How To Boost Your Tax-Free Retirement Savings
Roth and Traditional IRAs share a name but are total opposites from a tax perspective. Regular IRAs are tax deferred meaning you potentially pay the highest tax rates possible in the future whereas the Roth IRA incurs tax today in exchange for never paying any taxes in the future.
Obviously a zero tax IRA is preferable to a high tax IRA, but it’s much harder to meet the qualifications to get money into the lower tax situation. There are prohibitions above certain income levels, and you must leave the money in the account for at least 5 years before you can withdraw without a penalty. That said, a Roth retirement account is a good savings vehicle for investors who want a tax-free source of retirement income.
How can you start saving?
Roth IRA
One way you can build your tax-free retirement savings is by contributing directly to a Roth IRA. However, eligibility is dependent upon income—you cannot contribute anything to a Roth IRA if your income is over $144,000 (single) or $214,000 (married).
1 For those earning more, getting funds into a Roth IRA may require a conversion—which I’ll come back to later.
Roth 401(k)
Another way to boost your tax-free savings is by utilizing a Roth 401(k) plan, which some employer retirement plans offer. Like a Roth IRA, contributions are taxed today but don’t incur tax in the future. Conversely, a Roth 401(k) does not have income eligibility requirements and allows savers to contribute more then they could to an IRA—the 2022 contribution limit for 401(k) plans is $20,500 while the IRA limit is $6,000.
1Reach out to your plan administrator or HR person to see if your employer’s plan provides a Roth savings option.
Roth Conversion
If you cannot use either of the options above to get tax-free retirement savings, you might want to consider a Roth conversion or as some call it a back door Roth. Simply put, you pay the taxes on regular IRA funds now, move them to a Roth IRA account to grow, and they aren’t taxed later.
We help our clients execute this conversion using two different methods:
Convert Existing IRA or 401(k) Funds
With this method you would move your existing savings from a traditional IRA to a Roth IRA and pay ordinary income tax on the conversion amount.
For example, let’s say you have $100 in a regular IRA that you want to move to a Roth. Assuming you pay the highest marginal tax rate (37%), you would be taxed $37 for the conversion. Leaving you with 100 – 37 = $63 that moves to a Roth IRA where it then grows tax free.
Contribute Post-Tax Dollars Then Convert
In this scenario, you contribute after-tax dollars to a traditional IRA—contribution limits apply
1—without getting the tax deduction. Then move the funds from the traditional IRA to a Roth IRA.
With this conversion you have to be extremely careful about comingling pre- and post-tax funds. Otherwise, your regular IRA distributions—which are done pro-rata—would incur tax, even if you have post-tax funds in the account. Therefore, we recommend that our clients set-up a new IRA account specifically for their post-tax contributions and that they do their Roth conversion soon after the contribution is made. Additionally, it’s a good idea to work closely with your tax preparer to file the correct forms with the IRS.
Why does a pro-rata distribution matter? Let’s say you did comingle the pre- and post-tax funds but didn’t convert your post-tax funds to a Roth IRA. So, you have a regular IRA with $200 of tax deferred funds and $100 of post-tax contributions. If you want to withdraw $100, you cannot take only the $100 of tax-free money out, your withdrawal needs to be proportional to your pre- and post-tax holdings. So, only 1/3rd of your withdrawal could be tax-free, the remaining 2/3rds would be taxed as ordinary income.
If you had converted the after-tax funds into a Roth IRA when you originally made the contribution, you would have been able to take the full $100 from your Roth IRA since it’s not subject to the pro-rata distribution.
A Roth conversion may not be suitable for everyone, so you should work with a financial advisor to evaluate your options and get help from a CPA to ensure you pay the correct taxes. If executed properly, Roth conversions provide wealthy people with a tax-free savings vehicle that they may not have access to otherwise.
If you need help evaluating if a Roth conversion is a good decision for you, get in touch with us today!
