Retirement planning is far from simple. While that may seem like a blatant understatement, it’s especially true when you start looking at all your options and try to determine the right savings strategy for you. Each of your many options has pros, cons, and unique opportunities. While you know you need to invest, it can be challenging to decide what is the best fit for your unique financial situation.
Enter the Roth IRA. Here’s why you should consider adding a Roth to your financial plan and ways to capitalize on its benefits.
It can be tempting to think short-term and only invest in a traditional IRA for a tax deduction now, but the Roth’s tax-free withdrawals in retirement (after the age of 59½) could be an even greater benefit to you. A Roth is an incredible tool to help you limit and manage your tax liability in retirement. Instead of being forced to pay income taxes on all the money you need to live on, you can decide how much to take from a taxable account and how to supplement it from a tax-free account in order to manage your tax brackets and minimize your tax burden.
A Roth IRA offers tax deferral on any earnings in the account. Qualified withdrawals of earnings from the account are tax-free. Withdrawals of earnings prior to age 59 ½ or prior to the account being opened for 5 years, whichever is later, may result in a 10% IRS penalty tax. Limitations and restrictions may apply.
With most tax-deferred retirement accounts, the owner must begin taking required minimum distributions (RMDs) when they reach age 72, regardless of whether they need the money to live. Why does this matter? Essentially, not taking RMDs means you can leave the money in your Roth to grow for your lifetime, even making more contributions after you retire if you earn an income. You can then use this nest egg as an estate planning tool to provide tax-efficient income for future generations.
While the primary goal of a Roth is to save for retirement, the way it is set up allows for plenty of flexibility if you need to access your funds. Keep in mind that if you want to avoid tax penalties, you can only withdraw your contributions, not your growth. (1) This flexibility allows you to save for retirement without worrying about your money being tied up if you need it for an emergency.
If you need to dip into your earnings as well, you could face a 10% early withdrawal penalty unless you qualify for certain exceptions, such as:
There’s no doubt that Roth IRAs boast many pros, but one limitation is that most high-income earners don’t qualify for a Roth IRA. As of 2021, you’re not eligible to contribute to a Roth IRA if you make at least $140,000 as an individual or $208,000 as a married couple. (3)Thankfully, you aren’t out of luck. Here’s how you can still reap the rewards of a Roth IRA.
A Roth IRA conversion is when you move funds from a traditional IRA into a Roth IRA. If you have a traditional IRA but believe you’ll ultimately be in a higher tax bracket once you’re ready to withdraw your funds, then a conversion may be for you. Remember, the contributions made to a traditional IRA have not been taxed; so when you convert, you will be required to pay taxes on everything coming out of the traditional IRA before it’s deposited into the new Roth IRA.
With the taxes paid, the conversion can occur. Your funds can now grow tax-free regardless of how high you climb up the tax bracket ladder. The primary goal of a Roth IRA conversion is to lower your tax bill in the future.
Roth conversions can be performed a little bit at a time. That way, you can convert just enough of your account to bring your taxable income for the year to the top of your tax bracket without pushing it into a higher one. A Roth conversion strategy can be used over a span of years to move money from a traditional IRA to a Roth IRA while limiting your tax liability. In many cases it is important to have outside funds available to pay income tax on a Roth conversion.
Traditional IRA account owners have considerations to make before performing a Roth IRA conversion. These primarily include income tax consequences on the converted amount in the year of conversion, withdrawal limitations from a Roth IRA, and income limitations for future contributions to a Roth IRA. In addition, if you are required to take a required minimum distribution (RMD) in the year you convert, you must do so before converting to a Roth IRA.
A backdoor Roth IRA is an IRS-sanctioned loophole that lets high-income earners reap the benefits of a Roth without violating the income limits.
Let’s say your income exceeds the legal limit for a Roth IRA, but you still want to fund an account. First, you will need to open a traditional IRA and fund it with non-deductible contributions. Then you will immediately convert your non-deductible IRA to a Roth IRA and repeat this process each year in order to take advantage of tax-free growth. In this scenario, you can avoid the IRA income limits, but you cannot avoid the annual contribution limits. For 2021, you can fund a maximum of $6,000 (or $7,000 if over the age of 50). (4) This may seem small, but over time you can amass a sizable retirement savings, especially when combined with other tax-advantaged retirement vehicles.
There’s some fine print to keep in mind if you are considering a backdoor Roth. There are two five-year rules: The first rule says that you must wait at least five years from your first contribution before you can make a penalty-free withdrawal from your Roth IRA—even if you’re over age 59½. (5) The second five-year rule states that each of your backdoor Roth conversions has its own five-year period. (6) For example, if you do a conversion in 2021 and another in 2022, you’ll have to wait until at least 2026 to access the first conversion and 2027 to access the second.
As with anything tax-related, consult a wealth advisor to position your money in a way that minimizes tax liability and maximizes growth.
As of November 2021, the tax portion of President Biden’s signature infrastructure legislation, known as the Build Back Better Act, has been passed by the House and will soon be voted on in the Senate. This bill has far-reaching implications for people in all tax brackets, including a major change regarding backdoor Roths. As of 2032, backdoor Roths will no longer be available.This applies to single filers making more than $400,000 and married couples making more than $450,000. It also prohibits any after-tax qualified retirement accounts (like 401(k)s) from being converted to a Roth IRA, regardless of income level, starting in 2022. (7) If you were planning to take advantage of the backdoor Roth strategy, your timeline has been shortened considerably and this planning option should be reassessed.
It’s common to have questions related to which retirement account is best for you. If you’re interested in a personalized review of your retirement accounts and exploring the option of a Roth conversion or backdoor Roth, our team at Wealth Advocate Group is here to help. Reach out to us at Contact@Wadvocate.com or 440-505-5578 to schedule an introductory consultation.
This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss you specific tax issues with a qualified tax advisor.
David Thorne is CEO at Wealth Advocate Group, LLC, an independent, fee-based wealth management company based in Beachwood, OH. With over 25 years of experience, David specializes in working with executives, helping them create proactive strategies for incentive and non-qualified stock options, restricted stock (RSUs), and concentrated stock positions. David is known for delivering a high level of service to his clients through Wealth Advocate Group’s caring-first, relationship-based approach. Dave has a bachelor’s degree in finance and psychology from Kent State University and is a CERTIFIED FINANCIAL PLANNER™ professional. He has also been a featured guest speaker for several financial service associations, focusing on executive stock option planning and risk management. When he’s not working, you can find David spending time with his wife, Tiffany, and their three adult daughters. He loves participating in all types of fitness activities, including snowboarding, mountain biking, and hiking with his dog. To learn more about David, connect with him on LinkedIn.
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(1) https://www.investopedia.com/roth-ira-withdrawal-rules-4769951
(2) https://www.irs.gov/pub/irs-pdf/p590b.pdf
(3) https://www.irs.gov/retirement-plans/amount-of-roth-ira-contributions-that-you-can-make-for-2021
(5) https://www.fool.com/retirement/plans/roth-ira/5-year-rule/
(6) https://www.investopedia.com/ask/answers/05/waitingperiodroth.asp
