Three years back, the revelation of billionaire Peter Thiel's Roth IRA, ballooning from a modest $2,000 investment in 1999 to an eye-popping $5 billion, captured the media's attention. This extraordinary growth is not necessarily replicable but does highlight the power of Roth IRAs and also raises a pivotal question: How can Roth IRAs, designed to help Americans save for retirement, be maximized for the financial benefit and retirement readiness of the middle class?
Drawing from my advisory experience with mid-career professionals and families, it's clear that while the tax advantages of Roth IRAs are well-known, certain factors deter utilization:
1) Misconceptions about income eligibility for Roth contributions.
2) Lack of awareness about alternative contribution methods.
3) Uncertainty or lack of guidance on executing Roth conversions or backdoor contributions within tax regulations.
Direct Roth IRA Contributions
The simplest path to a Roth IRA begins with opening an account at a custodian, such as Charles Schwab or Fidelity. In 2024, individuals with a Modified Adjusted Gross Income (MAGI) below $161,000 (or $240,000 for married couples filing jointly) can contribute up to $7,000, or $8,000 for those aged 50 and above, to their Roth IRA. Note that even if your spouse does not have earned income, you can open a Roth IRA account for him/her and make the direct contribution.
Backdoor Roth IRA
For those surpassing these income limits, the Backdoor Roth IRA presents a viable alternative. This involves contributing to a non-deductible Traditional IRA and then converting these funds to a Roth IRA. Particularly suitable for high earners who have leftover savings after maxing out their 401Ks, this method allows for tax-free growth and withdrawals in retirement. Instead of leaving your savings in a taxable brokerage account, why not stash away $14,000 (including contributions for your spouse) into your Roth IRA accounts to enjoy tax-free growth and withdrawals in retirement? Later, we'll delve into the caveat for executing this strategy in a tax-compliant way.
401K Roth Contributions
If your employer-sponsored 401K plan provides a Roth 401k feature, congratulations, you will be able to make a much higher amount of Roth contributions. Firstly, it's vital to verify if your 401k plan offers a Roth option. Choosing Roth contributions for your 401k means you cannot deduct these contributions from your gross income since they are made with after-tax dollars. In 2024, the contribution limit is $23.000, with a catch-up contribution of $7,500 if you are 50-plus. Whether to opt for Roth contributions in your 401k hinges on several factors, including your current and expected tax bracket in retirement, and your current liquidity. Typically, most high-income earners will be in a lower tax bracket in retirement. However, we are currently in a historically low-tax environment and it’s not unlikely that every tax bracket will be elevated in 20 or 30 years Based on my experience, even high-income earners and diligent savers can find themselves in a higher tax bracket in retirement due to various income sources, such as large capital gains, full amounts of social security benefits, interest earnings, required minimum distributions, etc.
Mega Backdoor Roth
What if you still have a large cash surplus after maxing out your workplace 401k and would like to stash as much as possible into a Roth IRA? Check if your employer-sponsored 401K plan permits after-tax contributions and in-service withdrawals. If that’s the case, you will probably be able to pull off the Mega Backdoor Roth strategy, which lets you roll over up to $46,000 to a Roth IRA or Roth 401K in 2024. This strategy's nuances and complexities will be covered in a separate blog post.
For those with significant funds beyond 401k contributions and seeking to maximize Roth savings, the Mega Backdoor Roth could be an option, permitting rollovers up to $46,000 into a Roth IRA or Roth 401K in 2024. This strategy's nuances will be covered in a separate discussion.
Key Considerations for Tax-Compliant Backdoor Contributions
Step Transaction Doctrine: This legal principle might treat a series of separate steps as a single transaction if they appear to be integrated parts of a single scheme. In the context of a Backdoor Roth IRA, the IRS could potentially view the non-deductible Traditional IRA contribution and subsequent Roth conversion as one transaction, intended to circumvent income limits on Roth contributions. While the IRS has not strictly enforced this in relation to Backdoor Roth IRAs, awareness and cautious timing between steps are advised.
IRA Aggregation Rule: For tax purposes, the IRS treats all your IRAs, including traditional IRAs, Rollover IRAs, SEP IRAs, and SIMPLE IRAs, as one during conversions. This means if you have pre-tax dollars in any Traditional IRA, the proportion of the conversion that is tax-free is based on the ratio of after-tax contributions to the total balance across all your IRAs. This can affect the tax efficiency of the Backdoor Roth conversion and requires careful planning to minimize unexpected tax consequences.
In conclusion, Roth IRAs remain a powerful tool for retirement savings, offering tax-free growth and withdrawals. Whether through direct contributions, 401k Roth options, or Backdoor Roth strategies, there are multiple paths to leverage this vehicle, each with its own considerations and requirements. As always, schedule a meeting with us to explore tailored strategies to your financial situation and goals.
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