The Ultimate Guide to Roth IRA and Roth 401(k) Strategies: Maximize Your Tax-Free Retirement

Roth accounts—both Roth IRAs and Roth 401(k)s—are powerful vehicles for building tax-free wealth in retirement. While both offer the benefit of tax-free withdrawals, knowing when and how to use them strategically is key to maximizing their advantages. In this comprehensive guide, we’ll explore the ins and outs of Roth IRAs, Roth 401(k)s, Roth conversions, and advanced strategies like the Mega Backdoor Roth, so you can make informed decisions that align with your financial goals.

This guide pulls together key strategies, tips, and pitfalls from Roth IRA and Roth 401(k) accounts, conversions, asset location tactics, and withdrawal plans, giving you the insight to make informed decisions for your retirement future.

Quick Links

• What is a Roth IRA?

• What is a Roth 401(K)

• Roth Conversions: When It Makes Sense and When it Doesn’t

• High-Income Investors and Roth IRAs

• The Mega Backdoor Roth Strategy

• Roth IRA 5-Year Rule: What You Need to Know

• Asset Location and Roth Accounts

• Roth Withdrawals: How to Maximize Your Tax-Free Money

What is a Roth IRA?

You’ve been told that it is important to save for your retirement, so with your first job you started contributing to your 401k at work.  This was a great option as your company had matching dollars for the dollars you contributed AND it helped to lower your income for income tax purposes.  You’ve done a great job saving and are looking for other options to save for retirement.  Where to save those additional dollars now?

Traditional IRA’s have been around since the early 70’s as a way to save additional dollars into retirement.  However, Roth IRA’s have only been in existence for 25 years and were created by the Taxpayer Relief Act of 1997 to encourage people to save money for retirement in a more tax advantageous way.  You contribute after-tax dollars – dollars already taxed via withholding on your payroll check – and then have access to those funds, both contributions and earnings, TAX FREE after age 59 ½.  The Taxpayer Relief Act also opened the window to Roth Conversions which we will cover next within our blog series – Roth Strategies. 

Is a Roth right for me?  What are the benefits?

TAX ADVANTAGES

One of the biggest advantages of a Roth IRA is the tax-free growth and potential for tax free withdrawals.

While the dollars you contribute grow in your Roth IRA, those EARNINGS ARE NOT TAXED and when you do take distributions from your Roth IRA, you will be able to access these earnings TAX FREE.  It’s important to note that your contributions can always be withdrawn from day 1, but the only way the earnings can be distributed TAX FREE is if you had the account open for at least 5 years AND you are over age 59 ½.  The sooner you consistently contribute to a Roth during your accumulation years, the more tax-free dollars you will have access to in retirement.

You may also decide POST RETIREMENT to make contributions as long as you have some earned income.  Why might you want to do this?

Your named beneficiaries of your Roth IRA also get to access these dollars TAX FREE.  Let’s say your daughter is a doctor making a very good income and subsequently is in a high tax bracket at the time you pass away.  While receiving an inheritance can be a blessing for some, a large brokerage account that must be distributed over a period of 10 years (as it is for both Traditional IRA and Roth IRAs) could really be a tax headache for that high tax bracket daughter.  While she has to distribute the Roth dollars over the 10-year period, unlike distributions from a Traditional IRA (where every dollar is taxed) there will be NO TAX BURDEN for her.  She will withdraw those Roth dollars TAX FREE.

Other than the obvious of not paying taxes on those earned dollars, why are these tax-free withdrawals so important? 

Tax Diversification.  At the time you decide to pull dollars from your retirement accounts to support the lifestyle you desire in retirement, what will your tax picture look like?  Have taxes gone up and now you are in a much higher tax bracket than what you would have expected in retirement?  If you have contributed to an employer plan for your working years, it is likely that you will have a large amount of your retirement dollars that will be taxed as ordinary income when you take distributions (i.e. IRA, 401k, etc).   It would be nice to have multiple tax buckets from which you can draw your income from. 

You may also be trying to minimize your income in retirement because you are using an ACA subsidy strategy before age 65 Medicare  (see our previous blog post about ACA Subsidies) or minimize your Part B Premiums after age 65 (Part B IRMAA Surcharge blog link).  Being able to pull income from a tax-free source like your Roth IRA gives you more options to keep your income minimized.

FLEXIBILITY

When it comes to accessing your saved retirement dollars, the Roth IRA can give you much more in terms of flexibility than your other retirement accounts.

• Contributions – All dollars you contribute to your Roth IRA are IMMEDIATELY available for withdrawal.  No penalty, no taxes.  This is not the case for a Traditional IRA where every dollar withdrawn, whether it is the contribution or earnings, is taxed as ordinary income.

• No Required Minimum Distributions (RMDs) – At age 72, for all qualified plans outside of a Roth IRA, you MUST take a distribution from those accounts in the year you turn age 72.  Even if you don’t need those dollars, which can often be the case.

• Pre 59 ½ Early Withdrawal options – While these are considered “exceptions to the age 59 ½, 10% penalty rule”, it is important to know that these options exist:

  • Education Funding – You can withdraw to pay for qualified education expenses for yourself or your child. 

  • Withdrawals to help pay expenses for birth or adoption

  • First Time Homebuyer - up to $10,000 lifetime maximum.  If you and your spouse are buying your first home, together you can pull $20,000 total from your Roth IRA’s.

  • Unreimbursed Medical expenses or health insurance if you are unemployed.

Important note:  While you will avoid the 10% pre-59 ½ penalty in the above exceptions, you will still be required to pay taxes on these withdrawals IF the account has not been open for at least 5 years. This is commonly referred to as the 5-year rule, which we will be covering those nuances in greater detail in a later article.

If Roth IRAs are this great, how do I start?  Is there a catch?

First, you need to be aware that there are CONTRIBUTION LIMITS (2022): 

• $6,000 if you are under age 50

• $7,000 if you are older than age 50. 

There’s not a catch, however, there are eligibility requirements that must be met in order to contribute to a Roth IRA. Those are:

1. You or your spouse needs to have EARNED INCOME.  Not included are dividend/interest income, income generated from IRA distributions, etc.  However, as a NON-WORKING SPOUSE, you are permitted to contribute to a Roth IRA.

2. Income Phaseout Limits (2022): 

   • If you are a Single Filer, your Modified Adjusted Gross Income (MAGI) must be $129,000 to $144,000.

   • If you are a Married Filing Jointly Filer, your MAGI must be $204,000-$214,000.

3. How the Phaseout Limits work:

   • If your earnings are less than $129,000 (single) or $204,000 (married), then you can contribute up to the maximum contribution limit of $6,000.

   • If your earnings are within the phaseout ranges, then you are eligible to contribute a reduced amount.

   • If your earnings exceed $144,000 (single) or $214,000 (married), then you cannot contribute to a Roth.

The Roth IRA is a great tool to have as you save dollars for your retirement.  The money grows tax-deferred while the money is invested. Better yet, it is a source of tax-free income when you need those dollars in retirement. All this while giving you some flexibility to access a portion of those dollars if needed before retirement. 

What is a Roth 401(k)?

Roughly 75% of employers that Fidelity serves as an administrator offer a ROTH option in their 401K plans. If you were amongst the lucky 75%, when you enrolled into your 401K and were customizing contributions, you may have noticed that you had a choice between a Traditional or a ROTH 401K. Most people select the “Traditional 401K” option, and only 13.6% opt to contribute to a ROTH account. It could very well be that majority of plan participants do not take the time to research which choice would serve them better and go with the safe sounding “Traditional” option. So, when does it make cents (HA!) to choose one over the other? The answer depends on your financial priorities now versus the future, let’s take a look.

Future Tax Rates: If you believe that tax rates will be higher when you retire, you would most likely be best served using a ROTH 401K. Math is straightforward in this case; if you are in a lower tax bracket today, why not pay a lower tax now and enjoy tax free withdrawals in your retirement? If you were to contribute to a Traditional 401K in this case, then your tax deduction today would be lower than your tax liability when you must draw on your retirement savings.

Another scenario where future tax rates will be a determining factor is if your tax bracket will not change at all. If you are very successful and in the highest tax bracket today, with no prospects of ever being in a lower tax bracket – then one might as well pay the tax today and save for retirement in an account from which withdrawals are tax-free throughout your retirement. In this case a ROTH 401K would give you more tax planning flexibility and would not contribute to your already high tax bill.

Required Minimum Distributions (RMDs): Once you turn 72 years young, the almighty IRS requires you to start withdrawing from your retirement savings accounts; 401Ks, traditional IRAs and the like. If you did the right thing and saved as much as you could into a retirement account throughout your life – but have not saved any “after-tax” funds – each and every dollar you withdraw from a retirement account will be taxable and could distort retirement income and tax picture by large annual RMDs. While there may not be such a thing as saving too much, it is possible to put too much into a “Pre-Tax” account like your Traditional 401K.

This is where a ROTH 401K saves the day – even though IRS requires to take RMDs from Traditional and ROTH 401k accounts, there is no RMD requirement for ROTH IRAs. Which means that you can do a rollover and move your savings from a ROTH 401K to a ROTH IRA – and avoid distributions, especially if you do not need the income. This ties in nicely with the next point we will review.

Legacy considerations: If you pass away and leave your heirs Traditional and ROTH IRAs – they are likely going to be happier receiving ROTH portion of inheritance. Recently passed laws require that inherited IRAs must be completely distributed over the next 10 years by your heirs. Withdrawals from a Traditional 401K or IRA may increase your heirs tax bill for the next decade. For example, if an inherited IRA balance is $500,000 and one has 10 years do deplete the account, that’s an additional $50,000 of taxable income each year, and that is without any growth!

While the original owner of a ROTH IRA does not have to take Required Minimum Distributions at all, heirs must distribute the entire account over 10 years. The difference is that distributions from ROTH IRA will not have any impact on your heirs’ taxes since distributions are tax-free.

Having both types of accounts can be helpful when planning on who to leave which dollars. A simple example we can use is if one has two offspring – one extremely successful and one that is not as lucky. Since the successful child is in a high tax bracket already, it is more tax efficient to transfer a ROTH IRA to him/her and since the second child is in a low tax bracket – it may be more efficient to leave your Traditional IRA to this child.

It is important to note that if you open a ROTH IRA account specifically for the purpose of receiving ROTH 401K Rollover funds – there is a “5-Year Rule” you must abide by. While any funds you rollover are available for withdrawal tax and penalty free right away, any growth in the account is subject to a withdrawal penalty that goes away after 5 years.

Are there any circumstances under which a ROTH 401K is NOT a good fit?

So far, we investigated circumstances under which a ROTH 401k might serve you well, lets look at the flip side of the coin and explore when a ROTH account may not be as advantageous.

Charitable Considerations: If you are planning on leaving a portion of your assets to a cause that’s close to your heart, a ROTH IRA may not be the best source of funds to do so. Since charities are non-profit organizations – they are exempt from paying income taxes. Leaving a ROTH 401K or IRA to a charity will not provide any additional benefit to the cause. So, if you have a Traditional 401k or IRA and a ROTH 401k or IRA – a much more tax efficient approach would be to leave ROTH assets to your heirs and Traditional 401K/IRA to the cause of your choice. This way, neither charity nor your heirs will have to pay any taxes. Nothing to see here IRS agent, please move on.

Future Tax Rates: If you are currently in the highest tax bracket and at the peak of your career, but you are planning on being in a lower income tax bracket before your retirement – you may want to contribute to a Traditional 401K account now and once your income drops – switch to contributing to a ROTH 401K.

Another scenario where this may work is if you are in the final stretch before your retirement, your income is high, you are in a high tax bracket and you are diligently saving to beef up your nest egg before you turn in your parking pass. If your income drops off substantially after you retire, you may come out ahead if you contributed into a Traditional 401K while you work and then after your income drops – start converting Pre-Tax dollars from your Traditional 401K into a ROTH IRA. That way your tax deduction will be higher while you worked than the tax liability from your ROTH IRA Conversions after retirement.

Employer’s Match: It is important to note that some employers will not match your contributions to a ROTH 401K and only match your contributions to the Traditional 401K. So, the first step in determining if/how to save into a ROTH 401K is to check with your HR or Plan Administrator what rules apply to you. If your employer matches only contributions to the Traditional 401K, you then should contribute to the Traditional 401k up to the employer’s match limit and any contributions above the match can go into the ROTH 401K, if permitted by your employer plan.

Conclusion: While standalone factoids and “clean” academic cases may make a ROTH 401K seem like a clear-cut winner – in reality, there is no winner in this race. Simply because no one knows what our future holds. We don’t know if taxes will be higher or lower when we retire, we also can’t be 100% certain if our income in retirement will be higher or lower. With a 30–40-year planning horizon, there is enough uncertainty to make the photo-finish image blurry. So instead of picking one over the other, it may be better to instead tax-diversify your portfolio; elect to contribute into both a ROTH and Traditional 401k plans. That way you will walk into retirement with flexibility to manage your taxes, legacy and annual RMDs that will not make your accountant gasp.

Roth Conversions: When It Makes Sense and When It Doesn’t

On the surface, converting your traditional IRA to an investment vehicle that offers tax-free benefits like a Roth IRA sounds like a great idea. Why is that? It boils down to one thing – the words TAX-FREE. Americans love the word FREE, especially when it is associated with taxes. You might be a Russian communist if (in my Jeff Foxworthy voice) … You enjoy giving the government all your money.

However, what sometimes gets overlooked about Roth conversions is that you are merely choosing when you pay your taxes on that investment – now or later. Uncle Sam is going to get his one way or another. Given this tradeoff, it’s prudent for investors to take a step back and proceed carefully.

The main reason to be cautious about Roth conversions is that the ability to reverse it, in the event you are suffering from buyer’s remorse, is no longer an option. This is thanks to a provision within the Tax Cuts and Jobs Act (TCJA), implemented in January 2018, that eliminated Roth recharacterizations. Therefore, when deciding if converting your IRA to a Roth makes sense, it’s important to evaluate several factors – your age, your income now, your income in the future, your tax bracket before the conversion, and your tax bracket after the conversion. From there it gets easier to decide how much to convert, if any.

Under the right set of conditions, a Roth conversion can be a home run. This article aims to help you sort out the situations when a Roth conversion is an effective strategy towards building your wealth, your family’s wealth, and when it’s a trapdoor that ought to be avoided.

ROTH CONVERSION BASICS

Before overviewing Roth conversion strategies and pitfalls, it’s important to understand how a Roth conversion operates. A Roth conversion is a transfer of retirement assets from a pre-tax traditional IRA, SEP IRA, SIMPLE IRA, 401(k), or other defined contribution plan into a Roth IRA or Roth 401(k). The transfer of assets can be completed via a direct rollover, a trustee-to-trustee transfer, or a 60-day rollover. Additionally, you can structure your conversions by converting the entire amount in your traditional IRA in a single year, or by spreading out those conversions over multiple years.

The consequence of the Roth conversion is that the dollar amount of assets that gets converted will be included in your taxable income during that calendar year. Whereas the advantage is that the withdrawals from the Roth IRA are eligible for tax-free withdrawals, assuming 2 conditions are met – you wait 5 years, and you are over the age of 59 ½.  

The graphic below helps to better illustrate how a Roth conversion works for a single person who is earning $75,000 and converts $100,000 to a Roth IRA at a tax rate of 24%, paying the taxes due from funds outside the IRA:

WHEN A ROTH CONVERSION CAN ENHANCE YOUR WEALTH

As it turns out, there are 6 situations that investors might benefit from doing a Roth conversion:

1) You Believe Tax Rates Will Be Higher in the Future

Basing your decision on whether to convert your traditional IRA dollars to a Roth IRA is better understood when you realize that you really are trying to decide when you want to pay taxes on your retirement assets – now or later. To keep it simple, your goal is to pay the least amount in taxes. In other words, when converting to a Roth you are footing the tax bill upfront because you expect your marginal tax rate to be lower now compared to when you are retired.

While most retirees expect their income to be lower in retirement, this isn’t always the case. In fact, Required Minimum Distributions (RMDs) have the potential to sneak up on a retiree and push them into a higher bracket than they planned for. Additionally, the lower tax rates enacted by the TCJA are scheduled to sunset at the end of 2025. What this means is that even if your income remains unchanged, when you begin taking distributions in 2026 you are likely to pay higher taxes. As you can see in the tax table below, a married couple earning $160,000 under the TCJA currently has a marginal tax rate of 22%, but when the more favorable rates sunset their marginal rate will increase to 28%.

Mercado, Darla (December 15, 2017). "Find your new tax brackets under the final GOP tax plan". CNBC.

Congress may continue to modify tax rates in the future, but of course those insights won’t be known until future legislation is passed.

2) You Experience a Drop in Income

This scenario can be the golden goose of Roth conversions. Considering that a temporary drop an income offers the IRA owner the ability to convert their retirement dollars at a lower tax rate than the rate he/she generally pays. Some situations where this might be advantageous include retirement, employment change from full-time to part-time, a loss of a job, an extended leave of absence from work without pay, or a large operating loss if you own a business.

3) You are Young

One of the attractive features associated with Roth IRAs is that they provide tax-deferred growth. This is most beneficial if you have time on your side because the compounding effect of tripling or even quadrupling your money means that you only paid taxes on the original investment. In other words, most taxpayers would rather pay taxes on $100,000 and not on $400,000. To achieve this level of compound growth it typically takes decades and is why younger investors benefit even more from Roth IRAs.

4) Your IRA Investment Portfolio is Down

Sometimes a market correction is a blessing in disguise. That might be the case if you are in a position to do a Roth conversion. Think about it this way, you own the same number of shares of stock and are converting those shares at a lower market value. For example, you own 500 shares of XYZ fund in your traditional IRA and intend to continue to hold that fund as a long-term investment – it was worth $70,000, and now it’s worth $40,000. By converting your shares of XYZ fund, you only paid taxes on $40,000 rather than $70,000.  In this scenario, you benefit from assuming that XYZ fund will eventually be worth $70,000 again at some point in the future, but you only had to pay taxes on the converted amount.

5) You Want to Reduce Taxes Related to RMDs

As previously mentioned, RMDs have a funny way of sneaking up on retirees who have a large amount of their nest egg in traditional IRAs – on the account of the fact that the taxes can be significantly higher than one anticipated. A 73-year-old IRA owner with a $5M balance is required to withdraw $188,679 from their IRA, according to the IRS’s tables. Assuming that person is single, their tax rate is already in the 32% bracket, and that doesn’t even include other potential sources of income like social security and pensions. Further compounding the issue is that the required percentage being distributed only goes up with each passing year.

6) Your Goal is to Minimize Taxes to Your Heirs

One of the other benefits of a Roth IRA is that they are exempt from the RMDs during your lifetime. Therefore, the investments can continue to grow with compound interest. Additionally, the Roth IRA passes to your beneficiaries, and they receive their mandatory distributions tax-free. This makes the Roth IRA a great wealth transfer vehicle for people who want to leave a legacy to a loved one that is in higher tax bracket than the current IRA owner.  Even if your heirs are likely to be in a similar, or even lower tax bracket, inheriting a Roth IRA might be better tax-wise because the IRS only permits most heirs to distribute the inherited IRA over a maximum of 10 years.  So, during those 10 years, if they were to inherit a large Traditional IRA with taxes owed on each year’s distribution, their income tax bracket may be much higher.

WHEN A ROTH CONVERSION MIGHT HARM YOUR WEALTH

The obvious tax advantages of a Roth IRA – which are highlighted in greater detail in our other blog article, Why Choose a Roth IRA – have made it such that Roth conversions have grown in popularity. Examples of the hysteria might include, “my BFF converted her entire IRA to a Roth, so it must be right for me… Right?” Or “I read somewhere on Facebook that I should convert everything to a Roth IRA.” Unfortunately, relying on hearsay or reading the latest trendy online article can do more harm than good sometimes.

In fact, there are 5 legitimate reasons that Roth conversions can be harmful towards building wealth, including:

1) You Are in a High Tax Bracket          

Is it really better for someone in the highest tax bracket (39%) to do a Roth conversion? While your answer is likely “no - duh.” The allure of tax-free income later in retirement has tricked some investors into thinking this is the way to go. Is it a devastating decision in most cases? Probably not. However, the tradeoff can be significant. Say you decide to convert $200,000 while in the highest tax bracket at 39%, but in retirement your tax rate (with the conversion factored in) will be 25%. You just cost yourself $28,000 in taxes. As Scooby Doo famously coined the phrase back in 1969, “Ruh Roh!”

2) Retirees Expecting to Bounce their Last Check

A Roth conversion is best avoided when an individual is likely to spend all their money in their own lifetime – whether the spend down is intended or not. The reason being is that paying a large sum of taxes upfront leaves this person with less overall financial resources at their disposal for the remaining years they intend to live on their nest egg. It’s much better to spread out the IRA tax liability over their lifetime, thereby giving that individual a better chance to stretch those dollars longer.

3) Large Tax Deductions

Individuals that are in poor health, have a chronic condition, or have a family history of Alzheimer’s/dementia may want to think twice about Roth conversions. At least during the years in which they expect to incur significant medical costs. This is because the IRS allows you to deduct unreimbursed medical expenses that exceed 7.5% of your adjusted gross income (AGI).

Therefore, individuals with higher medical bills, relative to their income, can use those deductions to reduce the income taxes generated from their IRA withdrawals and/or RMDs. As it turns out, nursing home expenses, in certain instances, can be counted as medical expenses.

Where this deduction can be taken to the next level is when an individual is considering buying into a Continuing Care Retirement Community (CCRC). That is because the person can write off a portion of their down payment as a medical deduction. Given the sums typically required upfront, the deduction in this instance can sometimes exceed the hundreds of thousands. 

4) Your Primary Beneficiary is a Charity

For traditional IRA owners who intend to give that portion of their estate to a charity – whether it be because they don’t have heirs to give their money to or they have certain funds earmarked for that purpose – converting those dollars to a Roth is an unnecessary cost. That is because qualified non-profit organizations are tax-exempt. Meaning the charity does not have to pay taxes on any distributions from a traditional IRA. Why bother paying the taxes during your lifetime and then have potentially less go to the charity? Go for the win-win instead.

5) Shorter Life Expectancy

Because a Roth conversion requires you to front-load your tax liability from you IRA, the hope is that you live long enough to reap the benefits. In most instances, retirees with life expectancies of 5-10 years considering a Roth conversion are better off keeping their money in their IRA. If we dig a bit deeper into why that is – there is a breakeven point in time when the Roth conversion becomes more economical. In other words, the taxes you paid are an eventual tax-free investment that pays off after X number of years. In most instances, the breakeven point doesn’t occur until about 15 years or later.

IS A ROTH CONVERSION RIGHT FOR YOU?

There are other atypical scenarios that can change the trajectory of the economic benefits, so if you aren’t sure if a Roth conversion is right for you, we suggest consulting with an expert or continuing to scour the internet for more information. However, I want to caution the DIY approach for novices. The numbers generated by the breakeven calculators that you will find online often need more context if you want to truly understand if a Roth conversion will benefit you or not.

High-Income Investors and Roth IRAs

If you don’t like paying more in taxes than you need to and you make a sizable income, then a backdoor Roth IRA is a strategy you may want to consider. However, before explaining how to unlock this financial planning tool to your advantage, it is important to know the boundaries we are working with.

Here are the 2023 Roth IRA phaseout limits set forth by the IRS:

• Single = $138,000 - $153,000

• Married = $218,000 - $228,000

Learn more about other Roth Strategies

IRA RULES and considerations

Why the Roth phaseout limits matter is that if you exceed those limits, contributing directly to a Roth IRA is off the table. At least it appears that way on the surface…

Something else to know is that if a person is an active participant in a company-sponsored retirement plan and their income exceeds the Roth phaseout limits listed above, then that person is disqualified from making deductible IRA contributions. Therefore, the only other tax-sheltered alternative is to contribute to a nondeductible IRA, which is funded with after-tax dollars. 

Nondeductible IRAs will grow the contributions tax-deferred until the distribution phase begins, as early as the normal retirement age of 59 ½ and no later than age 73 when required minimum distributions (RMDs) begin. Of particular importance is that the growth portion within the IRA is taxable upon distribution and must be taken out before the nondeductible contributions can be taken out. This is otherwise referred to as last in first out (LIFO) tax treatment.

Backdoor ROTH IRA to the RESCUE

A Roth IRA, on the other hand, allows the owner to grow their after-tax contributions on a tax-deferred basis and take tax-free withdrawals at full retirement.  Translation - a Roth IRA is always better than a nondeductible IRA.

You might be wondering how a backdoor Roth IRA fits in with all this financial mumbo jumbo.  Think of the concept this way, the “backdoor” is a smarter entry point for a person who wants to sneak their way into the house of Roth without being hit with IRS penalties. 

So how does one actually slip their way past the IRS’ Roth income limits?  Their “backdoor way in” begins with contributing to a nondeductible IRA, and then converting those funds to a Roth IRA within the same calendar year.

The IRA Aggregation Rule

A word of caution to high-income earners with multiple pre-tax IRAs.  All of your pre-tax IRAs are treated as one account when calculating the tax consequences of a Roth conversion. In other words, the IRS’ aggregation rule requires the owner of multiple IRAs to include a proportionate amount of any pre-tax IRA balances (traditional IRAs) with their after-tax IRA balances (nondeductible IRAs) whenever performing a Roth conversion.

Example.  A successful attorney, Atticus Finch, is age 55 and is considering all of his options for tax sheltering as much money as he can. He currently earns $400,000 and exceeds the IRS’ Roth phaseout income limits. He is an active participant in his company 401(k) plan. Therefore, he is unable to contribute directly to a Roth IRA and does not get a tax deduction for contributing to a nondeductible IRA. Additionally, Atticus owns a Traditional IRA worth $100,000. Atticus is unsure whether or not he should convert his recent nondeductible IRA contribution of $7,000 to a Roth IRA.

Problem. Unfortunately for Atticus, his $7,000 nondeductible amount gets rolled in with the $100,000 of pre-tax IRA funds when he goes to complete the Roth conversion. Meaning only 6.5% ($7,000 / $107,000) of the conversion is sourced from the nondeductible IRA, and the other 93.5% gets converted from the traditional IRA. Because most of the conversion is from the traditional IRA, Atticus is paying taxes on $6,545. If he is single and his tax bracket is 35%, the backdoor Roth IRA strategy just cost him $2,291 in taxes. Needless to say, Atticus isn't happy the next year when the IRS says he has to cough up more in taxes. While it's technically not double taxation, most people who make this mistake feel that way.

Solution. The way that Atticus can prevent this problem is by rolling over all of his Traditional IRA funds to his law firm's 401(k) retirement plan. That is because 401(k), 403(b), and other employer-sponsored retirement plans are excluded from the IRA aggregation rule. The benefit of doing it this way is that Atticus doesn’t pay any taxes on the conversion and he gets the full benefits of a Roth IRA. It’s important to know that employer-sponsored SIMPLE IRAs and SEP IRAs fall within the IRA rules when considering a backdoor Roth conversion.

SUMMARY GUIDE TO PERFORMING A BACKDOOR ROTH

STEP 1 - Confirm there are no other pre-tax IRAs

STEP 2 - When there are pre-tax IRAs, rollover the funds to a 401(k)

STEP 3 - Contribute to a nondeductible IRA

STEP 4 - Convert to a Roth IRA in the same calendar year

The Mega Backdoor Roth Strategy

This must be an important topic because why else would the word MEGA be in the title?  There’s Megatron - leader of the Decepticons, Mega Man of the video game series and state lotteries title their big jackpots as Mega Millions.  So, this must be a BIG DEAL, right?

Well, it is and so much so that you’ll see political parties trying to ax this strategy every so often.  But until that happens, it’s important to know what this is, how it works and when you would want to use this strategy.

What is a Mega Backdoor Roth?

A Mega Back Door Roth is a strategy that allows you to get A LOT of dollars into a Roth IRA when you normally wouldn’t be able to if you’re a high earner.  In 2022, if you are filing as a Single or Head of Household, you cannot contribute to a Roth IRA if your income is $144,000 or more.  For those Married Filing Jointly filers, the income limit is $214,000.  A way around direct contributions into a Roth IRA are Roth Conversions which we covered in a previous blog.  We’ve also blogged about Backdoor Roths which then use the Roth Conversion strategy by contributing to a non-deductible IRA and then converting that contribution to a Roth IRA shortly after the nondeductible contribution is made. 

So, how can we turn these Backdoor Roths into MEGA Backdoor Roths? 

By leveraging your ability to MAKE AFTER-TAX 401(k) contributions.  These are contributions made ABOVE your normal 401k contribution limits.

Here’s an example:  Let’s say you are age 60, hoping to retire in 5 years and have extra dollars to boost your retirement plan assets.  The maximum employee contribution you can make in 2022 is $27,000 ($20,500 + $6500 age 50+ catch up).  You’ve already maxed out your employee contributions and have made the maximum after-tax contribution to your Traditional IRA with which you did a backdoor Roth conversion.  If your employer’s 401k plan allows – check your 401k Summary Plan Description – you can contribute additional dollars to your plan as long as YOURS AND YOUR EMPLOYERS contributions do not exceed $67,500 ($61,000 + $6500 age 50+ catch up).  

• Your Employee Contribution                  $27,000

• Your Employer’s Contributions              $12,000

• Total 401k Contributions           $39,000

• Your AVAILABLE ADDITIONAL contributions that can be made:  $28,500 ($67,500 - $39,000). 

This is your MEGA BACK DOOR ROTH Contribution amount.  This is STEP 1.

STEP 2 – Take an In-Service Withdrawal from your 401k and immediately roll those dollars into a Roth IRA.  You can pull out those after-tax contributions with NO penalties or taxes as long as your employer plan allows for in-service withdrawals (again, check the 401k’s Summary Plan Description). 

It’s important to note when you do the in-service withdrawal that there are no penalties/taxes on CONTRIBUTIONS.  That is not the case with the EARNINGS on those contributions.  In that case you would have to pay taxes on those earning AND if you are younger than 59 ½, a 10% penalty.

What if your plan DOESN’T allow for in-service withdrawals?  That would mean you would have to wait until you leave your job to move the money into the Roth IRA.  At that point, you can still roll the after-tax contributions into your Roth, but then the EARNINGS on those contributions would be taxed as ordinary income when you take them out of the IRA.

When should you use this strategy?

This is a GREAT strategy to get a TON of money into a Roth IRA, but you MUST have a lot of additional money to put aside for savings. 

Generally, you will first max out your contributions to your 401k to get the upfront tax break. Then if you are under Roth income limits, you (and your spouse) will want to max out your contributions to your Roth IRA.  Direct contributions to a Roth are much easier than the steps required to do a Mega Backdoor conversion.   

The bottom line is this can be an amazing tool if you are a Super Saver and have the excess cash to really boost your retirement savings.  Because of the intricacies of this strategy, you may want to consider getting professional advice to implement this the correct way and not cause unintended tax consequences for you now or in the future.

Roth IRA 5-Year Rule: What You Need to Know

As you prepare for retirement, a Roth IRA can be a wonderful way to build and grow your nest egg. The tax-free benefits previously discussed in our article, Why Choose a Roth IRA, are a major reason why investors gravitate towards owning a Roth IRA. However, the IRS is not in the habit of letting money just come and go willy-nilly, especially when it comes to tax-favored investment vehicles. Therefore, the Roth IRA has strict rules around contributions and withdrawals. This article focuses on one element of the withdrawal rules – the Roth IRA 5-year rule.

There are 4 key situations to understand when it comes to the 5-year rule:

1. Withdrawal of earnings

2. Rolling over a Roth 401(k) to a Roth IRA

3. Converting a traditional IRA to a Roth IRA

4. Inheriting a Roth IRA

The point of understanding these rules is to avoid paying unnecessary taxes or penalties to the IRS. If you aren’t careful, the resulting condition is a sad face.

WITHDRAWAL OF EARNINGS

The 5-year rule stipulates that you must wait to withdraw earnings tax-free until it has been at least 5 years since you first contributed to a Roth IRA account. This applies regardless of age – even if you are older than 59 ½, which is the age when retirees are eligible to withdraw money from their Roth IRA without incurring a 10% IRS penalty. Put another way, if the Roth IRA owner is younger than 59 ½, they may withdraw the original principal without paying an IRS penalty, however, the earnings portion that is taken out is subject to regular income taxes and a 10% IRS penalty. 

Of note, the 5-year waiting timeline begins January 1st of the year you made your first contribution. Therefore, if you contributed to your Roth IRA on December 1st, 2022, you are permitted to count the entire year towards the 5-year rule. In fact, you have until April 15th of 2023 to make a prior year contribution to your Roth IRA and have it count towards the 5-year rule.

Let’s say you are 58 years old, and you contributed $7,000 to your Roth IRA on April 15, 2023 – your 5-year waiting period ends on January 1st, 2027 because the 5-year clock started January 1st, 2022.  On or after 1/1/2027, you are permitted to withdraw both the principal and earnings without any taxes or penalties. Any withdrawals that include earnings occurring before January 1st, 2027, are subject to both taxes and a penalty. There are a few exceptions that allow you to avoid the penalty that will be covered in an upcoming blog article about withdrawals from Roth IRAs.

Another wrinkle applies to investors with multiple Roth IRAs. In this situation the 5-year clock starts ticking once the first Roth IRA is established. Once you have satisfied the 5-year rule for one Roth IRA, you have satisfied it for any additional Roth IRAs that you may open later.

ROLLING OVER A ROTH 401(K) TO A ROTH IRA

The 5-year rule must also be met in situations when you own a Roth 401(k), terminate employment, and decide that you want to rollover your Roth 401(k) to a brand-new Roth IRA. Unfortunately, the period of time that you owned your Roth 401(k) does not count towards the 5-year waiting period. On the other hand, you do not have to wait if you rolled your Roth 401(k) into an existing Roth IRA that you established more than 5-years ago.

CONVERTING A TRADITIONAL IRA TO A ROTH IRA

For those that have not met the 5-year rule and are under the age of 59 ½, withdrawing funds from a Roth conversion will trigger a 10% IRS penalty on the entire converted amount and you pay income taxes on any earnings. For those over 59 ½ the earnings are taxable. Regardless of age, this can be a very costly mistake when making substantial Roth conversions. To get more information about Roth conversions, check out Roth Conversions – When It Makes Sense and When It Does Not.

Income taxes are paid when converting a traditional IRA to a Roth IRA during the calendar year the conversion was executed. Also, in such instances the 5-year waiting period begins during the calendar year that the conversion took place. In other words, if you converted $20,000 in March 2020, the 5-year period begins January of 2020. This is not to be confused with how Roth contributions are able to take advantage of the tax year and get an extra 4 months to squeeze it in because of the April 15 deadline.

What can get messy with Roth conversions is that each conversion has its own 5-year period. For example, if you converted $100,000 to a Roth in 2020, that has its own 5 year waiting period that ends December 31st, 2024. Now say you converted another $50,000 in 2022 – that 5-year waiting period ends December 31st, 2026.

Given that there are different ways to get money into a Roth IRA and the varying timing of conversions, the IRS has ordering rules that determine what gets taken out first. When it comes to conversions, the oldest conversions are to be withdrawn prior to subsequent conversions. Untangling this a bit further, the order of withdrawals for Roth IRAs are contributions first, followed by conversions, and then earnings come out last.

INHERITING A ROTH IRA

Inheriting a Roth IRA may seem straightforward at first glance because the distributions are free from income taxes. This is true if the Roth IRA of the decedent was opened 5 or more years prior to their death. However, if the deceased owner of the Roth IRA did not satisfy the 5-year rule – either because the Roth IRA was recently opened or there was a recent Roth conversion – then the beneficiary must finish out the remaining years not yet satisfied within the 5-year rule. Otherwise, the earnings or converted amount are subject to taxes.

Due to the withdrawal ordering rules taxes can sometimes be avoided. The challenge is that the SECURE Act and rules around required minimum distributions (RMDs) have evolved to where non-spouse beneficiaries are forced to distribute the entire inherited Roth IRA within 10 years of the account owner’s death.

Alternatively, spouses can continue using the previous stretch rule that allowed the beneficiary to take distributions based on their own life expectancy rate. Other exceptions that allow for the Roth IRA stretch include:

• You are a minor child of the original owner.

• You are chronically ill or disabled in accordance with IRS definitions.

• The original Roth IRA owner was less than 10 years older than you.

• You inherited the Roth IRA prior to 2020 (before the SECURE Act took effect).

ADDITIONAL RESOURCES

To get more information and examples about the distribution rules from Roth IRAs, you may refer to chapter 2 of IRS Publication 590-B. In addition, if would like a better understanding of the ins and outs of various Roth planning techniques, we have an entire page dedicated to it called Roth Strategies.

Asset Location and Roth Accounts

You’ve probably heard so much about “Asset Allocation” that you may have thought I left out “A” in the title by mistake. “Asset Location” is not talked about nearly as often but has the potential to impact the bottom-line of investment account performance. The premise behind this strategy is rather simple; some investments are more tax efficient than others. The 3 most often used investment accounts have different tax treatment. So, there may be tax advantages to buying the least tax efficient investments in the most tax efficient accounts, and vice versa. Right? You may have also just realized exactly why this is not a cocktail party topic – it’s boring, and probably difficult to follow after a few drinks.

First Things First: I need to explain a few details that will serve as a foundation before we can put our nerd hats on. The 3 account types I mentioned above are:

1. Taxable accounts – these are your regular brokerage accounts without restrictions typical for retirement accounts, but also do not have any tax deferral features. You pay taxes on gains, interest, and dividends in the year they are realized.

2. Tax-deferred accounts – think of your 401K or your IRA. Gains, interest, and dividends are not taxed in the year realized. Instead, every dollar withdrawn from these accounts during retirement is taxed as ordinary income, because you received a tax deduction when you contributed into your 401K. In other words, dollars in these accounts have never been taxed, grew tax free and therefore are taxed upon withdrawal.

3. Tax-Exempt accounts – any account with the ROTH prefix and Health Savings Accounts are great examples. Funds contributed into your ROTH account have already been taxed so it would only make sense that withdrawing funds you already paid taxes on would be a tax-free transaction. Gains, interest, and dividends are also not subject to tax upon withdrawal from a ROTH account and is a tax benefit to encourage people to save for their retirement. Health Savings Accounts are completely tax exempt if used to pay qualified medical expenses, we looked into these accounts a while back, you may see the previous blog post HERE.

Moving Assets: When we refer to “moving” assets from one account to the other in this article, we do not mean physically transferring dollars or securities. Moving funds between accounts may result in a taxable transaction and do more harm than good. Instead, we are assuming that dollars are in accounts already and we are purchasing certain holdings in one account instead of the other, thus in theory moving them from one account to the other – but not in practice.

Calculators Out! A good place to start is to try and quantify expected benefits from moving assets into type of accounts best suited for them based on tax characteristics. For this we will turn to Michael Kitces’ article called “Asset Location for Stocks in a Brokerage Account Versus IRA Depends on Time Horizon”. In this analysis we assume that we have $1,000,000 to invest and it will be split 50/50 between Stocks and Bonds and see what the final after-tax result is after 30 years of growth between different accounts. We will assume that stocks grow at 8%, and pay a 2% qualified dividend which is taxed at 15% rate annually, and bonds pay 5% interest that will be taxed annually at 25% tax rate. Let’s take a look at the results:

Please note that I altered the table shared in the original analysis to include ROTH IRA outcomes which are IRA outcomes before taxes, hence same figures in gross and after-tax estimates in Scenario 3.

The conclusion we can make from reviewing the table above, is that any and all investments should be kept in a ROTH IRA. Since that is not realistic, let’s ignore Scenario 3 for the time being. Comparing scenarios 1 and 2 would suggest that bonds are best held in tax-deferred accounts and stocks should be purchased in taxable accounts. That would be true if one would never rebalance their portfolio over 30 year investment horizon. But how does turnover affect our comparison of assets held in taxable accounts? Michael Kitces to the rescue:

Rebalancing your portfolio has a significant impact on the final value of your portfolio and a turnover of just 10% (which means that your portfolio would completely change over a decade) will make it worth less than if you kept stocks in an IRA.

We can say with a great degree of confidence that it would be best to keep high-growth, tax-inefficient assets in tax-deferred or tax-exempt accounts, holdings with low expected returns can be kept in any account as impact will be limited either way and tax efficient assets with high expected returns should be placed in taxable accounts. An intuitive way to visualize this relationship is to graph the expected return of investments across the vertical axis vs. tax efficiency along the horizontal axis:

To button up this discussion we should look at the tax treatment of various investment vehicles and which account would most likely be suitable to keep them in:

Conclusion:

The best account to keep any assets in is a ROTH IRA – if one does not have to incur taxes to fund a ROTH IRA. Keeping assets in tax-appropriate accounts could potentially benefit investors. To some extent Asset Location is already considered when managing a portfolio – you will not find municipal bonds in an IRA or amongst investment choices for a 401K plan. The same applies to Master Limited Partnerships and other holdings that are most beneficial to hold in taxable accounts.

The real issue comes about when theory meets the real world. Most clients retire with a large IRA, a significantly smaller taxable account, and perhaps some funds in a ROTH IRA. This lop-sided dollar distribution will present issues to the asset manager. Therefore, depending on the size of the balance, a ROTH IRA may end up holding ONLY the most aggressive of holdings, due to its small size. Taxable accounts with the most “normal” asset distribution consisting of municipal bonds and equity ETFs. Meanwhile IRAs would have to be largely comprised of REITs, high-turnover mutual funds, and corporate bonds.

Aiming for tax efficiency is all well and good but explaining why someone’s ROTH IRA is 10 times more volatile than the other two accounts is an entirely different story. Another thing to consider, since assets with the highest expected returns tend to also be most risky – and if we stuff a ROTH IRA full of them which then blows up during a market downturn – we just eliminated the most tax efficient account a client may have had. In this situation it is best to abide by the “Everything in Moderation” rule or as most advisors will tell you – “This is where science meets art”.

Limitations:

It is important to understand that this analysis looks at how to allocate assets that are ALREADY IN these accounts and is NOT a good source of information to determine which accounts to save INTO. It is because one would have considered income taxes on dollars to be placed into taxable accounts and ROTH IRAs. This would change our starting point to $500,000 for IRAs and $350,000 for taxable accounts and ROTH IRAs if we assume 25% income tax rate. Needless to say – the outcome could be very different and is beyond the scope of this review.

Another limitation of this review is that we look only at results at the end of 30 years; shorter investment horizon results could have different outcomes and different breakeven points.

Roth Withdrawals: How to Maximize Your Tax-Free Money

You took great advice from a friend years ago to open and start contributing to a Roth IRA.  Over time you have employed other strategies like Roth Conversions and Backdoor Roth IRAs to boost your Roth IRA balances.  Now it’s time to start drawing from those dollars.   In a previous blog post, Roth IRA Owners Beware of the 5-Year Rule we touched on the 5-year Rule that must be adhered to in order to ensure that your distributions from your earnings are TAX FREE when you take them.  Because after all, isn’t that the greatest benefit of owning a Roth IRA? 

What other things must you consider before taking distributions from your Roth IRA?

• First, you can distribute ALL CONTRIBUTIONS you’ve made to the Roth IRA TAX FREE.  Those will be the first dollars that come out of the account.  You’ve already paid taxes on these dollars when you earned them.  The IRS is not going to penalize you a 2nd time by taxing your contributions on the way out.  And there is no 59 ½ rule here.  You can take out contributions ANYTIME even if you are under age 59 ½.

• AVOID the 10%, Pre-59 ½ Penalty Rule.  Don’t distribute any investment earnings in your Roth IRA before A59 ½, otherwise you will pay a 10% penalty on that amount.  HOWEVER, the IRS does give some exceptions that will allow you to avoid the penalty before 59 ½.

EXCEPTIONS:

• First-time home purchase – You are allowed up to $10,000 to help pay for a first-time home purchase.  If you are married, both of you can take this amount to help buy that first home.

• You become disabled or pass away.

• Qualified Education Expenses (Must adhere to 5-year rule - it’s been more than 5 years since you first contributed or converted) – things like tuition, fees, books, supplies and if enrolled at least half time, room and board qualifies as well.  This can be used for you, your spouse, child, or grandchild.

• Qualified Expenses for Birth or Adoption (5-year rule applies) - Limited to $5,000 per birth or adoption.  This is a relatively new exception that came about via the SECURE ACT that was signed into law in December 2019.

• Unreimbursed medical expenses or health insurance if unemployed (5-year rule applies).

Required Minimum Distributions (RMDs)

There are NO Required Minimum Distributions for Roth IRAs.  Unlike Traditional/SEP/SIMPLE IRA’s and 401k’s that require you to take RMDs the year you turn age 72, Roth IRA’s do not have that requirement.   Why might that be?  Well, one reason could be because the IRS doesn’t have any skin in that game.  When you take out your Roth dollars, those dollars have already been taxed, so it’s not as if the government is missing that revenue if you never take those earnings out of your Roth IRA.  No matter the reason, it is a great benefit to be able to keep those tax-free earnings growing for you in the stock market.

What if it’s an Inherited Roth IRA?

In this case, just like an Inherited Traditional IRA, you must take your Required Minimum Distributions.  However, if those assets had been in the original owner’s account for 5 years or more, these RMD’s are still TAX FREE.

Some other Considerations….

• IRA 60-Day Rule

Let’s say you have an emergency that needs immediate funding.  You recently purchase a home and that has temporarily depleted your “rainy day” funds in your bank account.  Is the Roth IRA an option if you don’t meet the 59 ½ rule or the 5-year rules?

YES – the IRS allows you to “borrow” from your Roth IRA without paying taxes or penalties IF YOU REPAY THE AMOUNT WITHIN 60 DAYS.  This is essentially a short-term, interest free loan, but do not miss the 60-day deadline.  If you do, you could face taxes and penalties.

One other caution – this can only be done once every 12 months.  So, if you took a 60-day distribution on October 1st and repaid the Roth IRA on December 1st, you would not have this option available to you again until October 1st the NEXT YEAR.

• SHOULD YOU withdraw from your Roth IRA?

What if you have other options to access dollars?  Maybe you’ve built up a nice nest egg that also includes a Traditional IRA portfolio that received a large 401k rollover from previous employer.  We know that a Roth IRA has amazing tax benefits that can grow and compound over time.  You might consider NOT taking advantage of those tax-free dollars just yet.  Why?

You might be in a particularly low tax year.  Let’s say you had a tremendous amount of tax deductions this year and now you are suddenly in the 12% tax bracket instead of 22%.  You need to take a withdrawal from your investments to cover significant home repairs before year end.  You know that this year is an anomaly, and you won’t have those same deductions next year and you will likely be in the 22% bracket. 

In this instance, it might make sense to take a distribution from your Traditional IRA or 401(k) knowing that you will have to pay taxes on those dollars, but at the LOWER TAX RATE of 12%.  This will allow you to leave your Roth IRA account untouched and continuing to grow in the markets where all that investment growth is then TAX FREE. Better yet those future withdrawals can be used when you are in higher tax years.

The bottom line is Roth IRAs are a fantastic savings tool as they provide an opportunity to take out dollars TAX FREE, but it is also important you are clear about the specific rules on how to distribute those dollars without incurring penalties or having to pay taxes.

Roth Strategies to Build a Secure Retirement

Roth IRAs and Roth 401(k)s are exceptional tools in any retirement plan, offering tax-free growth and withdrawals. By understanding the nuances of Roth accounts—when to use Roth conversions, how to optimize high-income strategies like the Mega Backdoor Roth, and how to withdraw funds strategically—you can build a retirement plan that maximizes your tax-free income.

The key to leveraging these Roth accounts effectively is understanding your personal financial situation and adjusting your approach based on current and future tax rates, investment returns, and your retirement goals. Whether you are looking to avoid RMDs, leave a tax-free inheritance, or simply enjoy tax-free income in retirement, having a well-planned Roth strategy will ensure you get the most out of these valuable accounts.

For personalized advice and a strategy tailored to your retirement goals, reach out to our team of financial advisors. We can help you create a tax-efficient retirement plan that takes full advantage of Roth IRAs and Roth 401(k)s.