Some have hailed the Roth IRA as one of the best investment vehicles for your retirement savings. It’s so good that Congress frequently tries to pass legislation limiting who can use them and how much you can put into one. But what’s all the fuss about?
What is a Roth IRA?
A Roth IRA is an individual retirement account that lets you invest for retirement with after-tax dollars. The growth of those investments is tax-free. And when you pull the money out in retirement, the distributions are tax-free.
Contrast that with a traditional IRA, where the contributions are made pre-tax. The investments grow tax-deferred, not tax-free. The taxes are paid when you pull the money out in retirement.
A good analogy is a farmer who either chooses to pay tax on the seed he plants or the harvest that he reaps. The Roth IRA is a tax on the seeds. The traditional IRA is a tax on the harvest.
But which one is the right choice?
If you think your future tax rate will be higher, use the Roth IRA. It makes more sense to pay the tax now at a lower rate and never again pay any tax on that money.
If, on the other hand, you think your tax rates will be lower in the future, then use the traditional IRA. It makes more sense to defer the tax and pay it at a lower rate in the future. However, I don’t know of too many people who think tax rates will be lower in the future.
Roth IRAs offer greater flexibility than other retirement accounts.
Your contributions to the Roth can be removed from the account without penalty. The same is not true with a traditional IRA.
Several qualified withdrawals let you take the earnings out before retirement and not be subject to an early withdrawal penalty. For instance, buying a home, paying for college, or paying a medical bill.
Roth IRA Limitations
The Roth IRA is a great tool. But it does have limitations, the biggest of which is that not everyone qualifies to make Roth IRA contributions. In addition, there are income limits after which you are prohibited from contributing to a Roth.
For the tax year 2022, you can contribute up to $6,000 to a Roth IRA, and $7,000 if you’re 50 or older. But once your income is more than $144,000 for singles or $214,000 for married couples, you can no longer make Roth IRA Contributions. That’s bad news for high-income earners. But there is a way to work around the income restrictions by making an indirect Roth IRA contribution, or what is commonly referred to as the Backdoor Roth IRA.
The Backdoor Roth IRA
The Backdoor Roth strategy is a simple strategy to execute, but it carries nuanced tax implications. The simplest way to execute a backdoor Roth is first to contribute after-tax dollars to a non-deductible IRA. Then, convert that contribution to a Roth IRA. It’s as simple as that. You received no tax deduction on the initial contribution, so you pay no tax on the Roth conversion. You’ve funded your Roth, and now that money can grow tax-free for the rest of your life. That, ladies and gentlemen, is the Backdoor Roth IRA.
Beware of the missteps.
Now, there are a couple of tax traps to look out for when executing a backdoor Roth IRA strategy. The first is that any earnings inside the non-deductible IRA converted to a Roth will be subject to ordinary income tax upon conversion. For this reason, it’s a good practice to leave the contributions in cash and not invest them until they have been converted to a Roth.
The second and biggest tax trap involves the IRS’s pro rata rules. I don’t want to get too far in the weeds on this, but if you have other tax-deferred retirement money sitting in traditional IRAs or SEP IRAs, a portion of your backdoor Roth becomes taxable. The easiest way to avoid this is to have zero balances in all your tax-deferred accounts. That can be accomplished by converting those accounts to Roth IRAs and paying the tax or rolling them into an employer plan, such as a 401k if your employer plan allows for that.
The third thing to be aware of is that Roth conversions are not the same as Roth Contributions. Roth contributions can be pulled out of the account anytime, without penalty. Roth conversions, on the other hand, must sit in the account for five years before they can be withdrawn penalty-free.
The Backdoor Roth strategy is best executed with the guidance of a financial planning professional. At DeBlanc Wealth Management, our team of financial advisors and CPAs is here to help you execute this strategy to reap its rewards and avoid the tax traps.
This is just one of the tools we use at DeBlanc Wealth Management to help our clients build tax-free wealth. If you are interested in learning more about how we can help you build tax-free wealth, please contact us to get started.
Wealth management services are offered through DeBlanc Wealth Management, LLC., a Registered Investment Advisor and sister company of DeBlanc, Murphy, and Murphy, LLC.