There has been a lot of talk in the media recently about ROTH IRA’s, Backdoor ROTH IRA’s, and Mega Backdoor ROTH IRA’s? The biggest reason for this is because we are in such a low tax environment. Do we know what the tax landscape will look like when we need the money? No, but we do know that now we are dealing with low rates, and we can choose to pay these low rates and deal with what we do know.
What Is It?
A ROTH IRA is a retirement account where you pay the taxes now (no tax break for contributing), your savings grows tax free and if you follow the rules, there is no tax due when you take money from the account. Generally, the rules are that the account has been open for 5 years and you wait to take money out until age 59.5.
Why Should I Have One?
First, it’s nice to have money in retirement that is tax free. Any money you take out of an IRA or a Traditional 401k is taxable at the Federal and, most of the time, State level as well. That means that if you need to take out $50K to live on for the year and you are in the 24% Federal Bracket and 5% State Bracket, you will need to take out $70,422 to have $50K after taxes. If your money is in a ROTH IRA or ROTH 401k, then you will take out $50K. Having different accounts to pull from with different tax consequences gives you options in retirement.
How Do I Get One?
First, you must have earned income. Then you will need to check the income limits for contributing to a ROTH IRA on the IRS site (https://www.irs.gov/retirement-plans/amount-of-roth-ira-contributions-that-you-can-make-for-2021). If your income is too high to contribute, then there are a few other ways to take advantage of this ROTH option:
- ROTH 401k with your Employer (Individual K if self-employed, with no employees)
- If you have a 401k with your employer, check to see if they offer ROTH 401k contributions. If so, then you can contribute up to the annual 401k contribution limit which is more than a ROTH IRA contribution limit ($19,500 for 2021 plus catch-up contributions if you are 50 or older).
- Back Door ROTH IRA contribution
- The way a Back Door ROTH contribution works is by making a non-deductible IRA contribution and converting this contribution to an IRA. It’s not exactly that simple because there are a few other things you must consider (such as having other IRA accounts that may need to be aggregated and thus can cause a taxable event). It is best to work with your advisor and your tax preparer before making any moves.
- ROTH Conversion
- If you have an existing IRA, you can do a ROTH conversion and pay the taxes now. Also, you will need to look at your current tax situation as well as future needs and see if this is the right decision for your situation.
- Mega Back Door ROTH Conversion
- A Mega Back Door ROTH conversion is making after tax contributions beyond the employee and employer contributions to your 401k plan subject to the annual cap allowed. There are many factors involved in doing this—making sure it is allowed under the annual ACP Test and confirming these contributions are allowed at all within your plan. It doesn’t stop there. Once you figure out if you are allowed to make these contributions, then you will need to convert them—it is possible to be done within the plan, with an in-service distribution if allowed by the plan or after you leave your company.
In summary, it is nice to have after tax dollars growing tax free so that you can have some tax-free distributions in retirement. However, each situation is different, and you need to know the rules for these different situations before you make certain decisions and end up with a big tax bill that you were not planning for. This is one way working with a Financial Advisor can help you, by navigating these complex decisions with you.
Financial Journey LLC is a registered investment advisor offering advisory services in the state of Virginia and in other jurisdictions where exempted. Information provided is for educational purposes only and not, in any way, to be considered investment or tax advice.