You might be rich, but you can still Roth
It must be because we’re trained that September is the start of the school year, but even as an adult I’ve always looked at September as a time to refocus on the months ahead. What’s positive about this attribute is that financial planning has a bit of a natural ‘school year’ cadence, where we have the ability to be proactive and filled with choice and opportunity right as the fall months arrive.
One way to think about being proactive about your financial life in the fall is reviewing your year-to-date income and how much you have contributed to your retirement accounts so far this year. If you have already maxed out your 401k and IRAs - awesome work! If you haven’t started yet, this is the time to ramp up those contributions so you can aim to put as much tax-advantaged money aside as possible. Today’s blog is all about retirement accounts and how despite the fact that you are locking your money up until retirement, there actually is more flexibility and opportunity than you might think!
I specifically want to focus on Roth IRAs. There’s a misconception that individuals over a certain income level have no way to contribute into a Roth IRA. While there is some truth to that statement, recent changes in the 2017 Tax Cuts and Jobs Act expanded the flexibility of taking advantage of the Roth account structure. This in conjunction with thinking about your taxes over the long run vs. just in a single year can make tax planning opportunities around retirement accounts hugely impactful.
To begin, let’s define Roth IRA. The Roth IRA is an individual retirement account that enables you to save after-tax dollars and grow those dollars without tax consequence. It was established in the 1997 Taxpayer Relief Act, named after Senator William Roth. (Fun Fact: This was the same Act that introduced the exemption of $250k per spouse of capital gains on the sale of a primary residence, dropped the capital gains rates, and established the child tax credit.)
Both the Traditional IRA and Roth IRA can receive after tax contributions (we will explain this later);
Both the Traditional IRA and Roth IRA grow investment earnings tax free;
The Roth IRA is unique from a Traditional IRA in the way it is taxed in retirement. In a Traditional IRA, you are taxed on withdrawals in retirement, whereas in a Roth IRA the money is all yours. Pay now, enjoy later. It’s a theme that comes up often at Mana.
How soon is too soon? What’s the right amount to contribute?
Anyone with earned income is able to contribute to a Roth IRA - even minors. So if you’re old enough to get a job, then you’re old enough for a Roth! (Although custodial Roth IRAs need to be set up for minors). The contribution limits are the same as a Traditional IRA, which is $6,000 as of 2019 for anyone under 50 and $7,000 as of 2019 for anyone 50 or over.
A general rule of thumb is if you expect to be in a higher tax bracket later in life, you contribute to a Roth now. This doesn’t necessarily mean you have to be making more money, but you might also believe that taxes have nowhere to go but up. Locking in the tax rate now with certainty can oftentimes be comforting knowing that the money saved in your Roth is yours. However, the tricky part about Roth IRAs is that there is an income limit. If you are a single filer, you can’t contribute to a Roth if you make more than $137,000. As a married couple filing jointly, the income (modified adjusted gross income) that prohibits you from contributing to a Roth is $203,000.
So you might think, you’ve maxed out your company’s 401k ($19k this year!) with a match of 3% and you’re good. Maybe Roth another time. But let’s do a quick example of a 35 year old with $200k saved in retirement who makes $300k/year. Her take home pay is around $14k/month, presuming she is maxing out her 401k and spend ~$600/month on employee benefits. With an average savings rate of 20%, she is spending $11,200 per month. If she wants to continue living the way she does now in retirement, saving in her 401k won’t be enough. Prioritizing tax efficient savings outside of her company 401k is her best likelihood of achieving this long term goal. The conundrum exists: she wants to save more for retirement in a tax efficient manner, but is beyond the Roth IRA income limit. Earlier this month on our blog, we wrote about tax efficient savings in a brokerage account, something that is often overlooked. But there is a step in between. It’s called a nondeductible Traditional IRA contribution.
As an employed individual (by someone other than yourself) making more than $137k/year, your options are limited in a single year.
Contribute to a Roth? -- No, your income is too high.
Contribute to a Traditional IRA and lower your taxable income? -- No, if you have a workplace plan, you can’t take a tax deduction for contributions to a traditional IRA.
Contribute $6,000 to a Traditional IRA as a nondeductible contribution? -- Yes. This you can do!
Why would I invest in an IRA if I don’t get the tax deduction?
If you are an active participant in a workplace plan, you can’t take a tax deduction for your contributions to a Traditional IRA. Even though you can’t deduct, you can contribute. You would take after-tax dollars (i.e. your savings) and contribute it to your Traditional IRA. You won’t get the tax benefit for your contribution, but your tax basis in your IRA is adjusted upwards.
At retirement, your account has grown to $500k. This time upon withdrawal, you will be taxed on $400k -- the earnings -- because you already paid tax on the first $100k when you contributed. You’re growing your money tax deferred. Instead of paying tax on your earnings every year, you can save that money, invest it, and over the long haul have more money in your pocket.
This is in contrast to a deductible IRA contribution. Let’s use a similar example. You contributed $100k of deductible contributions to a Traditional IRA. When you retire, this $100k has grown to $500k. If you withdraw 100% of the funds, you will be taxed on the $500k. You already got the tax benefit, so you are taxed on the full amount upon withdrawal.
What if I have a combination of deductible vs. nondeductible contributions?
This is a little tricky, because the onus is on you to keep track of this contribution to make sure that you don’t get double taxed in retirement. The IRS also wants to know, so give this info to your CPA so they can file a Form 8606 to the IRS. If no other action was taken - record keeping the amount you contributed (deductible vs. nondeductible) is all you need to do. Since the time between your nondeductible contribution and your withdrawal can be years if not decades, keeping a record of your tax documents in a secure (ideally electronic!) place where you keep all of your financial documents is highly recommended. Personally, I create a spreadsheet every year that is titled “Year - Tax Related Items”. Then when I start my next year’s tax planning, I’ve already got last year’s to work with.
Nondeductible contributions participate in the tax benefit as your investments grow over time, but it’s not quite as advantageous as contributions to a Roth IRA because ultimately when you withdraw these funds in retirement, you will be taxed on that growth. This is where a financial planner can help you think about your tax planning over a longer haul than just a single year.
What are some noteworthy strategies?
1. Backdoor Roth Contributions
Even though you can’t directly contribute to a Roth IRA as a high earner, as you now know, you can make nondeductible contributions into a Traditional IRA. In years past, there was this legal precedent called the Step Doctrine Rule, whereby even if every individual step of a process was legal, if the combination of those steps was intended to go around the rules (in this case, the income limit), then the entire process would be deemed as illegal. (I’m not a lawyer - this is not legal advice - this is my summary interpretation.) This made Backdoor Roth Contributions more challenging, because ultimately your motivation couldn’t be to do a Backdoor Roth (promise I’ll explain what it is!) but instead, there would need to be a reasonable timeframe between the steps in order to take this action. The Tax Cuts and Jobs Act, very fortunately in my opinion as a risk manager, helped clarify that this is actually OK! They don’t make it easy to find, but Footnotes 268 and 269 state:
268: Although an individual with AGI exceeding certain limits is not permitted to make a contribution directly to a Roth IRA, the individual can make a contribution to a traditional IRA and convert the traditional IRA to a Roth IRA, as discussed below.
269: Although an individual with AGI exceeding certain limits is not permitted to make a contribution directly to a Roth IRA, the individual can make a contribution to a traditional IRA and convert the Traditional IRA to a Roth IRA.
So what is this transaction? You take nondeductible contributions from a Traditional IRA and transfer them to a Roth IRA. Now, instead of having to pay taxes upon withdrawal on your earnings in retirement, these assets will be treated as though they were contributed to a Roth IRA in the first place.
Why it is super important to do this with a financial planner is because if you have regular IRA assets (that you have already deducted for your taxes) in addition to nondeductible contributions, the IRS applies a pro-rata rule. The math is complex, so I won’t include those details in this blog post (happy to discuss though!) We definitely recommend working with a professional - either CPA or financial planner - in making this technical move. The tax consequences of bad execution could be dire.
2. Mega Backdoor Roth
A Mega Backdoor Roth is a similar concept, but instead of transferring assets from a Traditional IRA, you are transferring assets from a Traditional 401k. Why it’s called Mega is because the contribution limits for a 401k are MUCH higher than for a IRA. IRAs caps are at $6,000 in 2019 or $7,000 for those 50 and over, but for 401ks you can contribute $19,000 of pre-tax dollars or up to $25,000 of pre-tax dollars for those 50 and older. But that’s not all. Some 401k plans will allow you to contribute after-tax dollars to your Traditional 401k, which means that you could contribute in total $56,000 to your 401k so long as you earn that much money in a year.
3. Roth Conversions
These backdoor contributions can be a great way to use after-tax dollars to get your money into a Roth IRA. However, Roth conversions are a possibility for individuals who have contributed pre-tax dollars to a Traditional IRA. A Roth Conversion is exactly what it sounds like -- you are converting your Traditional IRA to a Roth IRA and paying the taxes to cover that conversion. Since you got a deduction on your income in prior years, you have to pay it back! Where this strategy really shines is in lower income years. Let’s say over a 10 year period you contribute the max to your IRA at a time that your tax rate on average was 32% and then you decide to take a year off of work and only do some side projects, bringing your tax rate down to 12%. If you convert your Traditional IRA to a Roth IRA during this year, you won’t pay back taxes for what happened over the past 10 years, but instead, you’ll pay taxes at your current rate.
Work with your CPA or financial advisor to determine if this is a good strategy for you and how much you would owe in taxes as a result of this transaction. Don’t have the money to cover the tax bill? Talk to your custodian about the possibility of withholding for taxes directly from your Traditional IRA upon conversion. Be proactive about these discussions -- you don’t want to deal with the tax consequences of messing this up!
These strategies can be deployed on an annual basis, but even if you’re not sure yet if you’re an eligible candidate, we recommend prioritizing retirement savings. For young people, prioritizing retirement seems like a far off goal, but taking the steps early can help you tremendously over the long run. While you can do a Backdoor Roth, a Mega Backdoor Roth or a Roth Conversion with any amount of money, your annual contributions to these accounts are subject to the limits we discussed throughout the article -- so getting your money into the retirement accounts is the best way to start.
Stephanie Bucko is a fee-only financial planner based in Los Angeles, California and is the Chief Investment Officer of Mana Financial Life Design. Mana Financial Life Design provides comprehensive financial planning and investment management services to help clients organize, grow and protect their wealth throughout life’s journey. Mana specializes in advising professionals in the tech industry, as well as women who work in institutional investing, through financial planning and investment management. As a fee-only fiduciary and independent financial advisor, Stephanie never receives commission of any kind. She is legally bound by her certification to provide unbiased and trustworthy financial advice.