (after age 59 ½ and a holding period of five years), there is no tax bill. In the ideal case, the backdoor Roth can even be tax-free.

Take this example: John, age 52, is single. He earned $160,000 in 2019 and expects to earn about that amount or more in 2020, which means his income is above the limit for Roth contributions.

He cannot contribute to a Roth, but he can contribute to a traditional IRA. He has made no 2019 or 2020 IRA contributions to date, and in fact does not have an IRA. He wants to maximize his Roth opportunities.

John opens up a traditional IRA at a brokerage firm, as well as a Roth IRA. He contributes nothing to the Roth. He contributes $7,000 to the traditional IRA for the 2019 tax year before July 15. At the same time, he contributes $7,000 to the traditional IRA for the 2020 tax year.

He can do these contributions because there are no income caps on traditional IRAs. The Roth IRA he opened is not funded -- yet.

But now that he has $14,000 in his traditional IRA, he directs the brokerage firm to convert his traditional IRA to a Roth IRA. In this very limited example, the conversion is tax-free.

If John had other traditional IRAs, he would have to pay taxes on the conversion because of “aggregation” and “pro rata rules.”

Here is how Fidelity describes these rules:

“When it comes to conversions ... the IRS views all of your traditional IRAs as one account. If you have three traditional IRAs and a rollover IRA spread across different financial institutions, the IRS would lump all of them together.”

The accounts are aggregated and the conversion must be done pro rata -- “proportionally split between your after-tax and pre-tax balances, including contributions and earnings,” according to Fidelity.

It might be clearer to see an example of this in action, which you can find here: fidelity.com/viewpoints/retirement/earn-too-much-contribute-Roth-IRA-conversion.

In any case, now is a good time to fund a Roth IRA, either through the back door or directly if you qualify.

For more reading on backdoor IRAs, a good resource is forbes.com/sites/jimwang/2020/02/20/supercharge-your-retirement-savings-with-a-backdoor-roth-ira/#5753a74a8f08.

July 15 is almost here, so make sure to take care of your 2019 IRA contributions -- and your 2019 income tax return -- before the deadline.

For a quick video that covers the topics we’ve discussed in today’s column, go to vimeo.com/437251929.

Julie Jason, JD, LLM, a personal money manager (Jackson, Grant Investment Advisers Inc. of Stamford, Connecticut) and award-winning author, welcomes your questions/comments (readers@juliejason.com). Please visit www.juliejason.com.

DISTRIBUTED BY ANDREWS MCMEEL SYNDICATION

RetirementAgingMoney
life

Get Your IRA contributions for 2019 in Before July 15

The Discerning Investor by by Julie Jason
by Julie Jason
The Discerning Investor | July 3rd, 2020

If you have not made your 2019 IRA contribution yet, you are not alone. According to Fidelity Investments, the nation’s largest IRA provider, an increasing percentage of investors are making contributions to their IRAs during the last three weeks before the tax deadline -- this year, that deadline is July 15.

Due to the COVID-19 pandemic, both the IRA contribution deadline and the 2019 tax filing deadline were postponed to July 15. The July 15 date is good for this year only. Normally, the cutoff is April 15 for contributions for the prior tax year (and for filing your prior year’s tax return).

More than a third (34%) of tax season contributions came in right before the tax deadline in 2019, according to Fidelity. In May of this year, almost 51,000 clients made prior-year contributions to an IRA.

Let’s go over some IRA basics. For details, I highly recommend reading the official source: IRS Publication 590-A “Contributions to Individual Retirement Arrangements (IRAs) for use in preparing 2019 Returns” (tinyurl.com/jortqhl).

Starting in 2020, as long as you are still working, there is no age limit to be able to contribute to an IRA, thanks to the SECURE Act, which was signed into law in 2019. Before this change, the age cutoff was 70½. By the way, if you visit an IRA custodian website to do your research, be aware that some have not been updated to reflect this and other changes as a result of the CARES Act, which became law on March 27, 2020, and the SECURE Act.

Who can set up or contribute to an IRA? In general, anyone who earns money through a gig or a job can contribute to an IRA.

How much can you contribute to an IRA? The maximum you can contribute for 2019 is $6,000 ($7,000 if you are 50 or older).

What type of IRA is best? Most taxpayers have two choices: either a traditional IRA or a Roth IRA.

The important difference between the two types of IRAs has to do with taxes. Traditional IRAs are tax-deferred (meaning you pay taxes later when you start taking withdrawals). Deferrals don’t last forever -- withdrawals are mandated after age 72 (called “required minimum distributions,” or RMDs), and subject to severe penalties if not taken on time and in the right amount.

Roths are tax-free. That is, unlike the traditional IRA, “qualified distributions” are income-tax-free. Like the traditional IRA, no income taxes are triggered by income earned or capital gains realized during the time you own the IRA. Unlike traditional IRAs, the owner of a Roth IRA is not subject to RMDs (though beneficiaries of inherited Roth IRAs are subject to RMDs).

Can you get an income tax deduction? When you contribute to a traditional IRA, your contribution could be tax-deductible and also benefit from a tax credit, but only if you fall under IRS income limits. I must admit that I have to look up those limits every time I’m dealing with the subject, and I recommend you do the same. They change over time.

You’ll find both 2019 and 2020 limits in the most recent IRS Pub. 590-A (for 2019). The limits for deductibility are tied to your income and tax status (filing jointly with your spouse, filing separately, as head of household or individually), and whether you are covered by a 401(k) or other retirement plan at work.

There are also income limits on who can contribute to a Roth IRA, but as of a few years ago, there are no income limits that prevent you from converting from a traditional IRA to a Roth.

From my perspective as a personal money manager to high-net-worth families, I like to see people saving as much as possible -- maxing out their 401(k)s at work and their IRAs as well. While you are making your 2019 contribution, think about making your 2020 contribution as well, but be sure to notify your custodian of the tax year that applies to each contribution. The maximum you can contribute for 2020 is also $6,000 ($7,000 if you are 50 or older). That means if you haven’t done your 2019 contribution and wanted to maximize your savings, you could contribute a maximum of $6,000 per tax year ($12,000 for both years or $14,000 if you are 50 or older).

Send me questions about IRA contributions that I can answer in the column by emailing me at readers@juliejason.com. Please remember to tell me the city and state you are writing from, and the name of your newspaper.

Julie Jason, JD, LLM, a personal money manager (Jackson, Grant Investment Advisers Inc. of Stamford, Connecticut) and award-winning author, welcomes your questions/comments (readers@juliejason.com). Please visit www.juliejason.com.

DISTRIBUTED BY ANDREWS MCMEEL SYNDICATION

RetirementAgingMoney
life

Good News for Early Bird RMDs

The Discerning Investor by by Julie Jason
by Julie Jason
The Discerning Investor | June 26th, 2020

When I wrote about the suspension of required minimum distributions (RMDs) for 2020 by the CARES Act, which was signed into law on March 27, I received a number of emails from readers who could not take advantage. They had taken their RMDs earlier in the year, and there was no way for them to redeposit their RMDs if they couldn’t meet the rollover rules, which had two barriers: a 60-day time limit and a once-in-a-12-month-period limitation.

W.E. was affected: “My 2020 RMDs were received after the 2020 RMD Suspension was retroactively in effect, but before it was announced on 3/27/2020. Since the suspension of 2020 RMD was intended to benefit all seniors by reducing their 2020 tax burden and help to preserve their battered 401(k)s, I feel that I should be entitled to take full advantage afforded me being able to return and reverse my 2020 RMDs.”

He continued, “Can you make any suggestions on how seniors in my position, having received multiple suspended 2020 RMDs before the 2020 RMD Suspension was announced, can receive fair treatment and fully benefit from the CARES ACT?”

W.E., I have good news for you. On June 23, 2020, the IRS came through when it issued Notice 2020-51, which you can find here: tinyurl.com/y8o2zxjp.

The 60-day rollover period for RMDs in 2020 has been waived as well as the 12-month rule for anyone who has taken their RMDs so far this year. But, you have to do the rollover before Aug. 31.

First, any taxpayer who is subject to RMDs in 2020 from a defined-contribution retirement plan, including a 401(k), 403(b) plan, or an IRA (but not a defined benefit plan), can skip RMDs this year. This includes anyone who turned age 70 1/2 in 2019 and would have had to take the first RMD by April 1, 2020.

Second, anyone who took RMDs in 2020 and would like to “undo” them has until Aug. 31, 2020 to redeposit the RMDs. That is, an IRA owner or beneficiary who has already received a distribution from an IRA of an amount that would have been an RMD in 2020 can repay the distribution to the IRA by Aug. 31, 2020. There is no limit on the number of rollovers if you withdrew moneys multiple times or from multiple IRAs and other tax deferred accounts.

The notice also makes clear that RMDs from inherited IRAs are also eligible to roll over under Notice 2020-51.

R.R. wrote: “I am 77 years old with my birthday in December. I have been taking the RMD since I was 70 1/2.” R.R. then asked an important question: If he doesn’t take his 2020 RMDs, will he be required to take two RMDs in 2021? The answer is no. This is a suspension of 2020 RMDs, not a delay.

L.B. wrote: “I moved a large sum of money from my IRA into my cash account on Jan. 2 this year. With the new ruling I'd like to move it back to my IRA. Can I?” Now that we have Notice 2020-51, the answer is yes, but you must act before Aug. 31.

J.B. wrote: “I am 77 years old and have been taking my RMD the last four years. This year with the break on RMDs, I plan to roll some money over from my traditional IRA into my Roth IRA and still keep within my tax bracket. Normally I would have to take my RMD before I could do a rollover.” He then asked: Can he use the withdrawal to do a taxable Roth conversion? The answer is yes. Since the RMD he took in 2020 no longer has the character of an RMD (since RMDs are suspended), there is no restriction against using those moneys to convert to a Roth.

So, all in all, very good news for early bird RMDs. We can all agree with Melissa Ridolfi, the vice president of retirement and college products at Fidelity Investments, who said, “The fact the IRS has extended the date for retirees to repay a distribution into their IRA -- up to August 31 -- is welcome news.”

For a quick video that covers the topics we’ve discussed in today’s column, go to vimeo.com/432667715/e74f8e0997.

Julie Jason, JD, LLM, a personal money manager (Jackson, Grant Investment Advisers Inc. of Stamford, Connecticut) and award-winning author, welcomes your questions/comments (readers@juliejason.com). Please visit www.juliejason.com.

DISTRIBUTED BY ANDREWS MCMEEL SYNDICATION

RetirementCOVID-19Money

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