Roth to the Max

Matt Trogdon

WITH THE FINANCIAL markets down sharply, this is a great time to fund a Roth IRA, with its promise of tax-free growth. But the rules can be tricky.

The basics: You place part of your after-tax earned income in a Roth, invest it and—ideally—just leave it to grow. As long as the money stays there until you reach age 59½, and you wait at least five years, you can tap the account without owing a dime in taxes.

Let’s say Roxie puts $6,000 in a Roth IRA at age 25 and invests in a diversified portfolio of stocks. Her portfolio returns 7% per year until she hits age 60, at which point it’s worth $64,059. When she withdraws her money to spend it, she won’t have to pay any taxes on her $58,059 profit. Pretty sweet, right?

The annual limit for Roth IRA contributions is currently $6,000, or $7,000 for those age 50 and older. In 2023, those limits rise to $6,500 and $7,500. Not everyone can use a Roth IRA, however. Roth IRAs come with income limits, something many investors don’t realize until they see a penalty on their tax return.

If your tax filing status is single or head of household, your Roth IRA eligibility starts to phase out once your modified adjusted gross income reaches $129,000 in 2022 and gets completely phased out once your income tops $144,000. If your tax filing status is married filing jointly, your eligibility starts to phase out at $204,000 and is completely phased out at $214,000.

The penalty for making a Roth IRA contribution when you aren’t allowed is fairly steep. You’ll pay 6% every year on the excess amount you contributed, and that 6% penalty recurs annually until the situation gets fixed.

In our example, if Roxie made a $6,000 Roth contribution in 2022 and was over the income limit, she would face a $360 penalty each year until she no longer had any excess contribution. The simplest remedy is to withdraw the money and any earnings by the tax filing deadline, including extensions.

What if your income is over the limit? There are three common workarounds.

First, if you have a 401(k) or 403(b) at work, you may have the option to make Roth contributions to that account. The 2022 contribution limit for these employer-sponsored plans is much higher—$20,500 this year for people under age 50 and $27,000 for people 50 and older—so you can build up your Roth savings much more quickly.

Second, if you have additional room to save after contributing to your employer’s plan, you can try the “backdoor Roth” maneuver. This involves making a nondeductible contribution to a traditional IRA and then doing a Roth conversion. The process here can be somewhat involved, so it’s a good idea to contact a financial planner for help. If you have money in a traditional IRA from a previous 401(k) rollover, it becomes much harder to pull off the Roth conversion without paying some taxes.

Third, if your employer’s plan allows it, you can try the “mega-backdoor Roth” maneuver. Yes, that’s the actual name. This involves putting after-tax money into your 401(k) over the $20,500 annual limit, and then immediately converting it to Roth 401(k) money within your plan or by distributing it to a Roth IRA. To pull this off, you’d need to find out if your plan allows after-tax, non-Roth contributions, and if it allows either in-service distributions or an in-plan conversion. Again, consider contacting a knowledgeable financial planner for help, because this can get complicated.

Simpler is usually better when it comes to your finances. But building up Roth money is a case where the juice is actually worth the squeeze. I tell my financial planning clients that we want to build tax diversification. Ideally, by the time they retire, they should have a balanced mix of traditional retirement accounts, Roths and regular taxable accounts.

Many retirees who have amassed some wealth feel boxed in because the majority of their money is tied up in home equity and traditional retirement accounts. Building up a healthy-sized Roth can ease that problem—by providing the flexibility to spend without worrying about taxes.

Matt Trogdon is a financial planner with Craftwork Capital, LLC. He’s based in Washington, D.C., and has a special interest in helping Gen X and Gen Y families. He also serves as a workshop instructor for the Babson College Financial Literacy ProjectFollow Matt on Twitter @Matt_Trogdon and check out his earlier articles.

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