Front Street Wealth Management

Fee Only, Proactive Wealth Managment

What’s a Backdoor Roth?

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Q: A co-worker recently mentioned that she did a “Backdoor Roth” last year. I’ve been told that I’m not allowed to make any Roth IRA contributions because my income is too high. But, we likely earn a similar amount. Maybe I’ve been missing something. What is a “Backdoor Roth” and how does it work?

A: Your colleague may have clued you in on a little-known trick. However, it takes some careful planning. If you fully understand the rules and nuances, it might just be worth doing.

Let’s start with the income limits for making a Roth contribution. If you are single and your income in 2023 is greater than $153,000, you are not allowed to make a Roth contribution. The income limit in 2023 for those married filing jointly is $228,000.

Now, even if you happen to earn above those income limits, you are always allowed to make a “non-deductible” IRA contribution. Most people discover “non-deductible” IRA contributions totally by accident. This typically happens when you participate in your work-based retirement plan and end up making too much money to qualify for a tax deduction on your IRA contribution. Your IRA contribution then gets classified as “non-deductible.”

So, why would anyone make a non-deductible IRA contribution on purpose? Because you plan to immediately “convert” your non-deductible IRA contribution into a Roth IRA with no tax owed. And, if done right, you’ll have gone from not being allowed to make a Roth contribution to getting money into a Roth IRA “through the backdoor.”

But, there’s a small catch. This move only results in zero tax, if and only if you didn’t already have any pre-tax IRA balances in your life. If you do have pre-tax IRA accounts, then part of your subsequent Roth conversion will be taxed. In fact, the more existing, pre-tax IRA money you have will result in a greater proportion of your Roth conversion being taxed. Of course, voluntarily making a non-deductible IRA contribution and then getting taxed on a Roth conversion is not a good plan!

To fix this problem, however, there’s a perfectly legal “trick” you might consider. If you happen to be enrolled in a work-based retirement plan, you might be able to empty out your IRA balance by first doing a rollover into your retirement plan.

After the rollover is done, you’ll no longer have any existing, pre-tax IRA money mucking things up and none of your follow-on Roth conversion will be taxed. Following your rollover and after your subsequent non-deductible IRA contribution, the only dollars sitting in your regular IRA are considered to be after-tax money. With no tax deduction ever taken on that fresh IRA balance, no tax will be owed on your Roth conversion!

Jason P. Tank, CFA, CFP® is both the owner of Front Street Wealth Management, a purely fee-only advisory firm and the founder of the Money Series, a non-profit program committed to providing open-access to financial education, for all. Contact him at (231) 947-3775, by email at [email protected] and at www.FrontStreet.com

Series I Bonds and Debt Ceiling

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A year ago, I wrote about a rare, shining moment for Series-I savings bonds. It’s time for a quick update to help you decide to either hold them or cash them in.

Last May, new Series-I savings bonds investors were offered a guaranteed rate of almost 10%. The catch was, that amazing teaser rate was for just the first six months. After that short period, subsequent declared rates were at the mercy of inflation. Last November, the new rate came in at about 6.5%. In combination, as planned, the full first year return worked out to a healthy 8% or so.

The burning question is, what should you do now?

As widely predicted, the inflation fever has broken. Since Series-I bonds are explicitly tied to inflation, so too is their interest rate. The just-announced next six month window for Series-I bonds promises an annualized rate of only about 3.5%. That now sits below rates offered in safe money market funds at most brokerage firms.

It’s probably time to remind yourself of your TreasuryDirect login credentials and plot your next move for your excess cash savings. The US Treasury’s website is pretty awful to navigate, as you might remember!

Speaking of the US Treasury, a small group of politicians is playing a very expensive and serious game of chicken. By not automatically raising the debt ceiling, they are purposely calling into question our federal government’s willingness to pay its bills. One might see it as just political gamesmanship, but economically speaking it’s far more than that. It has real financial ramifications that could be long lasting.

To begin, we all know the government will ultimately pay its bills. The only question is, when and how will those bills be financed? If, through their political stunt, the US Treasury goes into technical default on its debt, forevermore investors across the globe will wisely demand just a bit higher interest rate when lending to our federal government in the future. After all, if you lend money and don’t get paid back on time, even just once, you don’t easily forget it.

Let’s do some math. On about $30 trillion of federal debt outstanding, how much more would it cost the American people if we had to pay a measly 0.1% more per year on our debt over the next 20 years? This works out to at least $600 billion of wasted interest expense. With that potential price tag, these politicians are clearly playing a very irresponsible game. How about using the official budget process to steer our nation’s spending priorities?

Death and Tax Changes

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They say the only certainties in life are death and taxes. Well, that’s almost true, with one small caveat. The only true certainties are death and tax changes. Case in point: Michigan’s new tax law for retirees that’s poised to phase-in over the next four years!

For retirees, this article might bring up ugly memories of 2012 when then-Governor Snyder controversially changed how retirees were taxed. Over the last 11 tax seasons, his complex system resulted in higher taxes for a growing legion of retirees. But, starting in 2023, a new, complex system is in place. This one, however, will result in lower taxes for retirees.

To set the table on the new law, for those born on or before 1945, there are no changes. Think of this group of retirees as the “finish line” that everyone else is now marching toward. This older cohort gets to deduct their pension benefits and retirement account distributions up to about $60,000 (single) and about $120,000 (married.) These deduction limits also grow with inflation each year.

For the rest, you are going to transition into the new tax law. Over the next four tax years, your deduction amount will march in 25% steps toward the big “finish line” deductions above. This means by 2026 all retirees will essentially be taxed the same. Then, and only then, will things be simple. But, until 2026, not so much!

The new law’s complexity starts in 2023. For those born between 1946 and 1958, this year you’ll get a choice of using either the old law’s deduction limits of up to $20,000 (single) and up to $40,000 (couple) or taking 25% of the “finish line” deduction. Naturally, for 2023, this 25% multiplier adds a wrinkle for a subset of retirees in this age cohort.

For those born between 1946 and 1952, your choice for 2023 will be to use the old law. For those born in 1953, 1954, 1955 and 1956, some math is needed to determine if the old law or new law is better for you in 2023. And, for those born in 1957 or 1958, no math is needed as getting some deduction under the new law is clearly better than getting no deduction under the old law.

For everyone else, you’ll have to wait beyond 2023 for your tax relief.

For those born in 1959, 1960, 1961 and 1962, mark your calendar for tax relief starting in 2024. For those born in 1963, 1964, 1965 and 1966, mark your calendar for 2025. And, for those born in 1967 or later, your tax relief starts in 2026.

Now, let’s place a small wager. How much do you want to bet that this new law is already on the chopping block?

For Real or a False Dawn?

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For those who tend to bury their head in the sand when markets get ugly, you might be surprised by what’s happened over the past six months.

Back in early October, the stock market rout seemed to be picking up steam. Inflation worries were raging and the Fed was talking tough about more interest rate hikes to come. As a result, many saw a recession just around the corner. And, then, as if a switch was flipped, stocks bounced and bonds popped.

At its lowest point last fall, the stock market was down about 25%. After the recent rebound, stocks are now only 10% off their highs. Similarly, back in October, bonds had dropped an unheard of 15%. Despite their recent recovery, bonds are down a still-dismal 8% from their highs. But, it’s been a really good run for bonds lately. Overall, you could say that roughly half of last year’s pain has been recouped, but, not at all, forgotten.

So, what has spurred the market’s recovery? As always, the answer is complicated, counterintuitive and possibly questionable.

The consensus expectation of a coming recession seems to have caught the attention of the Fed. Inflation is showing clear signs of declining, albeit very slowly. This trend has given the Fed some justification to turn more of their attention to the health of the economy and signal a “pause” in future interest rate hikes. Like everyone else, they want to see how the economy is faring.

Once the Fed started to speak in calmer tones, things shifted. The market adopted the mindset of “some bad news might actually be good news.” With each economic headline pointing to a slowdown, not only are future rate hikes taken off the table, the possibility for rate cuts goes up. That alone boosted both stocks and bonds. And, now, with the recent mini-banking crisis throwing a wrench into the system, the probability of future interest rate cuts is now the base case.

This can be seen in the shape of the yield curve. Longer-term interest rates are far below short-term rates. Today, you can safely earn around 4.5% just sitting in a money market fund. But, if you choose to lend to the government for 2 years, you’ll only earn about 3.8%. The yield is even lower still on the 10-year Treasury. That shows how confident investors are of future rate cuts. This phenomenon is known as an inverted yield curve and it’s historically been a bad sign. It has a perfect record as a recession indicator.

If the economy does go into a recession, the question is how deep will it be and how long will it last. There is little way to know for sure. On balance, and especially given how quickly the mood can shift, I’d say being a bit cautious with your portfolio is probably prudent.

Tax Tip: Property Tax Credit

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Q: I read your column from Sunday, February 26th and you got one thing wrong. Lower income taxpayers should provide their tax preparers with the amount of property tax levied as well as the taxable value of their home. This information is needed to apply for the Homestead Property Tax Credit on Form 1040-CR. In addition, lower income renters can benefit from this property tax credit, too!

A: Actually, I got two things wrong in that column! I incorrectly stated that the 2022 standard deduction for those married filing jointly was $27,700. That’s for 2023, not 2022. The standard deduction for married filers in 2022 is only $25,900.

With my conscience now clear, let’s go through the details of the Michigan Homestead Property Tax Credit. First, I’ll address homeowners and then move on to renters.

For homeowners: If your income falls below $63,000 and the taxable value of your homestead is less than $143,000, you qualify for a potential tax credit. Note, the taxable value of your home is not what your home is worth today. Your taxable value is what’s shown on your property tax statements. You can also look it up online.

The Homestead Property Tax Credit generally works like this. Let’s say your income was $50,000 and you paid $3,000 in property taxes. First, multiply $50,000 times 3.2%. This sets a threshold of $1,600. In this case, your $3,000 in property taxes exceeds this $1,600 threshold by $1,400. To figure your tax credit, you multiply $1,400 by 60%. Your property tax credit amounts to $840. Better yet, even if you happened to pay zero state income tax, the State of Michigan will still send you a tax refund check for the $840!

For renters: The same income test above applies for renters, too. But, since you don’t own a home, you instead use your annual rent expense to figure your tax credit. Multiply your annual rent expense by 23% and then compare it to your 3.2% of income threshold. Just like a homeowner, you are entitled to receive 60% of the difference as a tax credit.

Keep in mind, the maximum Homestead Property Tax Credit you can get is $1,600. And, one final tip, if you overlooked the Homestead Property Tax Credit in the past, the State of Michigan allows for you to go back a whopping four tax years to get your tax credit. Go take a look in your tax files. It might amount to some real money!