Preview of what we’ll cover today:

🛫 Backdoor Roth Basics: The workaround when income caps apply

🚧 Roth Eligibility Limits: Why pilots often exceed IRS thresholds

🧮 Joint Income Rules: How household earnings affect access

🔄 Conversion Process: Moving money without turbulence

⚠️ Pro Rata Rule: The hidden tax trap many pilots miss

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More About This Episode:

Ryan is joined by Zach Smith of Pilot Tax to discuss why many high-income pilots run into Roth limitations and what that means for long-term planning. While backdoor Roth IRAs can be a powerful tool for high-income earners to achieve tax-free retirement growth, it’s essential to understand the rules, potential pitfalls, and seek professional advice to ensure the strategy aligns with your specific financial situation.

Go Deeper Into The Episode:

0:00 – Intro (Backdoor Roth IRA)

1:25 – Things Pilots Do Wrong

3:08 – Backdoor Roth IRA 101

8:11 – Pro Rata Rule and Tax Implications

11:12 – Legacy Planning

14:06 – Final Thoughts

Resources:

Retire Pilots – https://retirepilots.com

Get your FREE Retirement Toolkit – https://bit.ly/3ZmZsaX

Pilot Tax – https://pilot-tax.com/

The Pilot’s Advisor Podcast is also on video. Watch & Subscribe on YouTube: https://bit.ly/3EIEBW2

Connect with Pilot-Tax: https://pilot-tax.com/

Episode Transcription:

(Note, this is an automated transcription. Please forgive any errors.)

Ryan Fleming  00:04

Zach Smith from Pilot tax is back on the podcast today. Zach, thank you for being here as always. And all we’re doing today is just talking about an issue that we have to explain many, many times, and the benefit and how great it can be in the grand scheme of things. And Roth money is the best kind of money. Roth money grows tax free forever, and when you want to use it, it’s tax free. It’s the greatest gift you could ever have in retirement planning. And so we want to talk about something called the backdoor Roth. And why are we talking about about the backdoor Roth today? Well, in many, many cases, airline pilots can’t qualify for a direct contribution into a Roth IRA. So this is how we get around that. So I’ll go through and just talk about this first problem that we have, and that’s that most airlines can’t use a Roth IRA. Why is that? Well, even though it has all these tax advantages that we talked about, tax free growth withdrawals in retirement that are tax free. The IRS imposes strict eligibility limits on who can contribute directly for 2024 and these are old numbers. Sorry, I should have got these updated to 2025 or 2026 but just keep in mind that if you’re filing, you know whether you’re filing single or joint, if you make over these balances, you cannot qualify for a direct contribution to a Roth IRA and Zach. How many? How much time do you spend trying to clean up the mess that people made by contributing to a Roth IRA when they don’t qualify?

Zach Smith  01:34

We have many, many, many every year where we’re messing around with corrective distributions, getting it cleaned up. Or a lot of guys have been contributing to a traditional IRA all this time, made too much money to take a deduction for it. So this is a huge, huge cleanup area for us. And you know, you and I doing this today can hopefully help some pilots understand exactly how these things function, so we can do it right on the front end.

Ryan Fleming  01:57

Yeah, and hopefully not clean up messes. We’re here to help you fix the problems you have. This is why I want you to work with the CPA. This is why I want you to work with a financial advisor so you actually know what the rules are out there. And we haven’t even talked about something called the pro rata rule. So we’re gonna get into all those things. We’ll try to make it as simple as possible. This first slide, last thing, I must say, most airlines, by the time you’re at year two, year three, pay. You do not qualify to make a direct contribution into a Roth IRA. So please, please stop doing that. You’re creating a big mess. There’s other ways to get Roth money in there, but if your income is over $240,000 joint or 161 single, you do not qualify for a direct contribution into a Roth IRA, so please stop doing that.

Zach Smith  02:44

Yeah, and I want to add to this, Ryan, that is not just on an individual basis. If you’ve got a spouse that’s working too, these income limits are on a joint basis, on a joint tax return. So we can’t just count your income. We got to count all income. This includes investment income, spousal income, military retirement, anything that’s hitting the front page of our tax return affects the eligibility to do these things,

Ryan Fleming  03:07

absolutely and the backdoor Roth, this is a problem, or not necessarily a problem, but it’s a solution that is for high income earners that do not qualify for a direct contribution. So we’re going to let Zach go through it, talk about it, how it works, how it looks on a tax return. I know a lot of people that try to do these backdoor Roths themselves, and then they go to Turbo Tax, and then it just blows up in their face, and they don’t know what to do. And I’m like, Well, I always say, well, who’s your CPA? And they’re like, me, like, well, there’s your first problem. So I’ll let you go and run with this one. Zach, All

Zach Smith  03:41

right, guys, so let’s talk about big picture. Ryan. Ryan is absolutely right here. So this is a great vehicle to get additional money into a Roth. Okay, we push these things left and right. We think they’re a great tool. Ryan’s favorite thing in the tax code is a Roth. Okay, he’ll tell you that all day long. All right. Now here’s the deal. Okay, company sponsored, 401, K plans are have a lot of oversight, okay? Corporate oversight. They’re subject to audits every year by independent accounting firms. Okay? The IRAs are different. We don’t have that same company oversight, so they are monitored and overseen by the IRS through IRS tax code. Okay, so there’s a lot of restrictions on these things. Ryan hit at it on the front end, once we hit a certain income level, when you put money into a traditional IRA, you can no longer take a deduction for it, and it is a lower threshold than the numbers that he gave you for the Roth. And then once we continue to go up the tax brackets, up the income level, we can then no longer be eligible to contribute to a Roth directly. This is how the IRS restricts some of the control and keeps control of these things. So what’s the work around, right? Ryan, what’s the work around the deal is with these backdoor Roth IRAs, we got to get the money in the back door. We can’t go directly to the Roth. Okay, so how you do these things is you put the money into a traditional IRA. First. But remember, we make too much money. We can’t take a deduction for it, so we have essentially post tax money or basis in this IRA. Once that funds clear, okay, once those funds clear, the deposit the next day, we want to roll those over to a Roth IRA. So we go traditional IRA first, then we go Roth IRA. The reason that these are permitted. Okay, you can’t contribute directly to a Roth, but Roth rollovers and conversions are permitted regardless of your income level. Okay, so what happens is that 7000 we put in the traditional IRA, we didn’t take a deduction for it, right? So that is post tax money. So when we roll that to the Roth IRA. None of it is taxable, and this is why it’s so important. And Ryan does a great job of staying on top of it. This is why it’s so important that once that money is in the traditional we want to roll it to the Roth immediately. We do not want it earning any money inside of that traditional IRA before we move it to the Roth. We want all our earnings in the Roth.

Ryan Fleming  05:57

And this is why I have this conversation a lot where people will be making monthly contributions to a traditional IRA throughout the year, and then they’re going to roll it later. Well, it kind of creates a mess, because you’re getting gains inside that account, so you’re just creating more of a tax bill. So ideally, the way, if it isn’t my ideal world, ideal world, I would want you to take a lump sum, $7,000 or if you’re over 50, it’s, you know, $8,000 but take that lump sum and put it in that account, that traditional IRA in January, not waiting to the very last minute in December and trying to squeeze it in, but in January, and we immediately convert it to that Roth, and then we get that tax free growth for the rest of our lives. But if you’re doing it monthly, you’re just creating a tax bill, absolutely get it in January. We get the whole year of earnings as well, right? And all I’ll say about that, the reason why I’m saying that is time in the market is probably the biggest factor there is out there, you know, starting early, letting your money work for you and, oh, by the way, this money’s tax free forever. It doesn’t get any better than this. You basically paid the government to go away. Go ahead.

Zach Smith  07:05

Zach, all right, he’s absolutely right. Pay the money to go away. Pay the money to the IRS now, make them go away. And Hey guys, listen, this money also passes tax free your kids, in my opinion, Roth accounts are one of the best wealth transition tools there is, on top of managing some of our problems in retirement, all right? So I think Ryan, Ryan and I are going to talk a little bit about the big hiccup, right? The big hiccup with getting these things done. This is called the Go ahead, Ryan,

Ryan Fleming  07:33

I was just going to add with what you were saying 100% I agree with you when we talk about legacy planning, passing on wealth to our children. Roth is an amazing thing because the government’s already gone. It’s out of the equation. And I even look at when you start building out income, even when your kids are in their 20s or 30s, them getting money in their Roth, Ira, even if it if you’re helping them out a little bit, as long as they have earned income, there’s ways to get around that, but that’s a great way to start passing on wealth. Absolutely thing that nobody knows about, and make Zach explain it, because he probably understands the math a little bit better, the old pro rata rule.

Zach Smith  08:09

All right, so here’s the big hiccup with doing the backdoor. Roth IRA, okay, as we talked about, the IRS puts a lot of restrictions on this to make sure that they get their tax money. Okay? Pro rata rule. Okay? We spend a lot of time cleaning this stuff up too, where people that are doing these on their owns didn’t realize that this applies. So here’s the deal. When you go to move money from a traditional IRA to a Roth IRA the IRS forces you to prorate all pre tax IRAs versus post tax money in those IRAs before you move it. So let me walk you through us through an example here. Let me make this really easy. Let’s say that we’ve got a pilot that’s got $93,000 in a traditional IRA. Either they’ve been contributing before they were making very much money, or, Hey, this may be a 401, K that got rolled to an IRA after they left another airline. We’ve got $93,000 in there. Let’s say this pilot wants to do a $7,000 Roth IRA backdoor. Okay, they put their seven grand into this traditional IRA, and then they roll their 7000 the next day to the Roth. Here’s the problem. Right before they rolled that $7,000 to the Roth, we had $100,000 balance in there, right? $100,000.93 of it was pre tax. 7000 was post tax. So what ends up happening is, when we go to move that 7000 to the Roth, 93% of that is going to be taxed upon the movement to the Roth. Because 93% of all balances, these are all IRAs. You got to, you got to balance out all your IRAs traditional, 93% of their total of traditional IRA balance outside the 401, K, 93% was pre tax. So we ended up getting hit with this unexpected tax bill on this tax avoidance strategy, because we have these other traditional IRAs.

Ryan Fleming  09:54

So it ends up being not very efficient at all with what they’re doing because of the pro rata rule, right?

Zach Smith  10:00

I agree. So anybody that’s got a fairly substantial balance in a traditional IRA, one of two things happen here. Either. Number one, Ryan and I do not recommend doing the backdoor Roth. We’re not trying to trigger tax implications to get money moved through the backdoor. Roth, Ira. Option one, we don’t do it. Option two, we start talking about trying to get some of this traditional IRA money converted to Roth before we start conducting the back door itself.

Ryan Fleming  10:29

And I like to point out here too, even if you did a little bit of Roth conversions every single year, that money’s tax free forever, okay? Otherwise it’s just going to keep growing, you know. And I talk to people about this all the time, well, I hope that traditional IRA doubles or triples by the time you retire, and that’s what everybody wants. We all want that growth. But the tax problem doubles and triples as well. You’re just getting bigger and bigger and bigger and bigger pizza pie that you got to pay tax on, how much tax you’re going to pay. I have no clue. I don’t know what the government’s going to do, but I’m pretty sure I feel like they’re not on my side, and I think taxes will probably go up, and even if they don’t, I mean, you’re paying that same tax on a much, much, much larger amount,

Zach Smith  11:12

absolutely, and I do want to add to that. So Ryan mentioned legacy planning a minute ago, these traditional IRAs and traditional 401, KS can create an absolute tax nightmare for your kids. Okay? Everybody wants to leave money for their kids. They want to leave a legacy, which I completely, I think that’s fantastic, right? Fantastic. The problem is, when your kids or beneficiaries inherit these large, traditional IRAs and 401, KS, generally, we’re subject to a 10 year rule, and they are subject to tax.

Ryan Fleming  11:39

Let’s, let’s make it real for somebody, because we have a lot of clients where their kids end up becoming airline pilots. So let’s say 30 year old pilot, he’s now a Delta captain, making really, really good money. Parents pass pass away, and he just inherited a $2 million beneficiary, Ira, $2 million of tax deferred money that the IRS hasn’t been paid yet. So, huge windfall, $2 million that he just gets passed on. But what does that look like in the grand scheme of things, where you’re talking about that has to be paid out in 10 years?

Zach Smith  12:14

This is a huge problem, Ryan, and you’re absolutely right. We do have a lot of kids of pilots that go on to fly in the airline. I deal with this on a fairly regular basis, and the hard part is our 30 year old Delta captain. He doesn’t need that money right now. He doesn’t need it right and he’s got high income, and now, all of a sudden, we’ve got to have $2 million of taxable income distributed to that beneficiary, to that guy, and there is nothing we can do about it. So now we’re adding 200,000 plus of income per year for money that he does not need, getting us up into the 35 37% tax bracket, depending on where we’re

Ryan Fleming  12:48

at and oh, by the way, if a good financial advisor is doing their job and the markets cooperating, that $200,000 is just not even taking into account the growth of that account over 10 years. So it’s actually going to end up being a lot more

Zach Smith  13:02

than that, right? This is a huge problem. This is a huge problem that nobody thinks about when they’re saving over the long run. And we’ve seen it a lot in our hands. Unfortunately, when we hit that point, our hands get

Ryan Fleming  13:14

tied, yeah, absolutely, because you have to take the money the IRS is going to get paid. They’ve been deferring taxes on this, you know, for a long, long time, and it’s, it’s like, pay up. Here we go. And there’s rules that that force, force that down the path. So not to muddy the waters, but what, what I want you to gather from this is, we wanted to explain the backdoor Roth a little bit more, so pilots understand it, but understanding that taxes and tax planning, strategic tax planning is very, very important. Roth, money is the best kind of money. Pay the government to go away. The sooner you do it, the better that money grows tax free forever, the rest of your life, and can be passed on to your kids, completely tax free. All right. Zach, you want anything else to add? Close with this, I appreciate your time talking about the back door rough Absolutely.

Zach Smith  14:04

I think we covered most of it. And as always, Ryan and I are here for questions. And every situation is going to be different. We know that just depending on family income, all that kind of stuff, so we’re here to answer questions as needed.

Ryan Fleming  14:16

And the last thing I’ll say is we plan to do some of these podcasts explaining one issue at a time, just to make it a little bit more clear for you guys, if there’s any questions you have, if you want to direct them to Zach or myself, and we could do a quick podcast on it, trying to make it a little bit more clear for you guys. That’s the idea that we’re trying to put together here with this. I think we’ll talk about the distribution phase of retirement at some point, just so pilots understand the distribution phase a little bit better and how the decisions they make today truly affect what life looks like down the line. Zach as always, appreciate your time. I know you’re very, very busy there with your firm at pilot tax. If you guys do not work with Zach Smith at pilot tax, I highly recommend you guys at least have a conversation. Been working with pilots for 30 years, done. Doesn’t matter what carrier you’re with. He knows American pilots. He knows United pilots. He knows southwest Delta, much like myself, he knows all these carriers and their 401 K plans and the tax implications. So reach out to him. Thank you guys. Look forward to talking to you next time and fly safe.

Speaker 1  15:21

Information is for illustrative purposes only and does not constitute tax investment or legal advice. Always consult with a qualified investment legal or tax professional before taking any action.