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What is a Roth? For our purposes, there are two correct answers:
This article focuses on the second answer, so if you are looking to read more about Senator Roth I’ll defer to Wikipedia. For those interested in retirement accounts, we’re going to look specifically at three questions: How are Roth accounts different from traditional retirement accounts? Who can use Roth accounts? And are there tips and tricks for funding Roth accounts?
Roth accounts are alternatives to “traditional” accounts such as Individual Retirement Accounts (IRA) and 401(k) accounts. (Note: you will sometimes see these referred to as tax-deferred or qualified accounts)A traditional retirement account incentivizes workers to save money for retirement by allowing individuals to put a portion of their wages into a retirement account without first paying taxes on those wages. For example, someone making $100,000 who contributes $19,500 to a 401(k) in 2020 would have taxable income of $80,500.
There is a second benefit once the money is in a retirement account. Investors are typically on the hook for taxes due to capital gains, interest, and dividends. Not so in retirement accounts. Money invested in a retirement account is able to grow without tax implication.
This “free ride” does come to an end eventually, however. In general, when it is time to take money out of a traditional retirement account, withdrawals are treated as regular income and taxed accordingly. (Note: Like all things tax-related, there are exceptions.)So how does a Roth account look different? In three key ways.
First, unlike traditional retirement accounts, Roth accounts do not offer a tax break for contributions. As a result, money put into Roth accounts is considered post-, or after-, tax.
Second, distributions from Roth accounts are entirely tax-free.
Third, there are no Required Minimum Distribution (RMD) for Roth accounts. Basically, because the money was taxed already there is less urgency on the government’s part to ensure that money exits the account than in a traditional retirement account that remains untaxed until distribution.
While the first and third are important to note, it is the second difference that draws the most attention to Roth accounts.
If you have reason to believe that your tax rate will be higher in the future than it is now, putting money into a Roth retirement account is a winning proposition. You can pay taxes now at your current, low tax rate and rest easy when tax rates skyrocket in the future. A slight exaggeration, but you can see the appeal of this type of account.
Please note, there are other differences as well. However, many of those are specific to the type of Roth account, whether IRA or 401(k). We’ve written on the differences between an IRA or 401(k) account here, but an exhaustive review of Roth IRAs is still in the works.
As of 2020, Individuals with earned income are able to make contributions totaling up to $6,000 combined to their Roth and/or Traditional IRA. However, the ability to make Roth contributions is impacted by your modified AGI.
Full contributions: Married (filing jointly) up to $196K; Single up to $124K
Reduced contribution: Married between $196K and $206K; Single between $124K and $139K
No contribution: Married >$206K; Single >$139K
It suffices to say that Roth 401(k) accounts are much more accessible for high-income earners than Roth IRAs. Simply, if your employer offers a Roth option you can make Roth contributions to your 401(k).
Those with modified AGIs above the limit are not entirely out of luck, however, as there are ways to get money into a Roth IRA other than a straight contribution.
As fair warning, this section wades a bit further into the tax weeds than some readers might enjoy. For those interested, plow on.
Perhaps the most common approach for adding money to a Roth when your earnings put contributions out of reach is termed a “backdoor” contribution. This occurs when a Traditional IRA contribution is “converted” over to an individual’s Roth IRA. Ideally, this is done before that individual has accumulated a large IRA balance, and in a perfect world, the contribution was made with after-tax money. If both those situations occur, the conversion can be done with virtually no tax implications.
There are a few undefined concepts in that paragraph, but if you are exploring this approach it is worth discussing in more detail with your financial and/or tax advisor to make sure you are a good candidate, so make a note of questions and talk to your trusted professional.
Conversions are also used as a strategy to take advantage of years where your income is lower than in other years. The strategy is to convert a portion of your traditional IRA to a Roth IRA so that you “max out” a lower tax bracket. For example, if the 22% tax bracket covers income up to $168K and your taxable income is $148K, you can increase your income by ~$20K without bumping yourself into the next tax bracket. Again, this requires coordination between your financial advisor and tax professional, both to decide if it makes sense for your situation and to calculate and execute the conversion.
The last approach depends on your employer’s 401(k) plan but is another take on the conversion. Taking after-tax 401(k) contributions and converting the dollars into Roth.
Let’s use Microsoft as an example. In addition to Roth and Traditional contributions, Microsoft allows employees to make after-tax contributions to their 401(k) account. This is similar to a Roth in that the contribution is after tax, but different in that investment gains from after-tax dollars are taxed. However, Microsoft wrote their plan to allow these after-tax dollars to be converted into their Roth 401(k) (yes, this is similar to the backdoor Roth contribution outlined above). This strategy improved recently when the Microsoft plan provider, Fidelity, updated its systems to allow for these conversions to take place daily. The end result is essentially a massive Roth contribution ($27,750 for 2020) on top of the allowed $19,500 annual 401(k) contribution.Short of switching jobs, there is little you can do if this option is not a part of your company’s 401(k). However, this is an often-overlooked benefit that, if you have the capacity to save at increased levels, can provide a huge boost to your retirement savings.
As always, if anything in this article caught your attention, or raised questions you want answered, don’t hesitate to reach out to your team at One Day Advice. We are here to help you navigate these topics, and no question is too simple or too complex to bring up.