Don’t Miss Out On This Powerful Tax Strategy For Clients

Matthew Jarvis, CFP®, shares how backdoor Roth contributions can be a game changer for your clients and several ways advisors mess it up.

4 min read

One Little Thing Advisors Do To Tank Onboarding
Matthew Jarvis
Financial Planner, CFP®

Sure, everyone knows about backdoor Roth contributions, but most advisors screw them up. Backdoor Roth contributions are the most significant source of amendments we do on new client tax returns.

If you can get systems, processes, and checklists to handle these contributions seamlessly, you can deliver massive value to your clients in tax planning; otherwise, you’re just causing problems for your clients.

Let’s explore why backdoor Roth contributions matter and how advisors can avoid common mistakes.

Why use backdoor Roth contributions

For most clients—and the vast majority of advisors—the best tax planning involves small, consistent steps over time. You don’t need to do anything drastic like moving to Puerto Rico to avoid getting killed in taxes when you could be making annual backdoor Roth contributions.

However, backdoor Roth contributions are nuanced and complicated, which is why so many advisors choose to overlook them for the seemingly measly $6,500 they contribute.

Indeed, a single $6,500 contribution won’t look like much for a high-earning client. But if that client is married, that contribution doubles to $13,000, and if we make this contribution year after year for a decade, suddenly, you have $130,000 in tax-free money—my favorite kind of money!

When advisors can catch it early with clients, you could use backdoor Roths to build a massive six or seven-figure growth for your clients over several decades.

Who doesn’t want that?

At some point during retirement, your clients will need a lump sum of money. We all hope it will be for something fun, like buying a new RV to tour the country or buying a dream cabin on the shore of a mountain lake.

But your clients may experience emergency medical expenses or need long-term care, in which case, they’ll be incredibly grateful to have access to a pool of money where the taxes have already been paid.

Every advisor should consider backdoor Roth contributions for all their clients every year.

You can have all the philosophical debates about pre-tax or post-tax that you’d like. However, consistently using backdoor Roths to build tax-free wealth for your clients should not be overlooked.

There’s a lot of power in having a tax-free bucket for your clients to draw from for one-time, unanticipated events.

Common mistakes

Because backdoor Roth contributions are complex, it’s easy for even well-meaning advisors to mess them up. Too often, advisors forget that the backdoor Roth is a multistep process that must be seen through all the way to reporting on the client’s tax return. 

Here are some of the most common mistakes we’ve seen advisors make.

Mistake #1: Reporting the account value when the conversion occurred rather than the account value on December 31.

Here’s how this rule bit me several years ago:

The client had a backdoor Roth contribution that we converted, and the client retired later that year. We rolled their 401K over into an IRA and filled out the 8606.

Instead of putting a zero for the December 31st balance, it was $2 million, which blew up the entire strategy.

Thankfully, I made this mistake back when we could still do Roth recharacterizations, so I was able to fix this one.

Today, if you did the 8606 and the December 31 balance was different from what you thought it would be, that’s just game over. You’re out of luck.

Unfortunately, you’ll have to tell the client that this went from a tax-free conversion to owing taxes on almost all of it—which is a significant problem.

Remember that the backdoor Roth is a multiple-step process to avoid this mistake. There are multiple steps involved that you must see through to the end.

To do the conversion, you need to do it on a non-deductable contribution IRA, then do a distribution from the IRA, and then a contribution to a Roth. That’s how the contribution works.

After you’ve gone through all that, you’ll generate a 1099 R with an option for “$6,500 gross” or “$6,500 taxable.” You must be proactive and ensure that the client’s tax preparer knows that tax has already been paid on that $6,500 and that it’s reported on line ten (or line four) of the 1040.

If you don’t check for these things, the client will get taxed on their contribution again, resulting in amendments and a significant mess for everyone involved.

Mistake #2: Assuming the conversion is complete without checking in with the client’s CPA

There’s enormous value in getting this thing right the first time, so you don’t have to go back and clean it up later. The system for backdoor Roth contributions isn’t set up for success, and the 8606 is not required to be filed.

However, if you don’t have a paper trail, it could come back to bite you, as there is no statute of limitations for audits of basis.

You must check in with your client’s tax preparers so that the non-deductable items are reported correctly year after year.

Not only do you want a paper trail with tax forms, but best practices suggest that you track this personally for each client.

Mistake #3: Failure to consider all IRA accounts together

Sometimes, I bring on new clients who want to keep an account on the side, separate from the other accounts under management.

While the client may think this separate IRA isn’t a big deal, it can wreak havoc when it’s time to make a backdoor Roth contribution, as all accounts need to be considered together.

I gently remind my clients that we employ tax strategies that carefully consider all of their accounts. If we cannot monitor this other account and something changes, it could cause substantial problems going forward.

Your best solution for this problem is to manage all assets in-house.

Mistake #4: Failing to communicate this multistep process to your client and their CPA

When preparing to do a backdoor Roth Contribution with your clients, let them know what to expect.

Share how the backdoor Roth might sound shady, but the IRS approves it. There may be moments where the process feels a bit rocky, their tax preparer may push back, etc, but you’ll be tracking the entire process to ensure it all works out.

Setting expectations from the beginning of the process can ensure the client doesn’t panic when things come up.

Action Items

Advisors wanting to add backdoor Roth contributions to their tax strategy toolbelts must have a system, processes, and checklists to follow to ensure that the contributions are completed correctly.

You really can’t see these things through without a guide, so check out Retirement Tax Services, subscribe to their newsletter, and enroll in the Backdoor Roth Masterclass.

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