How the tax benefits of a Roth retirement account could reduce your lifetime tax bill, even if you make too much to contribute directly.
This article was originally posted in March of 2023, but Roth IRAs are only going to be more valuable if tax rates increase in the future! I’ve also added a few updates for 2024 to keep things current.
You have probably heard of Roth IRAs, and perhaps your workplace 401(k) has a Roth option, but do you know how they actually work? What about a Roth conversion, or a backdoor Roth? Most importantly, how do you decide if one of these strategies is right for you? Read on to find out more about all things Roth! (If you are maxing out your 401(k) at work, be sure to check out the section on Employer Sponsored Retirement Plans, where I explain why doing that as Roth contributions actually helps you save even more for retirement.)
But first, a reminder that I am not a tax professional and do not provide tax advice. This post presents general information related to tax and financial planning. You should always consult your tax professional and/or financial planner for specific advice based on your personal situation before making financial decisions.
Roth Basics
The Roth IRA, named after its main architect, Sen. William Roth of Delaware, came into being in 1998 as a result of the Tax Payer Relief Act of 1997 (1). Compared to a “traditional” IRA, where the contributions are usually tax deductible, contributions to a Roth IRA are made after taxes are paid on the money. Both types of IRA accounts grow without being taxed, but when it’s time to take money out, the tax picture is very different.
Distributions from traditional IRA accounts are generally subject to income taxes, even if you are no longer working. This includes both the pre-tax contributions, since you never paid taxes on them in the first place, and also any earnings that have built up in the account over time.
With a Roth IRA account, you can take your original contributions back out at any time without tax consequences, since you have already paid taxes on them. In addition, distributions of the earnings that have built up over time are also tax free, so long as you are over 59½ years old and have had some Roth IRA account open for 5 years (2). (Roth conversions have slightly different rules, which I describe below.) This tax free forever growth can be very beneficial to your retirement planning!
New for 2024: As of January 1st, 2024, funds in a 529 Plan can be rolled over into a Roth IRA without incurring taxes or penalties. Great right? But wait, there are a lot of restrictions and even more questions still awaiting clarification from Congress and the IRS. Here are the basics (3):
Sounds a bit complicated, but still, maybe a good thing to do with leftover 529 funds? Probably not yet. Here are some of the questions that still remain to be answered that could apply to your situation (4):
The bottom line: If you have a very straightforward situation that avoids all the issues that are still up in the air, and there is no other good option for the funds, like changing the beneficiary to someone else in your family, then doing the rollover might be a good idea. But the best approach at this time is likely to wait until more of the issues are clarified, to be sure you know exactly what tax liability you will incur, if any. |
Why Roth
Taking a lifetime view of your tax bill means trying to pay taxes whenever your tax rate is the lowest. Conventional wisdom says that will be in retirement, when you are no longer working, but there are a number of reasons that may not be the case. These include historically low current tax rates that could rise in the future, or being forced into large Required Minimum Distributions (RMDs) if you have a lot saved into traditional pre-tax retirement accounts. See my previous post on Lifetime Tax Planning where I discuss in more detail why your retirement tax rate could actually be higher than it is now.
2024 Update: The Tax Cut and Jobs Act reduction in tax rates and increases to deductions and tax credits are set to expire after 2025, unless Congress acts to extend them. |
Given that you pay taxes now on Roth contributions in exchange for not paying taxes when you withdraw the money in retirement, the Roth IRA will clearly be beneficial if you expect to have a higher tax rate in retirement. And since no one really knows what tax rates are going to do in the future, it makes sense to have at least some portion of your retirement savings in a Roth retirement account.
There are also other advantages to Roth savings:
No Required Minimum Distributions (RMDs). Because you pay no taxes on the distributions from a Roth retirement account, the IRS has no motivation to make you empty the account over your lifetime. Roth 401(k) accounts used to be subject to RMDs, but the SECURE Act 2.0 has eliminated that requirement as of 2024 (5). So if you don’t need the money, you can leave it to grow tax deferred until you do, or until it passes to your heirs.
Tax diversification. Having retirement accounts that are taxed differently provides flexibility that can be used to manage taxes in retirement. You can adjust where you take additional funds beyond any RMDs, for example taking taxable distributions from traditional IRAs in years you have large deductible medical expenses that will offset your taxable income, but using non-taxable distributions from Roth IRAs in other years.
Withdrawals don’t affect taxation of other income. Other retirement income like social security and pensions are generally taxed at income tax rates. In addition, the percentage of social security subject to taxes depends on your overall income (6). Withdrawals from a Roth type account will not get added to your income and so won’t increase that percentage or push other income into a higher tax bracket.
However not everyone is eligible to contribute to an individual Roth IRA account. Just as with a traditional IRA, you must have earned income of at least the amount of your contribution. But to contribute to a Roth IRA, your income must also not exceed certain limits (7).
How to Roth When You Make Too Much
If your income exceeds the limits to contribute directly to an individual Roth IRA account, there are a number of strategies you can use to get the benefit of Roth retirement savings.
Employer Sponsored Retirement Plans
In 2006 401(k) employer retirement plans were allowed to offer a Roth option, and many of them now do. The passage of the SECURE Act 2.0 at the end of 2022 provided for Roth versions of SIMPLE IRA and SEP IRA small business retirement plans, effective in 2023. (See my previous post on the SECURE Act 2.0 in 2023 here.) There are no income limits on employee contributions to an employer sponsored retirement plan.
2024 Update: While Roth contributions to SIMPLE and SEP IRA Plans were authorized as of 2023, guidance on how to actually implement these provisions was very limited, so there wasn’t much early adoption. A recent IRS Notice has provided enough clarification that it is likely employers will start offering these options in the near future, or if you are a business owner, you can choose to offer them if it will benefit you and/or your employees (8). |
If your employer offers it, or you can establish one for your own business, contributing to a Roth retirement savings plan is the most straightforward way to build up your tax-free retirement assets. And for those who can afford it, employer retirement plans have higher contribution limits than individual IRAs (9), which means you can save even more for retirement.
And then there’s the thing many people miss about the contribution limits: the maximum dollar amount you can contribute as an employee to a 401(k) is the same if you contribute pre-tax or Roth (post-tax).
Contributing the maximum to a Roth Employer Retirement Plan lets you save more for your retirement than maxing out pre-tax contributions.
Why? Because you are actually using not just the contributions themselves, but also the taxes you are paying separately to fund your retirement. So if you are trying to save as much as you can for your retirement, you believe having some Roth assets makes sense, and you can afford to pay the additional taxes now out of your take-home pay, maxing out your Roth 401(k) contributions can boost your after tax retirement savings.
The Different Flavors of Roth Conversions
What if you don’t have access to a Roth savings option in your workplace, and you make too much to contribute directly to an individual Roth IRA, but you still want to build your Roth retirement savings? There are several ways to use a Roth conversion to end up where you want to be. But the details of executing any Roth conversion strategy can be tricky, so please be sure to consult with your tax professional to understand the required steps and tax consequences.
Simple Roth Conversion
The same legislation that created the Roth IRA in 1997, also allows for conversion of existing traditional pre-tax IRAs to Roth IRAs, as long as income taxes are paid on the amount converted. There are no income limits on Roth conversions, so if you have large balances in pre-tax IRA accounts, converting them to Roth IRAs can be beneficial in the long run. The steps are relatively simple, especially if you are doing it between two accounts at the same custodian, however there are some things to be aware of (10):
Be sure that you have no need to withdraw the converted funds for 5 years. Unlike a Roth IRA that you funded with direct contributions, where you can take the original contribution back out at any time, any funds you withdraw from a converted Roth IRA before 5 tax years have passed are subject to penalties.
The full pre-tax converted amount will be added to your income when you file your taxes, so you can end up paying taxes on the conversion in a higher bracket. One common approach to mitigate this is to make these conversions in steps during years when taxes would otherwise be lower, for example between retirement and the start of social security, pensions, or RMDs. While there is no limit to the amount that can be converted at one time, if each conversion is sized to just fill a particular tax bracket, the tax cost can be planned ahead of time.
Conversions only make sense if you have separate cash outside the IRA to cover the taxes due on the converted amount. Keeping part of the conversion out to cover taxes will be considered a distribution, which could result in additional taxation and possibly penalties if you are younger than 59½. In addition you will reduce the funds that are growing tax deferred for your retirement.
Backdoor Roth
This is a specialized use of a Roth conversion where post-tax money is contributed to a traditional IRA, and then converted to a Roth IRA before it grows and creates taxable earnings. If done correctly, there will be no tax consequences to the conversion itself. For those that do not have access to a Roth option in a workplace retirement plan, it can be a way to get around the income limits on Roth IRA contributions. However, while the strategy is generally considered legal, the tax implications, transfer method used, and timing must be carefully considered. One thing people often miss:
The IRS looks at all of your IRA accounts to determine what pro-rata amount of any Roth conversion is taxable, you can’t specifically convert the post-tax money you just contributed (11). If you have a lot of pre-tax IRA assets this strategy is unlikely to be beneficial (pre-tax 401(k) assets are not included in the calculation). For example if you have $94,000 total pre-tax IRA assets, and then try a backdoor Roth strategy with an additional $6,000 after tax contribution, you will owe taxes on 94% of the converted amount (the ratio of pre-tax balance ($94k) to total balance ($100k)), even if there are no earnings yet. (While this feels like double taxation, you get to mark some of the original pre-tax balance as now post-tax, but it still remains in a traditional IRA where the earnings are taxed when they are distributed.)
Thanks for hanging in with me on this rather long and technical post, I hope you found it worth your time! If you have any questions about whether one of these strategies is right for you, be sure to reach out here.
References
1 - Roth IRAs, https://www.kiplinger.com/retirement/retirement-plans/roth-iras#:~:text=The%20Roth%20IRA%2C%20named%20after,is%20a%20powerful%20retirement%20tool, accessed 03/25/23.
2 - Roth IRA ‘five-year rule’ can trigger an unexpected tax bill: Here’s what you need to know, https://www.cnbc.com/2023/02/06/roth-ira-five-year-rule-heres-what-you-need-to-know.html, accessed 03/26/23.
3 - Rollovers From a 529 Plan to Roth IRA: What to Know, https://www.savingforcollege.com/article/roll-over-529-plan-funds-to-a-roth-ira, accessed 03/25/24
4 - Tax-Free 529 to Roth IRA Transfers are Here, But Questions Remain, https://www.savingforcollege.com/article/529-roth-ira-transfers-questions-remain, accessed 03/25/24
5 - Retirement Plan and IRA Required Minimum Distributions FAQs, https://www.irs.gov/retirement-plans/retirement-plan-and-ira-required-minimum-distributions-faqs#:~:text=Roth%20IRAs%20do%20not%20require,required%20from%20designated%20Roth%20accounts, accessed 03/25/23.
6 - Income Taxes and Your Social Security Benefit, https://www.ssa.gov/benefits/retirement/planner/taxes.html, accessed 03/26/23.
7 - Traditional and Roth IRAs, https://www.irs.gov/retirement-plans/traditional-and-roth-iras#:~:text=The%20most%20you%20can%20contribute,taxable%20compensation%20for%20the%20year., accessed 03/26/23.
8 - SEP and SIMPLE IRAs and the SECURE 2.0 Act: IRS issues Notice 2024-2 clarifying provisions, https://www.wolterskluwer.com/en/expert-insights/sep-and-simple-iras-and-the-secure-20-act, accessed 03/25/24
9 - 401(k) limit increases to $22,500 for 2023, IRA limit rises to $6,500, https://www.irs.gov/newsroom/401k-limit-increases-to-22500-for-2023-ira-limit-rises-to-6500, accessed 03/26/23.
10 - What Is a Roth IRA Conversion?, https://www.fool.com/retirement/plans/roth-ira/conversion/#:~:text=The%20government%20only%20allows%20you,IRA%20in%20a%20single%20year, accessed 03/26/23.
11 -Backdoor Roth IRA: What It Is and How to Set One Up, https://www.nerdwallet.com/article/investing/backdoor-roth-ira, accessed 03/26/23.