It’s All about the Roth IRA
As a financial advisor, I like to ask my clients what their financial goals and aspirations are. All too often, they say, “I just want the greatest amount of growth while paying the least amount of taxes.”
But, as we all know, taxes are generally inevitable on portfolio growth. That is, unless your money is socked away in a tax-sheltered retirement account, such as a Roth IRA.
With a Roth IRA, you pay taxes on your contributions but those contributions grow tax free and withdrawals in retirement are not taxed either, providing you have reached at least age 52 ½.
True, you don’t get the immediate tax break you do when contributing to a traditional IRA. BUT you will pay taxes on what you contributed to a traditional IRA—and its earnings—when you make withdrawals in retirement. AND you are required to make specific annual withdrawals, starting at age 72. You are not required to take distributions from a Roth, and when you do, they aren’t taxable.
Besides tax-free retirement income, there are other advantages to choosing a Roth over a traditional IRA, especially if you think you might be in a higher tax bracket when it comes time to start dipping into your retirement money. They include:
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- Excellent liquidity— We all know we’re not supposed to tap into our retirement savings. But sometimes life happens and we need to withdraw retirement savings for emergencies or big ticket items we can’t pay for otherwise. Traditional IRAs in most cases come with both a tax bill and a 10% penalty for early withdrawals. But you can take money from a Roth, tax and penalty free, as long as your withdrawal comes only from contributions and not earnings. Just be sure to follow Roth IRA withdrawal rules. (Your financial advisor can help with that.)
- No Required Minimum Distribution—Money in a traditional IRA is subject to RMDs, or required minimum distributions, beginning at age 72. If you fail to withdraw the required amount on time, you would be subject to stiff penalties. But there are no RMD requirements with a Roth. That means you can keep your money invested as long as you want, allowing it to grow and avoiding having to sell assets during a down time in the market.
- Better for beneficiaries—You can inherit a Roth account without going through probate as long as the deceased listed you as the beneficiary and you are still living. The distribution rules for beneficiaries can be complicated and depend in large part on your relationship to the original account owner and when the original account owner died; if the death occurred after Dec. 31, 2019, different rules apply than for an account whose owner died before then. If the Roth account you inherited was opened at least five years ago, you get the same tax-advantaged treatment as the original account. But withdrawals from Roth IRAs less than five year old are subject to income tax at your ordinary rate, plus a penalty.
If the original owner died after 2019, you don’t have to take RMDs but you have to withdraw the entire amount within 10 years. There are some exceptions: for example, if you are inheriting the account from your spouse. Your tax or financial advisor can explain the exceptions to you and help you determine whether you qualify.
All that sounds good—but there’s a catch. There are income limits aimed at preventing high earners from opening a Roth IRA. In 2021, your modified adjusted gross income must be below $140,000 for single filers or below $208,000 for married couples filing jointly. And there are limits on how much even qualified earners can contribute to an IRA account each year. For example, in 2021. The total contribution limits to all your IRAs (traditional and Roth) is $6,000 ($7,000 if you are over age 50) and the limits are lower for higher income earners who are below the $140,000 ceiling (or $208 for married couples).
But there’s a workaround for that. With some careful maneuvering, all or part of a traditional IRA can be converted to a Roth, thanks to a strategy known as the “backdoor Roth IRA.” There is a catch of course—you must pay taxes on any earlier contributions that were deductible. But once you have paid up, you will have a Roth and all its advantages.
Here’s how the “backdoor” strategy works: You open a new traditional IRA and make NON-deductible contributions to it, then convert it to a Roth IRA. Anyone can convert traditional IRAs to Roths, no matter what his or her annual income is. You can also convert money in an existing traditional IRA account to an IRA but will most likely owe taxes on the money you convert because you got a tax break when you contributed to the traditional IRA.
There is also a strategy known as a “mega backdoor Roth, which, as its name implies, allows high-earning people with large savings to funnel it into a tax-free account.
This is a strategy that makes sense only after a high earner has maxed out on contributions to any kind of IRA—and has a large amount of cash to put into a Roth IRA. It’s a fairly complicated procedure, but basically works like this: Roll the money you have in a traditional 401k account into a traditional IRA, then convert it to a Roth IRA (Expect to pay taxes on any money that was not previously taxed, such as contributions to a traditional 401k.) You can avoid limits on your contributions by rolling over funds from your workplace retirement plans, which have significantly higher contribution limits. This works only if you are enrolled in an employer-sponsored traditional 401k plan that allows after-tax contributions and in-service withdrawals. And you cannot make after-tax contributions needed for mega backdoor Roth until you’ve maxed out your 401(k) contribution.
If you are interested in doing a mega backdoor Roth, better talk with your financial advisor/tax consultant soon, as there is proposed legislation that could close this particular “loophole.”
Winnie Sun is a registered representative with and securities are offered through LPL Financial, Member FINRA/SIPC. Investment advice offered through Sun Wealth Group a registered investment advisor and separate entity from LPL Financial.
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.
Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual.
This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.