Making the most of your Roth IRA

by | Mar 29, 2023 | backdoor Roth, financial planning, Roth Conversion, Roth IRA, tax planning | 0 comments

How to maximize Roth IRA contributions, conversions, and distributions without tax or penalty

Contributing to your Roth IRA is an excellent way to grow your wealth tax-free. It grows tax-free and withdrawals come out tax-free..well, there are a few caveats to that last part. Let’s go over the details:

How much can I add?

The contribution amount changes most years (it’s set by the IRS), so over time it will be important to track this increasing number.  The amount depends on the year and on your age, per the chart below…and these numbers are PER PERSON, regardless of your tax filing status:

CAREFUL! of Earned Income:

These amounts are only allowed if you have EARNED income.  Your social security, pension, and investment distributions do not count as earned income.  Earned income comes from a job, typically.  Even rental income doesn’t always count – so we’ll want to be careful there.

 

CAREFUL! This amount changes as your income increases:

Technically it’s based on your MAGI, or modified adjusted gross income, AND on your tax filing status.  If you’re under the threshold, you can contribute the full amount. If you’re over the threshold, you cannot directly contribute to your Roth IRA.  If your income is in between these limits, you can do a reduced amount.  If you’re in this in-between area, we’ll work together with your tax pro to calculate this amount.

These amounts often change every year, and 2023 is no exception.

Here are the 2022 and 2023 thresholds:

 

Timing Matters

Contributions to IRAs (including your Roth IRA) are tied to the tax year, not the calendar year.  This means you have until tax day, including extensions, to make your contribution.

This is especially helpful in determining if* and how much you can contribute each year since you’ll know your final year income numbers in January (likely).

 

What about the Backdoor Strategy?

Don’t worry if your income is over the thresholds – you can still add money to your Roth IRA…it’s just a little more complicated.  Instead of contributing directly (via the front door) to a Roth IRA, you use a Traditional IRA as a middleman (the backdoor) and then “convert” the money to Roth.

When you contribute to a Traditional IRA, you have the choice to make it deductible or non-deductible on your taxes. In this case, we’ll choose the non-deductible option, making it like a direct Roth contribution in that way.

If your income is over the thresholds (2022: $144,000 | $214,000) (2023: $153,000 | $228,000) then this is the strategy for you.

Direct Roth Contributions work like this:

The Backdoor Strategy works like this:

CAREFUL! If your IRA has money in it already:

If you have a Traditional, Rollover, SEP, or SIMPLE IRA AND there’s money in it, we’ll likely need to skip the backdoor strategy (direct is still an option if you’re eligible). Doing so can have a huge impact, and not usually a good one. This is because of the IRS pro-rata rule. The IRS treats ALL your IRA accounts as one account, and any new money (like your $6,000 contribution) will be treated as a portion of the whole…so the tax-free/non-deductible portion is no longer the entire $6,000, but a portion of the value of all of your accounts. Obviously, this is not ideal!  You don’t want to pay taxes on dollars you’ve already paid taxes on!

Example:

Bottom line: if you have an IRA with money in it, we’ll want to consider other strategies.  Maybe we’ll roll it into your employer account (401k, 403b, etc.), or maybe we’ll convert it and pay the taxes…and maybe we’ll do nothing.  This is really the analysis you want to do with your financial planner.

 

Can I get my money OUT of my Roth IRA account?  What if I need it?

The answer is: it depends…on how long you’ve had the account, how old you are, and which specific dollars you take out (like contributions vs earnings). Typically, any dollars you contributed can come out at any time tax and penalty-free.  It’s the earnings that may have tax and a 10% penalty applied (if you’re under 59.5). But if the dollars went into the account due to a conversion, then you want to make sure you don’t withdraw those dollars for at least 5 years to avoid most of these hefty taxes and penalties (again it’s worse if you do this before you turn 59.5). See the grid below for details on when your distribution may be taxable and/or have a 10% penalty applied.

Taxable Impact of the Dollars you take OUT of your Roth IRAs:

*there are a few exceptions from the 10% penalty on earnings. See this flow chart “Will a Distribution from my Roth IRA be tax and penalty-free” for more details!

CAREFUL! EACH conversion you do has its own 5-year rule.

Wait. The word “conversion” sounds like “contribution” – how are they different?

This is an often misunderstood, but very important distinction.

A contribution is when you put money directly into any account. Typically this is from your paycheck or savings account. It can be tax deductible or after-tax. You can contribute to a Roth IRA, a Traditional IRA, a 401k, a deferred comp plan, a brokerage account like a Trust, a Joint or Individual account, an HSA, a 529 Plan, etc. So when you’re adding to your Traditional IRA for the backdoor strategy, that part is a contribution.

A conversion is when you take the funds already in an investment account and move it to another account. The most common form of this can happen annually like in the case of the backdoor strategy. But it also often happens in those years after retirement and before social security and/or your required minimum distributions are required to start. (but that’s another post…)

Mostly the difference is semantics, but when considering taking money out of your Roth IRA, it’s important to know how the dollars got into the account since the tax impact can vary by so much!

 

DON’T FORGET: Tell your tax pro!

Each strategy (direct or backdoor) is reflected on your taxes a little differently, and your tax professional will want to know if and which strategy you’re doing. There is no tax impact* of either strategy, but the filing process is a little different.

 

What ELSE?!

One more note on basic math principles. The lifetime taxable impact is THE SAME if you have a Roth IRA or a Traditional IRA so long as you are in the same tax bracket during your entire life.  If you expect to be in a higher tax bracket later in life, it’s likely better to pay taxes today. Alternatively, if you expect to be in a lower bracket later, then waiting until then to pay taxes is likely better for you.  Since we don’t always know what is going to happen, working with your planner on a strategy designed for you is going to be key.

As with most planning topics, the details matter, and not every strategy is right for everyone. Rising Financial can help you determine how to use these guidelines for you.

 

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