It’s widely known that Roth IRAs can be a great vehicle to save for retirement as they offer tax-free growth. However, after more than 20 years (Roth IRAs were established by the Taxpayer Relief Act of 19971, there are still some people out there who worry that Congress will change the rules and tax Roth money when we withdraw. In a recent article, self-proclaimed “IRA Expert” Ed Slott said, “Roth 401(k)s and Roth IRAs are a cash cow for the government, and the fact that they keep bringing up ideas like Rothification to expand Roth-type retirement accounts shows that they want more Roths, not less. Since Roths have existed, Congress has been expanding access to them, because it brings in more revenue.”2
So, if you’re late to the Roth game or want to find ways to “supersize” your Roth, consider these six strategies.
1. Regular Roth IRA Contributions
The first and simplest way to get dollars into a Roth is to make regular, annual contributions. However, income limits apply which are based on Modified Adjusted Gross Income (MAGI). Your MAGI is determined by taking your Adjusted Gross Income (AGI) and “adding back” certain deductions.3 Most tax preparation software programs will calculate this based on information you input and provide you with your IRA contribution eligibility (or lack thereof). For 2019, single filers with less than $122,000 MAGI and married couples filing jointly with less than $193,000 MAGI can make the full Roth contribution of $6,000 (or $7,000 with the “catch-up” contribution for those age 50+). Note that you or your spouse, in the case of a “spousal contribution,” must also have earned income of at least the amount you’re contributing to your Roth IRA.
2. “Backdoor” Roth IRA Contributions
If your income is too high to contribute to a Roth IRA directly, you may want to consider a practice commonly known as a “backdoor” contribution. This refers to contributing to a Traditional IRA and then converting it to Roth. This became popular starting in 2010, when income limitations on Roth Conversions were eliminated.4 This strategy works best with non-deductible contributions for those who don’t have any existing pre-tax IRA assets, including SEP or SIMPLE IRAs. If this is the case, the after-tax portion of the Roth conversion is then tax-free; however, any earnings would be subject to tax for the year the conversion was made. If other pre-tax IRA assets do exist, the “IRA aggregation rule” comes into play and a portion of the after-tax dollars being converted would be taxable.5
The “backdoor” Roth strategy has long been questioned as to its legality. However, on July 10, tax law specialist Donald Kieffer Jr., IRS Tax-Exempt and Government Entities Division, said on a Tax Talk Today webcast, “The ‘backdoor’ Roth method – which involves contributing to a traditional IRA and then converting to a Roth IRA – is allowed under the law.”6
3. Roth 401(k) Contributions
Many defined contribution plans now allow Roth 401(k) contributions, which have the same tax treatment as Roth IRA contributions, but with a much higher contribution limit ($19,000, or $25,000 for individuals age 50+ when including the “catch up” contribution) and no income limits.7 Roth 401(k) dollars can be rolled into a Roth IRA upon separation from service (from one’s employer) or at retirement. Although, if an employee receives a company match on a Roth contribution, the company match will be a pre-tax contribution.8
4. After-Tax 401(k) Contributions
Some defined contribution plans allow contributions above the standard limits set by section 402(g) of the Internal Revenue Code (i.e. the $19,000 or $25,000 mentioned above). It works like this – participants whose plans qualify defer up to the Section 402(g) limit and receive any employer matching and/or profit-sharing contributions. Then, they contribute additional money up to the Section 415 limit ($56,000 in 2019, or $62,000 if age 50+) as an after-tax contribution.9 That money can then be converted to Roth in the same year the taxes were paid, if the plan allows in-plan Roth Conversions, or rolled directly to a Roth upon separation from service or retirement; however, earnings on those dollars would need roll to a pre-tax IRA or be taxable in that year as a Roth Conversion.
5. Roth IRA Conversions
Income restrictions for Roth IRA conversions were lifted in 2010 making it an attractive strategy to consider during low tax years. For example, let’s say you retire at age 64, don’t have a pension, delay the start of Social Security until age 70 and have enough after-tax investments to live off of, before you’ll need to tap into pre-tax 401(k) and IRA assets at 70.5 – when you’ll need to begin taking annual Required Minimum Distributions (RMDs). Under this scenario, you’ll likely be in a lower income tax bracket from age 65 to 69, giving you five years to convert pre-tax IRA dollars to Roth at a “discount” to the tax rate you’ll be paying post-age 70.5 when you’ll have RMDs and Social Security income. Today’s lower tax rates, due to the Tax Cuts and Jobs Act (TCJA), make this strategy especially attractive, as my bet is that tax rates will likely be higher again in the future, either when the TCJA law sunsets after 2025, if not earlier – if Congress changes the tax code prior to then.
6. 401(k) In-Plan Roth Conversions
Also called an in-plan Roth rollover (IRR). Similar to a conversion of pre-tax IRA assets to Roth, some defined contribution plans allow in-plan rollovers to designated Roth accounts within the same plan. This results in the entire amount of the rollover, including earnings, being included in gross income, less any basis in the amount transferred.10 This option could be attractive for a variety of reasons, such as: Roth wasn’t previously allowed in your plan and you’re willing to pay some tax now in order to get dollars into the new Roth account for tax-free growth; your spouse recently stopped working and you’ll be in a lower tax bracket this year; or, you’ll be in a lower tax bracket this year for some other reason, for example a business loss.
As you can see, there are several ways to build your Roth IRA assets, even if you’re nearing retirement. Having Roth assets provides a lot of flexibility when it comes to managing your tax bracket in retirement, as you have different tax “buckets” to draw income from. When taking Roth distributions, you’ll need to keep the various 5-year rules in mind, based on whether dollars were Roth contributions or Roth conversions. Work with a tax and/or financial advisor who is well-versed in Roth IRA rules to avoid any unintended early withdrawal penalties.
A good tax advisor can also be an invaluable resource to aid in running tax projections to help decide on amounts to convert to Roth in a specific year and/or how much to take out of pre-tax vs. Roth IRA “buckets” in any given year during retirement. A well-planned Roth strategy can potentially save you thousands of dollars in taxes – well worth the time and cost of planning ahead and working with professional advisors to execute it properly.