Tax Alpha with Raul Shah: (mega) backdoor Roth

0:09Raul Shah:Welcome back to another episode of Tax Alpha with Raul Shah, founder of Dockshaw Financial, a value investing firm that is focused on helping everyday investors and retirees maximize their portfolio growth while protecting their wealth from heavy taxation through advanced tax planning. It's been around since 2023 and has since generated nearly 39 % annualized equity return for its clients at 38.9. In addition to his work in the markets, Rutwell is also an educator at Johns Hopkins University, where he teaches a tax planning course for that community. Rutwell, welcome back to the show. It's great to have you on Investing Experts and Seeking Alpha.

0:53Raina, thanks so much for having me back. This is now our third episode. Can you believe that? I feel like time's flying. And the reception to the podcast has been unbelievable. You know, people are hungry for real financial knowledge, practical financial and tax planning tips. And I'm so ready to deliver and keep delivering and help this Seeking Alpha community. That's been wonderful to me, by the way. I mean, you know, I've been a contributor since 2018. And every time we do these podcasts, I get a swarm of emails, people saying, oh, I never thought about that. Just reaching out to say hi. I've even had clients come from the podcast.

1:25So it's been a wonderful matrimony and this is the sharpest investing audience out there. You can't fool them. So I'm excited to get in to today's topic.

1:33Raul Shah:Our community of investors and thoughtful responses and thoughtful questions, I think is one of our best qualities at Seeking Alpha, if not our best quality. So appreciate you being part of that community. Appreciate all the people that have written in for a refresher. We have had already a conversation about asset location and Roth conversions. And now for our third episode, Rhett, I will let you introduce and get right into it. All right. We have got the backdoor Roth and the mega backdoor Roth today. These are two of the most powerful tax planning strategies for high earners. And I put high earners in quotes because these strategies apply to a lot of people who are around the 24 % tax bracket.

2:23And I'll get into the numbers in just a second. So this is a strategy to actually bypass the Roth IRA limits or the Roth IRA income limits that the IRS has imposed. And so it's a wonderful strategy to be able to diversify your tax base and be able to contribute funds to a Roth IRA when normally your income would prohibit you from doing so. I use this strategy with clients all the time. Again, we're going to cover the backdoor and the mega backdoor Roth. But first, I do want to get into something that I think is crucial to understanding how these tax planning strategies work. So the first thing is we have to understand the three different types of account buckets, shall we say.

3:09And each of these buckets is taxed differently. So bucket number one is what we call your tax deferred bucket. So those are things like your traditional IRA, your 401k, your 403b, 457 TSP plan. The tax deferred accounts are very unique. You put money into those accounts and you You get a tax deduction today, and then you ultimately pay tax when you pull that money out in retirement at your ordinary income rate. So that's bucket one. Now, bucket two, we have the brokerage account or the taxable account. Now, the brokerage account is sort of a pay-tax-as-you-go account. So every year that you realize capital gains, short-term or long-term, interest, qualified or non-qualified dividends or interest, you're going to pay tax in that year.

4:02And if you've held an asset for longer than a year, you get long-term capital gains tax treatment, which is very favorable. And then on the third bucket, we've got your tax-free accounts. So like your Roth IRA account, your HSA, your Roth 403B, your Roth 401k, all of these accounts, You pay tax when you put money into the account, but you don't pay any tax on any of the gains or anything that goes on in that account. Every dollar you pull out is going to be tax-free as long as you follow a couple IRS rules, which is you're over 59 and a half, and you've had the account open and funded for longer than five years.

4:38So those are the three buckets. And when you go into retirement, and this applies to everybody, whether you're listening and you're 20, 30, 40, 50, 60, it doesn't matter. Ultimately, at some point, you're going to become retired. And you don't want to only have all of your money in your pre-tax bucket, which is what most people listening probably have. It's what most people in general have. People, they max out their 401ks or their 403bs, and that's kind of it. They call it a day. Now, the problem with that is that you're putting all of your tax eggs in one basket, is what we say, because you are betting that your tax rate in retirement is going to be lower than your tax rate today, right?

5:17That's why it's advantageous. You're putting money in the 403B, you're deferring tax, let's say, at the 32 % bracket if you're a high earner. And then when you're in retirement, if you're in the 24 % bracket, well, now you've arbitraged 8 % or saved 8 % on every dollar now that you pull out. But the problem with this is that you don't know, right? Nobody knows what future tax rates are going to be. They could be higher in the future. They could be lower in the future. We just don't know. And so in order to hedge ourselves against that risk, it's really beneficial to have all of your accounts funded to some degree.

5:51And so high earners who typically can't get to the Roth because of their income, they're going to be to get to this with that strategy. Let's talk about the backdoor Roth. Essentially, what we're going to do is make a non-deductible contribution or an after-tax contribution to our traditional IRA account. When we do so, what we can then do is actually convert it or transfer it to the Roth IRA. That's the backdoor Roth in a nutshell. If you can't contribute directly to the Roth, you can use the backdoor if your income is too high. So we talked about those income limits. What's the actual specific number?

6:30Well, in 2026, if you are single at$153 ,000 of your modified adjusted gross income, you start to get phased out of making Roth IRA contributions. And if you're listing and you're married filing jointly, it's$242 ,000, I believe, is when you start getting phased out. The numbers change every year. That's not that important. The concept, though is very important. If you're making above that number, essentially what you want to do is make an after-tax contribution to that traditional 401k, move it to the Roth, and now you've put money on your Roth IRA. You can max it out like normal. So if you're under 50, you can put$7 ,500 in just like that.

7:10If you're over 50, it's 8 ,600 because you get that 1 ,100 catch-up contribution. And that's the backdoor Roth. Now we're going to talk about the nuances and traps with this in just a second, but that's the idea. Now, as for the mega backdoor Roth, take what I just told you, take out traditional IRA and substitute 403B or 401K. You're moving after tax money from a 401K to your Roth IRA. So it's just a discrepancy between where the funds are originating from. Now, why is it called mega? Well, in a 401K, you can pack in way more than$7 ,500, right? The limit as$72 ,000 in 2026. So you could put in$72 ,000 of after-tax contributions if you wanted to and move all of that to a Roth IRA.

7:57Plus, technically, you could also max out your traditional IRA with after-tax funds, move it to a Roth, and you could put in over 80K in after-tax money to your Roth. So that is the concept in a nutshell. What we're trying to do here is we're trying to bypass those IRS income limits that are preventing you from putting money into your Roth IRA by using the backdoor Roth and the mega backdoor Roth. And again, there's nuances to this, there's traps to this, but that's the general idea, if that makes sense.

8:25Raul Shah:Would you walk us through one of the most illustrative nuances that you could think of, or maybe a recent client that came in that you use this that might help show listeners, viewers, kind of when to put this into play and what maybe to think about twice? Yeah, fantastic question. So let's just walk through the whole process. Let's say that person ABC comes to Dock Shop Financial and they say, hey, I've got this money. This is my income. I can't contribute to a Roth. How do you do a backdoor Roth? Okay. The first nuance is you do not want to have any pre-tax money, meaning untaxed money in your traditional IRA, your simple IRA, or your set IRA.

9:05All of your IRA balances, your traditional pre-tax IRA balances, they have to be cleared of pre-tax funds. Why is this? Well, if it's not the case, you're going to trigger what's called the IRS pro-rata rule. So let's say that you go to put in$7 ,500 in after-tax money to your traditional IRA, but you've already got$7 ,500 of pre-tax money in that account. If you go and you try to do the actual backdoor Roth, which is move that$7 ,500 contribution to your Roth IRA, because that pool of money is split, half of it's untaxed, half of it's taxed, 50 % of your backdoor Roth, I'm putting my quotes up here, is now going to be taxable.

9:50So you've defeated the purpose because not only did you pay tax to put money into that account, but now you're paying tax again on half of that contribution to move it to the Roth. So you don't want to trigger the pro rata rule. If you've got pre-tax funds in your IRA, you have to move them to your 401k, do the backdoor Roth, and then you can bring those pre-tax funds back in. But that leads me to the second nuance, which is you can't bring those pre-tax funds back in until the year is up. A lot of people, what they'll do is they will do a backdoor Roth at the start of the year, and then they bring in pre-tax funds into their account.

10:23Maybe it's a rollover IRA or they forget and they somehow put pre-tax money into their accounts. well then that's going to trigger the pro rata rule retroactively so you have to be very careful with the timing of when you actually you know facilitate these backdoor rots and the third trap that people fall into is that they'll put after-tax money in their traditional ira they'll invest it and then they won't convert it to the roth ira until later on and the portfolio might have gone up and now what you've done is you've introduced pre-tax gains that's going to throw off your backdoor Roth and it's going to make part of it taxable.

11:01So the cleanest setup to do this, all of your IRA balances, your traditional pre-tax IRA balances have to be zero, cleared out of any pre-tax funds. You make your after-tax contribution, you then transfer to the Roth, and then you have to file form 8606 with the IRS, or at least your accountant does, because that's the form that tells the IRS not to tax that conversion. Otherwise, you'll get double taxed on this. I had a client came in, they brought over a pretty great size portfolio. They have a lot of income and they didn't file form 8606. So the last year that they did their backdoor Roth, they got taxed twice on that money.

11:40So you can't ever forget that. So it's a very big nuance, but that's the way, that's the clean setup. Make sure there's no pre-tax funds in those IRAs, do the backdoor Roth, file form 8606. And that's in general how that's going to work.

11:53Raul Shah:I have a really maybe basic question that may be half lay up to you, half kind of impossible to truly answer because it's just kind of, you know, human nature. But you mentioned that notion of, you know, somebody not filing the right form and not having or not utilizing an accountant to do it for them. What would you say is helpful or instructive for people to be thinking about when taking on an accountant? Because I've heard that from a few people that the right form wasn't filed or they messed this up or this person, when they got to this accountant, realized that the last accountant did this for them.

12:34Raul Shah:And what would you say? I say half layup because I know this is literally your business. But also, what can people keep in mind when looking at accountants? Sure. I always say that the real fundamental difference between what a wealth management company like Doc Shaw Financial does versus what an accountant does. And by the way, you need both, in my opinion. But wealth management, good wealth management is proactive about your tax planning. So they're looking and projecting out all the taxes that they expect you to pay. And then they're working with you on trying to mitigate that number and not make unsensible mistakes.

13:11Tax filing, which is what accountants do, is always retroactively, The accountants are taking what you're giving them and then they are filing your taxes. They are not sitting down with you to proactively figure out tax strategies to help you pay tax over your lifetime. That's not their job. It's not a fault of the account. It's not what they do. They file the taxes, but they don't sit down and work with you on tax planning like a wealth manager does. So in general, if you're doing advanced tax planning strategies, like what we do with clients, whether it's Roth conversions or asset location or backdoor Roths, you want a good accountant.

13:47You want an accountant that's at least familiar with that. And so you just email, you ask the accountant questions. You say, hey, you know, these are some of the things that I'm thinking about doing. Are you familiar with these strategies and at least how to follow them correctly? And for clients, what I do is every March, I actually send them an email. It's called their tax email. It has all the tax planning moves that have been done in their account. It has all of the forms. So if they need 8606 or the 1099s, the 1099Rs, everything is packaged in that one email. They just send it to their accountant so their accountant knows exactly what to do.

14:20And in some cases, I'll even collaborate with the accountant on behalf of the client. So there's ways to get it done correctly. But it's really just communicating and making sure that you and the accountant are on the same page. People who are, let's say, earlier on in their career that are still building their wealth, they still have tremendous opportunity to do tax planning. In fact, the younger you are, it's not really necessarily about how much money you have. It's about your age. The younger you are, the more effective tax planning is. I always tell people retirement planning starts when you're 25, the day you take your first job after grad school or internship or whatever.

14:58And the longer that you have, the better off that you will be. And so it's always great to work with an accountant where you are comfortable bringing those strategies to them and you know that they're going to execute the correct forms and do everything in an orderly fashion. Not everybody needs a wealth manager. It's sort of like personal training, right? And I know I just said in the background, right? You should have both a wealth manager and a tax filer. And that's true. But there are always going to be a subset of people that are very capable and they have the time to do things themselves.

15:31So it's always about priorities in terms of what you want your time to look like. But at the end of the day, you don't want to wait too long to do smart retirement strategies. You want to start when you're young because you're going to get so much more of a compounding benefit by doing so. To kind of give you sort of an example with numbers, let's say we take two people and let's just hypothetically say that their lifetime effective average tax rate is 24%. Now, let's say that one person starts tax planning at 55 and the other one starts at 25. If you were to drop their effective tax rate just 1 % to, what did I say, 24?

16:14Let's say you drop it to 23. The person who's 55 doesn't have that many years compared to the person of 25 of saving that 1%. So we always talk about what's the value of 1 % compounded over a long period of time. That's hundreds of thousands of dollars. It's a large amount of money. So the younger you start, the more time you have for tax planning compounding or alpha, should we say, to really benefit you. I do want to touch on the mega backdoor Roth because I talked about the traps with the backdoor Roth. There are a couple with the mega backdoor Roth that you really need to keep in mind. The first one is that a lot of people think that they are making Roth contributions, but they're making after-tax contributions.

16:58And that's a really big nuance because if you're making Roth contributions, you're putting in after-tax money, but those gains on those investments, assuming you follow the IRS rules on your age and the length of the accounting, those gains are going to be tax-free. But if you're putting in after-tax money, thinking that it's Roth money because they're both after-tax, the after-tax funds, all of the gains are pre-tax. And so people make this mistake all the time where they think they're putting in Roth contributions, but they're actually putting in just plain after-tax contributions, and they're going to wind up with a very hefty tax bill.

17:37Because if you pay ordinary income tax to put money in an after-tax 401k, and then you pay ordinary income tax on all of the gains, you're paying the highest tax rate you're ever going to pay twice on the same dollar. So you really don't want to do that. So that's a huge nuance that people kind of trip up when they're doing these mega backdoor watts from their 401k. The other big nuance is they will put money, they'll put after-tax money into their 401k and they'll invest it and they'll just forget to convert it. Like they just get kind of lazy and they don't convert it. It's the same problem as in the scenario I just explained.

18:14Those gains are tax-free. So, sorry, excuse me, those gains are pre-tax. So the longer that you keep those pre-tax funds earning interest, the higher your ultimate tax bill is going to be. So when you do these backdoor rots or the mega backdoor rots, you want to take those after-tax funds and quickly move them to the Roth accounts and then invest them so that you're not paying tax on all of those gains. And then, you know, with the mega backdoor Roth, there's no form 8606 needed. You really just get a 1099R about your custodian issues. So it's a little bit less paperwork for your account in that regard.

18:48Although the 8606 is not like, you know, it's not like rocket science. You know, any accountant should be able to figure that out. You know, at the end of the day, the backdoor Roth and the mega backdoor Roth are for those high earners. who are not able to directly contribute to their Roth accounts, but you need to have all three buckets of those taxations as you go into retirement. So you need money in pre-tax accounts, you need money in taxable accounts, and you need money in tax-free or post-tax accounts. That way it's a hedge because you don't know what future tax rates are going to be, but if you've got money in all three of those buckets, you can very strategically then choose which funds to pull from in retirement that will keep your tax rate low, as opposed to just putting all your eggs in one basket and hoping that a tax rate is XYZ in the future, which you can't predict.

19:34Raul Shah:Thank you, as always. We'll really appreciate you taking the time and talk to you next month. Absolutely. Thank you again, Raina. Just a reminder, anything you hear on this podcast should not be considered investment advice. This is for entertainment purposes only, and you should seek advice from a licensed professional before investing. If you enjoyed the episode, leave a rating or review on your favorite podcasting app, and we'll see you soon with a new episode.