Backdoor Roth Going Away

Backdoor Roth Going Away?

Under the current proposals in Washington, the Backdoor Roth is going away. If approved, investors would not be allowed to convert any after-tax money in IRAs to a Roth IRA as of January 1, 2022. This would eliminate the Backdoor Roth strategy and also kill the “Mega-Backdoor Roth” used by funding after-tax contributions to a 401(k) plan.

We have been big fans of the Backdoor Roth IRA and have used the strategy for a number of clients. We will discuss what to do if the Backdoor Roth does indeed go away. But first, here’s some background on Roth IRAs.

The Backdoor Roth Strategy

There are two ways to get money into a Roth: through making a contribution or by doing a conversion. Contributions are limited to $6,000 a year, or $7,000 if you are 50 or older. For Roth IRAs, there are also income limits on who can contribute. For 2021, you can make a full Roth contribution if your Modified Adjusted Gross Income is below $125,000 (single) or $198,000 (married).

If your income is above these levels, the Backdoor Roth may be an option. Let’s say you made too much to contribute to a Roth. You could still make an after-tax contribution to a Traditional IRA and then convert it to your Roth. You would owe taxes on any gains. But, if you put in $6,000, after-tax, and immediately converted it, there would be zero gains. And zero taxes. Yeah, it’s a loophole to get around the income restrictions. But the IRS determined that it was legal and people have been doing it for years.

This change won’t happen until January 1. So, you can still complete a Backdoor Roth now through the end of the year. I have some clients who wait until April to do their IRAs, but this year, you had better do the Backdoor by December 31. If you are eligible for the Backdoor, you should do it. Why would you not put $6,000 into an account that will grow Tax-Free for the rest of your life? Couples could do $12,000 or up to $14,000 if they’re over 50.

Instead of the Backdoor Roth…

Your 401(k) Plan may offer a Roth option. Many people are not maximizing their 401(k) contributions. You can contribute $19,500 to your 401(k), or $26,000 if over 50. Let’s say you are currently contributing $12,000 to your 401(k) and $6,000 to a Backdoor Roth. Change that to $12,000 to your Traditional 401(k) and $6,000 to your Roth 401(k). You can split up your $19,500 in contributions however you want between the Traditional and Roth buckets. I often find that with couples that there is room to increase contributions for one or both spouses.

Self-employed? Me, too. I do a Self-Employed 401(k) through TD Ameritrade. Through my plan, I can also make Traditional and Roth Contributions. And I can do Profit-Sharing contributions on top of the $19,500. It’s better than a SEP-IRA, and there is no annual fee. I can set up a Self-Employed 401(k) for you, too.

What if you have both W-2 and Self-Employment Income? In this case, you can maximize your 401(k) at your W-2 job and then contribute to a SEP for your self-employment. Contact me for details.

Health Savings Accounts. HSAs are the only account where you get both an upfront tax-deduction and the money grows tax-free for qualified expenses. And there’s no income limit on an HSA. As long as you are participating in an HSA-compatible high deductible plan, you are eligible. If you are in the plan for all 12 months, you can contribute $3,600 (individual) or $7,200 (family) to an HSA this year.

529 Plans. You want to grow investments tax-free with no income limits and very high contribution limits? Well, that sounds like a 529 College Savings Plan. If your kids, grand-kids, or even great-grand-kids will go to college, you could be growing that money tax-free. They don’t even have to be born yet, you can change the beneficiary later. We can use 529 plans like an inter-generational educational trust that also grows tax-free. And 529s will pass outside of your Estate, if you are also following the current proposals to cut the Estate Tax Exemption from $11.7 million to $5 million.

ETFs in a Taxable Account. Exchange Traded Funds (ETFs) are very tax-efficient. Hold for over a year and you could qualify for long-term capital gains treatment. Today, long-term capital gains taxes are 15%, whereas your traditional IRA or 401(k) money will be taxed as ordinary income when withdrawn, which is 22% to 37% for most of my clients. Some clients will drop to the 12% tax bracket in retirement, which means their long-term capital gains rate will be 0%. A married couple can have taxable income of up to $81,050 and pay zero long-term capital gains! (Taxable income is after deductions. If a couple is taking the standard deduction of $25,100, that means they could have gross income of up to $106,150 and be paying zero capital gains.)

Tax-Deferred Annuity. Instead of holding bonds in a taxable account and paying taxes annually, consider a Fixed Annuity. Today, I saw the rates on 5-year annuities are back to 3%. An annuity will defer the payment of interest until withdrawn. There are no RMDs on Annuities, so you could defer these gains for a long-time, potentially. And if you are in a high tax bracket now, you could hold off on taking your interest until you are in a lower bracket in retirement.

Save on Taxes

If Congress does away with the Backdoor Roth, we will let you know. There are a lot of moving parts in this 2,400 page bill and some will change. Whatever happens, my job will remain to help investors achieve their goals. We invest for growth, but we know that it is the after-tax returns that matter most. So, my job remains to help you find the most efficient and effective methods to keep more of your investment return.

7 Missed IRA Opportunities

Individual Retirement Account (IRA) is the cornerstone of retirement planning, yet so many people miss opportunities to fund an IRA because they don’t realize they are eligible. With the great tax benefits of IRAs, you might want to consider funding yours every year that you can. Here are seven situations where many people don’t realize they could fund an IRA.

1. Spousal IRA. Even if a spouse does not have any earned income, they are eligible to make a Traditional or Roth IRA contribution based on the household income. Generally, if one spouse is eligible for a Roth IRA, so is the non-working spouse. In some cases, the non-working spouse may be eligible for a Traditional IRA contribution even when their spouse is ineligible because they are covered by an employer plan and their income is too high.  

2. No employer sponsored retirement plan. If you are single and your employer does not offer a retirement plan (or if you are married and neither of you are covered by an employer plan), then there are NO income limits on a Traditional IRA. You are always eligible for the full contribution, regardless of your household income. Note that this eligibility is determined by your employer offering you a plan and your being eligible, and not your participation. If the plan is offered, but you choose not to participate, then you are considered covered by an employer plan, which is number 2:

3. Covered by a employer plan. Here’s where things get tricky. Anyone can make a Traditional IRA contribution regardless of your income, but there are rules about who can deduct their contribution. A tax-deductible contribution to your Traditional IRA is greatly preferred over a non-deductible contribution. If you cannot do the deductible contribution, but you can do a Roth IRA (number 4), never do a non-deductible contribution. Always choose the Roth over non-deductible. The limits listed below do not mean you cannot do a Traditional IRA, only that you cannot deduct the contributions.

If you are covered by your employer plan, including a 401(k), 403(b), SIMPLE IRA, pension, etc., you are still be eligible for a Traditional IRA if your Modified Adjusted Gross Income (MAGI) is below these levels for 2018:

  • Single: $63,000
  • Married filing jointly: $101,000 if you are covered by an employer plan
  • Married filing jointly: $189,000 if your spouse is covered at work but you are not (this second one is missed very frequently!)

Your Modified Adjusted Gross Income cannot be precisely determined until you are doing your taxes. Sometimes, there are taxpayers who assume they are not eligible based on their gross income, but would be eligible if they look at their MAGI.

4. Roth IRA. The Roth IRA has different income limits than the Traditional IRA, and these limits apply regardless of whether you are covered by an employer retirement plan or not. (2018 figures) 

  • Single: $120,000
  • Married filing jointly: $189,000

5. Back-door Roth IRA. If you make too much to contribute to a Roth IRA, and you do not have any Traditional IRAs, you might be able to do a “Back-Door Roth IRA”, which is a two step process of funding a non-deductible Traditional IRA and then doing a Roth Conversion. We’ve written about the Back Door Roth several times, including here.

6. Self-Employed. If you have any self-employment income, or receive a 1099 as an independent contractor, you may be eligible for a SEP-IRA on that income. This is on top of any 401(k) or other IRAs that you fund. It is possible for example, that you could put $18,500 into a 401(k) for Job A, But this is more like a series of popular online friv games than what is described above. contribute $5,500 into a Roth IRA, and still contribute to a SEP-IRA for self-employed Job B.

There are no income limits to a SEP contribution, but it is difficult to know how much you can contribute until you do your tax return. The basic formula is that you can contribute 20% of your net income, after you subtract your business expenses and one-half of the self-employment tax. The maximum contribution to a SEP is $55,000, and with such high limits, the SEP is essential for anyone who is looking to save more than the $5,500 limit to a Traditional or Roth IRA. 
Learn more about the SEP-IRA.

7. Tax Extension. For the Traditional and Roth IRA, you have to make your contribution by April 15 of the following year. If you do a tax extension, that’s fine, but the contributions are still due by April 15. However, the SEP IRA is the only IRA where you can make a contribution all the way until October 15, when you file an extension. 

Bonus #8: If you are over age 70 1/2, you generally cannot make Traditional IRA contributions any longer. However, if you continue to have earned income, you may still fund a Roth IRA after this age.

A few notes: For 2018, contribution limits for Roth and Traditional are $5,500 or $6,500 if over age 50. For 2019, this has been increased to $6,000 and $7,000. You become eligible for the catch-up contribution in the year you turn 50, so even if your birthday is December 31, you are considered 50 for the whole year. Most of these income limits have a phase-out, and I’ve listed the lowest level, so if your income is slightly above the limit, you may be eligible for a reduced contribution. 

Retirement Planning is our focus, so we welcome your IRA questions! We want to make sure you don’t miss an opportunity to fund an IRA each and every year that you are eligible. 

What Are Quarterly Tax Payments?

The IRS requires that tax payers make timely tax payments, which for many self-employed people means having to make quarterly estimated tax payments throughout the year. Otherwise, you could be subject to penalties for the underpayment of taxes, even if you pay the whole sum in April. The rules for underpayment apply to all taxpayers, but if you are a W-2 employee, you could just adjust your payroll withholding and not need to make quarterly payments.

If your tax liability is more than $1,000 for the year, the IRS will consider you to have underpaid if the taxes withheld during the year are less than the smaller of:

1. 90% of your total taxes dues (including self-employment taxes, capital gains, etc.)
2. 100% of the previous year’s taxes paid.

However, for high income earners – those making over $150,000 (or $75,000 if married filing separately) – the threshold for #2 is 110% of the previous year’s taxes. Additionally, the IRS considers this on a quarterly basis: 22.5% per quarter for #1, and 25% per quarter for #2, or 27.5% if your income exceeds $150,000.

Many taxpayers will find it sufficient to make four equal payments throughout the year. If that’s the case, your deadlines are generally April 15, June 15, September 15, and January 15. However, if your income varies substantially from quarter to quarter, or if your actual income ends up being lower than the previous year, you may want to adjust your quarterly estimated payments to reflect these changes.

You can estimate your quarterly tax payments using IRS form 1040-ES. Of course, your CPA or tax software should automatically be letting you know if you need to make estimated tax payments for the following year. You can mail in a check each quarter, or you may find it more convenient to make the payment electronically, via IRS.gov/payments.  For full information on quarterly estimated payments, see IRS Publication 505 Tax Withholding and Estimated Tax.

Please note that the estimated payments will fulfill the requirement of 100% of last years payment, or 90% of this year’s payment if that figure is lower. However, it is not required that you pay 100% of the current tax bill, so if your income is significantly higher this year, you could still owe a lot of taxes in April even after making quarterly estimated payments.

If you’re self-employed, you don’t need to be a tax expert, but you do need to understand some basics and to make sure you are getting correct advice. When you aren’t being paid as a W-2 employee, it is up to you to make sure you are setting money aside and making those tax payments throughout the year, so that next April you aren’t facing penalties on top of having a large, unexpected tax bill.

FAQs: New 20% Pass Through Tax Deduction

You’ve probably heard about the new 20% tax deduction for “Pass Through” entities under the  Tax Cuts and Jobs Act (TCJA), and have wondered if you qualify. For those who are self-employed, here are the five FAQs:

1. Do I have to form a corporation in order to qualify for this benefit?
No. The good news is that you simply need to have Schedule C income, whether you are a sole proprietor (including 1099 independent contractor for someone else), or an LLC, Partnership, or S-Corporation.

2. How does it work?
If you report on Schedule C, your Qualified Business Income (QBI) may be eligible for this deduction of 20%, meaning that only 80% of your net income will be taxable. Only business income – and not investment income – will qualify for the deduction. Although we call this a deduction, please note that you do not have to “itemize”, the QBI deduction is a new type of below the line deduction to your taxable income. The deduction starts in the 2018 tax year; 2017 is under the old rules.

There are some restrictions on the deduction. For example, your deduction is limited to 20% of QBI or 20% of your household’s taxable ordinary income (i.e. after standard/itemized deductions and excluding capital gains), whichever is less. If 100% of your taxable income was considered QBI, your deduction might be for less than 20% of QBI. If you are owner of a S-corp, you will be expected to pay yourself an appropriate salary, and that income will not be eligible for the QBI. If you have guaranteed draws as an LLC, that income would also be excluded from the QBI deduction.

3. What is the Service business restriction?
In order to prevent a lot of doctors, lawyers, and other high earners from quitting as employees and coming back as contractors to claim the deduction, Congress excluded from this deduction “specified service businesses”, including those in health, law, accounting, performing arts, financial services, athletics, consulting, or any business which relies primarily on the “reputation or skill of 1 or more employees”. Vague enough for you? High earning self-employed people in one of these “specified service businesses” are not eligible for the 20% deduction.

4. Who is considered a high earner under the Specified Service restrictions?
If you are in a Specified Service business and your taxable income is below $157,500 single or $315,000 married, you are eligible for the full 20% deduction. The QBI deduction will then phaseout for income above this level over the next $50,000 single or $100,000 married. Professionals in a Specified Service making above $207,500 single or $415,000 married are excluded completely from the 20% QBI deduction.

5. Should I try to change my W-2 job into a 1099 job?
First of all, that may be impossible. Each employer is charged with correctly determining your status as an employee or independent contractor. These are not simply interchangeable categories. The IRS has a list of characteristics for being an employee versus an independent contractor. Primarily, if a company is able to dictate how you do your work, then you are an employee. It would not be appropriate for an employer to list one person as a W-2 and someone else doing the same work as a 1099.

Additionally, as a W-2 employee, you have many benefits. Your employer pays half of your Social Security and Medicare payroll tax (half is 7.65%). As an employee you may be eligible for benefits including health insurance, vacation, unemployment benefits, workers comp for injuries, and the right to unionize. You would have a lot to lose by not being an employee.

Even still, I expect we are going to see a lot of creative accounting in the years ahead for people trying to reclassify their employment from W-2 to pass-through status. Additionally, businesses which are going to be under the dreaded “specified services” list will be looking for ways to change their industry classification. We will continue to study this area looking for ways for our clients to take advantage of every benefit you can legally obtain.

This information is for educational purposes only and is not to be construed as individual financial advice. Contact your CPA or tax consultant for details on how the new law will impact your specific situation.

Self-Employed? Buy an SUV

In the new Tax Cuts and Jobs Act (TCJA), there are quite a few provisions which will help small business owners, whether you are an Independent Contractor (1099), a self-employed Sole Proprietor, or owner of an LLC or Corporation. One of the key provisions is the expansion of Section 179, which enables owners to expense certain items (take an immediate tax deduction) instead of depreciating those purchases over a longer number of years.

Section 179 has existed for many years, but Congress has continually changed the rules, setting caps on how much you can deduct. At the start of 2017, you could only take bonus depreciation of up to 50%. Under the TCJA, for 2018, bonus depreciation is increased to 100%, the cap increased from $520,000 to $1 million, and now you can also purchase used equipment and receive bonus depreciation.

As a business owner, Section 179 can help you deduct:

  • Equipment for the business
  • Office furniture and office equipment
  • Computers and off the shelf software
  • Business vehicles with a Gross Vehicle Weight Rating (GVWR) of over 6000 pounds

You cannot use Section 179 to deduct the costs of real estate (land, buildings, or improvements), for passenger cars or vehicles under 6000 GVWR, or for property used outside of the United States.

One of the most attractive benefits of Section 179 is the ability to deduct a vehicle for your business. Under Section 179, your first year deduction on a 6000 GVWR vehicle is limited to $25,000. You would first deduct this amount. Second, you are eligible for Bonus Depreciation, which used to be 50%, but now is 100%. That means that a business owner can effectively deduct 100% of any qualifying vehicle in 2018, even if it is a $95,000 Range Rover.

To be deductible, you must use the vehicle for business at least 51% of the time. If you also use the vehicle for personal use, you may only deduct the portion of your expenses attributable to the percentage of business miles. The way to maximize your Section 179 deduction, is to use the vehicle 100% of the time for your business. If the IRS sees you claim 100% business miles on your tax return, you had better have another vehicle for personal use. You might use your spouse’s vehicle, or perhaps keep your old vehicle, for personal miles. Don’t forget that commuting between home and the office are considered personal miles, not business miles.

The 6000 pound GVWR doesn’t mean that the vehicle literally weighs over 6000 pounds, but has a total load rating (vehicle, passengers, cargo) over this weight. If a manufacturer lists the weight of the vehicle, that is not the GVWR; the GVWR is often 1500 or more pounds higher than the vehicle weight. Make sure you are looking specifically at the official GVWR. You can generally find the GVWR printed on a sticker in the driver’s door frame to confirm.

The list of qualifying vehicles varies from year to year and from model to model, but includes most full-size trucks and SUVs. Be careful – sometimes a 4WD model is over 6000, but the 2WD version is not. On one SUV, a model with 3rd row seating was over 6000, but without the extra seats, it was under 6000. An another SUV, 2016 models were over 6000 GVWR, but the new and lighter 2017 model was not.

There are many lists on the internet of which vehicles qualify; in addition to full-size pick-up trucks and vans, most large SUVs such as a Tahoe, Suburban, Expedition, or Escalade are also above 6000 GVWR. Several mini-vans qualify (Honda Odyssey, Dodge Grand Caravan), as do some more medium size SUVs (Jeep Grand Cherokee, Toyota 4Runner, Audi Q7, BMW X5, Ford Explorer). Again, be absolutely certain your vehicle will qualify before making a purchase. One of the nice things about the new law is that now you do not need to buy a new vehicle to qualify for bonus depreciation; used vehicles are also eligible.

Please check with your tax preparer. You cannot deduct more than you earned, so don’t buy a $50,000 SUV if you only show $30,000 in net profits. Lastly, consider these caveats:

  • You have a choice between taking the “standard mileage rate” of 54.5 cent/mile for 2018, or using the “actual cost” method. When you take the standard rate, that already includes depreciation. If you use Section 179 to purchase a vehicle, you are going to be locked in to using “actual costs” for the life of that vehicle. You cannot take the Section 179 deduction upfront and later switch the standard mileage rate.
  • If you are using “actual costs”, you can also deduct your other operating expenses such as gasoline, oil changes, maintenance, insurance, tolls, and parking, but will need to document your costs. Keep those receipts!
  • You may still be required to keep a mileage log to prove you are using the vehicle for more than 50% business miles. If business use falls below 50%, you may be required to pay back some of the depreciation. Let’s just say that would be expensive and a headache.
  • If you depreciate 100% of the cost of the vehicle upfront, that will reduce your cost basis to zero. When you sell the vehicle, you may be creating a taxable gain.

Under the TCJA, these expansions to Section 179 are temporary through 2022; bonus depreciation will be phased back down from 100% to 0%. So if you want to buy an SUV or truck, you have a five-year window to take advantage of this full depreciation.

This tax deduction is especially effective if you have a banner year of high income and anticipate being in a very high tax bracket, because it will let you accelerate future depreciation on a vehicle into the current year, provided the vehicle is purchased and placed into service that year. Please remember that this section 179 deduction is available only to the self-employed and not to W-2 employees.

I feel I should point out that driving a large SUV or truck may not be the most cost effective decision. I am not suggesting everyone rush out and buy a Suburban just to get a tax deduction. But if you do need a vehicle for your business, or were thinking about buying a vehicle this year, it can certainly help to know about this tax deduction. And it might influence which vehicle you choose to buy!

Self Employed? Discover the SEP-IRA.

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The SEP-IRA is a terrific accumulation tool for workers who are self-employed, have a family business, or who have earnings as a 1099 Independent Contractor. SEP stands for Simplified Employee Pension, but the account functions similar to a Traditional IRA. Money is contributed on a pre-tax basis, and then withdrawals in retirement are taxable. Distributions taken before age 59 1/2 may be subject to a 10% penalty.