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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 Project. Follow Matt on Twitter @Matt_Trogdon and check out his earlier articles.
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Yes. Great strategy for the next 10 years. Backdoor provisions will go away in 2032 permanently. So stack up the cash as much as you can.
Kevin, I believe you are referring to the part of the Build Back Better plan that was to eliminate the ability to perform Backdoor Roth conversions in 2032. However, this part of the act was written out when it was still being negotiated as a bill. Once it was signed, this verbiage had been eliminated, so unless I am mistaken (entirely possible) the ability to do Backdoor Roth conversions will still be intact past 2032. That is, of course, unless Congress in it’s infinite wisdom changes things in the future.
I have converted most of my IRA to a Roth and love its tax-free shield. In fact I have started buyng individual TIPS bonds there to benefit from inflation increases and NOT paying more taxes on that inflation.
Good article. However, as a minor point of consideration it should be noted that a few states don’t give Roth IRA’s the same protection from creditors that they give to IRA’s. So if a low income person happens to live in a state that doesn’t protect a Roth IRA but does protect an IRA from creditors, they might decide the future potential tax benefit might be outweighed by the better asset protection afforded to an IRA in their state. Like so many financial decisions, it’s important a person look at their specific situation to ensure the Roth IRA makes sense for them.
Wow. I’d read some states don’t protect IRAs like they do 401(k)s but never heard of this.
The Roth vs Traditional calculations can get really complicated really fast, and is (yet another) data point people have to consider when thinking of saving for retirement. I’ve gotten to where I just tell people, if they don’t want to take a deep dive into the technical weeds sorting through the details, to just save in whichever type of account motivates them to save the most, and not worry about it. I my mind, for most people, that’s what makes one approach better than the other–the one that gets the most money consistently in their retirement accounts. And as Matt hinted in the article–if you’re really on the fence about this, why not fund each type in roughly equal proportions? Then, as John Yeigh has so eloquently put it, you’ll be assured of only being half-wrong. But you’ll also be half-right, and that’s half the battle, isn’t it? Which isn’t a bad place to be, in my opinion.
Maybe a good rule of thumb is to use Roth if you’re in the 12% tax bracket or below, otherwise traditional.
Definitely agree. Getting people to save in the first place is the hardest battle.
I agree with the importance of building tax-free income for retirement. However, have you ever considered the impact if an individual is able to save more on a pre-tax basis, say 2% because of less negative impact on take-home pay? This may be more relevant for lower income workers.
Is it possible to have more income in retirement albeit taxable, by saving more on a pre-tax basis?
Good comment. I don’t know the exact percentages, but with so many people having paltry IRA account balances, those folks may have been better served to simply have as much as possible saved since their tax rate in retirement will probably be minimal.