234 | Tax-Loss Harvesting & Backdoor Roths with Hilary Hendershott

Hilary Hendershott: Welcome to another episode of your go-to financial wisdom podcast, Love, your Money, where we navigate the complexities of personal finance, breaking it down, and making it actionable for you. I’m your host, Hilary Hendershott, here to guide you to be successful with money. Today, we’re diving deep into two powerful tactics that savvy financial advisors and investors use to optimize their financial portfolios and minimize taxes, those being backdoor Roth IRAs and tax loss harvesting. For many, the world of IRAs and tax strategies sounds like a foreign language but it really is my mission to change that. You do have to get used to the alphabet soup of acronyms, but it’s okay. Whether you’re a high earner who’s been phased out of direct Roth IRA contributions or you’re looking for smart ways to reduce your taxable income through your investments, today’s episode is really tailored for you.

We’ll start by unlocking the mystery of backdoor Roth IRAs. This is a strategy that might sound like you’re sneaking through a hidden passage but it is perfectly legal and incredibly smart. Then we’ll shift gears to tax loss harvesting, a technique that can help you turn the lemons of investment losses into lemonade by saving on taxes. I really want you to have a clear understanding of how these strategies work, why they might be a fit for your financial plan, and how to start implementing them today. So, whether you’re listening on your morning commute during your workout or as you wind down for the evening, let’s get ready to make your financial future even brighter.

Before we begin, I do have a quick request for you. If you enjoy Love, your Money and are willing to help me get the word out to help and empower others just like you, would you kindly take just two minutes and leave me a five-star rating and review? I will be so grateful to hear from you what you love about the show and what requests you have that would make it even better. I look forward to hearing from you what your top-of-mind financial concerns are and I’ll be sure to weave them into future shows. Okay, let’s dive in.

[EPISODE]

Hilary Hendershott: So, imagine the Roth IRA is a locked treasure chest. Inside, you get tax-free growth and withdrawals but, uh-oh, there’s a catch. You earn too much money and the IRS says no key for you. But don’t worry. Where there’s a will, there’s a way, or in our case, a secret passage known as the backdoor Roth IRA. Let’s embark on this adventure together and unlock that treasure chest, shall we? First, what’s a Roth IRA? A Roth IRA is a type of retirement savings account that allows your money to grow tax-free with withdrawals in retirement also being tax-free provided certain conditions are met. You would pay tax on the contributions that you put into the account now in order to have the growth and distributions be tax-free in retirement.

But here’s the rub. If you’re making the big bucks, the IRS has that treasure chest that is the Roth IRA locked up tight. In 2024, if you’re a single filer earning more than $161,000 or married filing jointly earning over $240,000 of adjusted gross income, you’re locked out of that Roth IRA. Not fair you say? Oh, we agree. But fear not, we have found that secret passage, the backdoor Roth IRA. It’s not as cloak and dagger as it sounds. Here’s how it works. Okay. So, you contribute to a traditional non-deductible IRA. You use after-tax money, i.e., you’ve already paid tax on this money. You do not deduct it from your AGI in the year you put it into the non-deductible traditional IRA. There’s no income limit to do this. You can put in up to $7,000 in 2024 or $8,000 in 2024 if you’re aged 50 or older. And then you convert that nondeductible IRA to a Roth IRA and presto change-o, there are no income limitations on Roth conversions so this is totally allowable. You convert that nondeductible traditional IRA into a Roth IRA. Yes, you will pay taxes on any pre-tax contributions and earnings now, but remember, it’s all about the tax-free future.

Now, I really only recommend this strategy for investors who don’t have other IRA balances. So, if you have a rollover IRA, SEP, or simple IRA, please listen carefully. There’s a tax rule called the Pro-Rata Rule. You can google it if you want to. I’m not going to explain it today in detail, but suffice it to say, it decreases the benefit of a backdoor Roth rather significantly. If you have a balance in any other IRA where you received a tax deduction, what Congress does or the IRS does is they just start ratcheting down the tax benefit in that other account. It also makes your accounting or bookkeeping about the backdoor Roth basically a nightmare. You can do the backdoor Roth without fear if all you have are 401(k)s, 403(b)s, or like a TSP plan. Those are all okay because they’re not IRAs.

So, question: is the backdoor Roth legal? Yes, or I wouldn’t talk about it on the show. Definitely. It can sound like you’re pulling a fast one, especially with the name backdoor. The IRS is fully aware of this strategy and it really is perfectly legal. Remember, you do have to pay tax on those contributions in the year you make them and you lose the benefit or it gets, again, ratcheted down if you have any other deductible IRA balances at any custodian. So, why bother doing it? Well, basically, because your Roth balances will probably be a huge asset during your retirement. In a nutshell, traditional IRA balances benefit you in retirement if your tax rate in retirement is lower than it is today.

So, if you’re in your highest earning years, and probably therefore in the highest state and federal income tax brackets, then it’s likely that after you stop working, your taxable income will go down. Because you’re earning a ton now, you’re probably saving a big percentage of it, then after you retire, you won’t have to draw as much as you’re being paid now. You’re paying tax on all of your wages now, right? So, it seems likely that you might be in a lower tax bracket after retirement. However, if your income is middle of the road and Congress raises the income tax rates before you retire, then pulling from that Roth IRA will be a huge financial advantage. Most people don’t understand that part and they think that Roth IRAs are better in all situations. Even unfortunately, a lot of financial advisors I hear talking about it don’t understand the math of that but, hey, there it is.

Basically, if you retire at age 60 and live until 90, you really are likely to go through many different presidential elections, which lead to different tax regimes. So, having the flexibility of being able to pull from both Roth and traditional IRA accounts is a really good thing. Getting more into how Roths work, this backdoor strategy allows your investments to grow and be withdrawn tax-free in retirement. Plus, there are no required minimum distributions, which are called RMDs, which start at or near age 73, depending on when you were born unlike traditional IRAs. So, for traditional IRAs, at some point, Congress says, “Hey, we want our tax money.” So, you’ve been growing your IRA. It came maybe probably from a 401(k). You rolled it over into an IRA. And it’s grown and grown and grown, and Congress is saying, “Hey, we want our money,” so they force you to distribute. I have many clients who are taking those required distributions. We call this being in RMD. And unfortunately, they’ve saved too much. Sounds like a good problem to have. I agree.

We prefer this to the opposite but the IRS calculates your required minimum distribution based on your life expectancy. So, you don’t get to say, “No, no, leave my money in my IRA, please.” And that leaves some people taking out more money than they want to and paying income tax on all of that. Most folks who end up doing that just pay the tax and put the money back in their brokerage account but they’ve lost that tax money, which is a bummer. In the Roth IRA, your money can keep growing for you as long as you like, and of course, you can give it to your kids or heirs tax-free. The backdoor Roth IRA is kind of like finding a hidden key to the Roth treasure trove. It’s a clever workaround for higher earners to enjoy the Roth IRA’s benefits. Just remember, definitely consult with your financial guide, a.k.a., your financial planner or perhaps your tax professional to navigate this strategy safely and efficiently.

And for our next adventure, let’s dive into the tax-savvy world of tax loss harvesting. Could it be another treasure trove waiting to be discovered? Let’s find out together. Tax loss harvesting is an investment strategy where investors sell off assets that have decreased in value to realize a loss, which can then be used to offset capital gains taxes on other investments or even reduce taxable income. By strategically selling underperforming assets, investors can lower their tax liability without significantly altering their portfolio’s long-term investment strategy. In other words, tax loss harvesting can be a hands-down win, like if you’re in a position to do it, and you have losses that are out of threshold that make the trades viable, in other words, don’t do it for $5. But you definitely want to do this or you want your financial advisor doing this for you.

So, this technique requires careful timing and understanding of tax rules, including the IRS’s wash sale rule to ensure the losses are eligible for tax benefits. So, here’s the process step by step. First, identify investments that are currently in a loss position. This should be available to you in your holdings report, performance report, or anywhere in your online portal. You want the fair market value of the stock today or mutual fund today to be lower than the cost basis or purchase price. Second step, sell them at a loss. Wave goodbye and sell those assets to realize the loss. The losses will show up on your Form 1099, which is issued by the custodian at the beginning of the next year, and you will submit that form on your taxes to claim the deduction against gains on your tax return. $100 of loss nets out $100 of gains completely so that makes that a non-tax event.

Third, reinvest wisely. Here’s the key, reinvest the proceeds into similar but not identical, to avoid the wash sale rule, investments to maintain your portfolio’s balance and potential for growth. This part is really important. Why is that? Well, because the IRS says if you’re going to harvest the loss, you have to actually say goodbye to that investment for 30 days. I don’t recommend sitting out of the market in cash to wait 30 days, so you need to find an investment that fits into your overall allocation but doesn’t trigger the wash sale rule. Tax loss harvesting is like having a coupon for your taxes. By strategically realizing losses, you’re effectively lowering your taxable income or reducing the taxes owed on capital gains from other investments. It’s a proactive approach to make inevitable market downturns – they happen to all of us – to make those downturns work in your favor keeping your long-term financial goals on track and potentially speeding up your journey to wealth.

Okay. Here are a few things to keep in mind before you dive into tax loss harvesting. Just to reiterate, of course, the big hazard sign here says wash sale rule on it. Because if you incur the wash sale rule by buying an investment after you sell the investment that was in a loss position, if you buy something that the IRS says is too similar to what you owned before, they’ll actually negate your harvested losses. They don’t want you to sell an investment at a loss and buy the same or substantially identical investment within 30 days after the sale. So, definitely play by the rules and ensure your losses are eligible. Consider this a long-term strategy so you’re not going to hit a home run with tax loss harvesting. It’s more like a marathon, not a sprint. Best used as part of a broader investment strategy which is, of course, focused on long-term growth and tax efficiency.

All right. So, tax loss harvesting is a real testament to the fact that even in downturns, there are opportunities to be seized. By turning your investment losses into tax savings, you’re not just making the best out of a bad situation, you’re actually taking steps to enhance your financial future. Remember, the world of investing is full of surprises. And with the right strategies, even the sour moments can lead to sweet outcomes. And there you have it, folks, a whirlwind journey through the strategies of backdoor Roth IRAs and tax loss harvesting. These are really powerful tools. We are doing these for our clients on a continuous basis. They can really enhance your financial arsenal and open up new pathways to maximizing your investments and minimizing your taxes.

Remember that both of these strategies should be looked at through the lens of your long-term financial plan. Definitely coordinate with financial partners, your financial advisor, tax advisor because you can go really wrong if you don’t understand the intricacies of how these might interplay with the other things that you’ve done in your portfolio that year. Okay. Thank you for joining me on this adventure. And until next time, keep charting your course to financial success with confidence and savvy and the Love, your Money podcast. Stay tuned for more financial wisdom and strategies to empower your journey to financial freedom and happy investing!