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To Roth or not to Roth is not the question

Retirement Funding

It’s when and how that lead to the benefits of tax-free growth, income, and legacy planning.

The general rule of thumb for the Roth decision is to pay taxes when you think the rate will be lowest.   But that may be easier said than done.

Knowing the multiple strategies for getting investments into the tax-favored Roth structure can point you in the right direction.

 As stated by Judge Learned Hand nearly 90 years ago, “Anyone,  may so arrange his affairs that his taxes shall be as low as possible, he is not bound to choose that pattern which will best pay the Treasury; there is not even a patriotic duty to increase one’s taxes.”

Roth strategies are core to “arranging one’s affairs” for tax efficiency.  The rules are incentives and are available to anyone who may advantageously employ them.

 Strategy 1. Contributions

For those who qualify, the most straightforward way to put money in a Roth IRA is to walk it in through the front door.  As with any IRA contribution, earned income is a requirement for eligibility, but so too are limits, under which, that income must fall.  For single filers, eligibility to make a full Roth IRA contribution in 2020 means Modified Adjusted Gross Income (MAGI) of less than $124,000.  Partial contributions are allowed for income falling between $124,000 and $139.000.   For married taxpayers who file jointly, the magic MAGI is below $196,000, with limited eligibility between $196,000 and $206,000.

The full annual contribution is $6000 for those under 50 with an additional eligibility of $1000 for those over the half century mark.

 Strategy 2. The Back-door Roth

Of course, many who would like to take advantage of the tax-free growth afforded to Roth IRA exceed the income limits to do so.  Fortunately, in 2010 laws were amended to allow taxpayers of any income level to do conversions of existing IRA accounts, thereby moving them into the Roth space and extending the advantages that go with it.  

Since anyone with earned income may contribute to a Traditional IRA, the Back-Door Roth Strategy was born.  By making a non-deductible contribution to a Traditional IRA, the account contains only after-tax money, referred to as basis.  If a conversion is then processed, which means recognizing as income, any growth or earnings that has yet to be taxed (in this case there is none), the account may go forward as a Roth IRA.  This two-step process conveniently works around the eligibility limits, and, as result, opens the opportunity to a much larger audience.

There is a caveat to the Back-door approach and that is the aggregation of IRAs and the pro-rata tax treatment applied to them.  That is to say, that if one has an IRA which only contains pre-tax monies, either from the rollover of a pre-tax retirement plan, or resulting from making tax-deductible contributions to a Traditional IRA, those funds will be aggregated with any other IRA and treated as one.  By way of example, if one has a pre-tax IRA with $54,000 in it and then contributes $6000 to another IRA in non-deductible fashion, then for the purposes of conversion, he actually has 1 IRA valued at $60,000, 90% of which is pre-tax and 10% which is after-tax.  Any attempt to convert under these circumstances will be met with disappointment as every dollar converted will be treated as 90% taxable and 10% non-taxable.   Therefore converting the $6000 account will be treated as converting 1/10th of a $60,000 IRA and tax will be owed on the portion not yet taxed, in this case 90% of the conversion amount.

That said, there is a strategy to navigate these waters as well.  One path might be to roll the pre-tax IRA into a company sponsored retirement plan which is not considered for matters of IRA conversion, thereby clearing the decks of pre-tax money and paving the way for the back-door strategy.

 Strategy 3. Roth 401k

Most company-sponsored retirement plans now have a Roth option built right in.  The good news here is that no income limit applies, so anyone can use it.

For people who are young and/or in a low marginal tax bracket, forgoing a tax deduction now might be attractive in exchange for the tax-free treatment of withdrawals in the future.  The best way to go about making this decision is to do some forecasting.  Despite the common belief that our tax brackets will be lower once we leave our working years in the rearview mirror, it’s often not the case.  First, tax laws (and brackets) change.  It is literally an act (or many acts) of Congress we’re talking about here.   Secondly, for those who have diligently saved in retirement accounts throughout their careers, they often find that when the time to pay the piper comes, in the form of Required Minimum Distributions (RMDs), they are forced to recognize more income than they need, and forced to pay the taxes that go with it.

Speaking of RMDs, Roth IRAs don’t have them. Just be sure that any Roth monies wind up in the IRA structure (after a triggering event), rather than remaining in the Roth 401k, which does require minimum distributions.

 Strategy 4. Mega back-door

What if you really do want to contribute pre-tax to keep your taxable income low in the current year, but don’t want to be left out of the Roth party?

Well, there’s good news.   Some 401k plans allow for “after-tax” contributions in addition to the better known pre-tax and Roth options.   And, like the back-door Roth, these after-tax contributions can be converted to Roth.  Just know that the normal salary deferral buckets must be filled up first before after-tax contributions can be accepted.

The actual contribution limit for 401k contributions is $57,000 in 2020, for a participant under the age of 50.  The limit includes employee and employer contributions, so think employee contributions to pre-tax or Roth, company match, and profit-sharing contributions if there is one.  The normal scenario might look like this for a participant under age 50:  Salary deferral contributions of $19,500 in 2020 into pre-tax or Roth option, and a company match of 3%.  If the employee’s salary is $180,000 the match equates to $5400.   When added to the salary deferral amounts the total is just $24,900, leaving a whopping $32,100 that can still be contributed after tax, and then converted to Roth.  For someone living well below their means, or already sitting on substantial savings, the ability to put this much away is very attractive, add Roth treatment to the mix and you’ve got the best of both worlds.

 Strategy 5. Roth Conversion

Lastly, either as a stand-alone strategy, or in combination with other strategies already mentioned, there is the Roth Conversion Strategy.  This strategy is fairly straightforward and consists of paying the tax toll on monies already invested in pre-tax accounts so they can go forward with Roth treatment.

There is strategy to be employed here as well, and ideally this maneuver would be made when values are low, marginal tax rates are low, or both.  This might be the result of a decline in investment values, a break in employment etc., but if the expectation is that values and/or tax rates will be higher in the future, then converting can be advantageous.  This is a strategy that can also be employed when the desire is to pre-pay the tax bill on an intended inheritance.  Either way, awareness of the rules can bring meaningful rewards.

As the saying goes, it’s not what you make, but what you keep, that matters.