The Roth IRA was created by the late Senator William Roth of Delaware in 1997. It is an after-tax IRA, which, unlike a traditional IRA, does not offer a tax deduction to the IRA holder for making a Roth contribution. However, if the Roth has been opened for at least five years and the IRA holder is over the age of 59 1/2, then all Roth distributions are tax free. In addition, there are no required minimum distributions (RMD) for Roth IRAs allowing it to grow unhindered. Continue reading to learn the best ways to boost your Roth IRA!
Who is Eligible for a Roth IRA?
The maximum Roth IRA contribution for 2024 is $7,000, plus another $1,000 “catch-up” contribution if you are at least age 50. Contributions can be made up until Tax Day (usually April 15) of the following year. The rules impose income limitations on who can make Roth contributions. If one has annual income above $161,000 (single) or $240,000 (married) then direct Roth IRA contributions are not allowed in 2024.
However, there is a work-around known as the “Backdoor Roth IRA.” If one earns too much to contribute to Roth IRA, the Backdoor Roth IRA will allow them to still make Roth IRA contributions. This is a result of a 2010 law that ended the income limitations for Roth conversions in order to generate additional tax revenues for the Treasury. Hence, one can now make an after-tax IRA contribution (not deductible) and then immediately convert the funds to Roth. There would be no tax on the conversion since the contributions were made after-tax. However, if one has pretax funds in an IRA, the amount that converted without tax is based on the percentage of pretax vs. after-tax IRA funds.
The Power of the Roth IRA
The primary benefit of a Roth IRA comes down to tax savings. It can be argued that it is the best legal tax shelter still entrenched in the tax code. Below are a few examples that show the enormous tax benefits of a Roth IRA:
Example 1: Bill is age 22 and makes an annual $365 Roth IRA contribution (just $1/day!) until age 70. Assuming Bill has a personal income tax rate of 25%, and was able to generate an annual rate of return of 8% and a tax rate of 25%, at age 70, Bill would have $193,210 in his Roth IRA. If he invested with personal funds instead, he would have just $99,265.
Example 2: Hilary is age 30 and makes an annual $5,000 Roth IRA contribution until age 70. Assuming Hilary also has a tax rate of 25% and an annual rate of return of 8%, at age 70, Hilary would have $1,398,905 in her Roth IRA. If she invested with personal funds, she would have just $873,380.
Example 3: Mike is age 45 and he maxes out his Roth IRA every year until age 70. Let’s assume he has a tax rate of 24% and generates a 10% rate of return. At age 70, Mike would have stashed $820,275 in his Roth IRA. However, if he invested with personal funds, he would have just $566,597.
What these three examples show first and foremost is that saving inside a Roth IRA is way more beneficial than not saving inside a tax-advantaged retirement account. Plus, your end result is dependent on when you start and how much you contribute annually. Obviously, the earlier you start and the more you can put away each year, the better off you will be when you are retired.
4 Best Ways to Boost Your Roth IRA
Roth IRA Contributions
The easiest way to build your Roth IRA is by contributing to it! Anyone US person with earned income (or a spouse that has the same) is allowed to open and fund a Roth IRA. As mentioned earlier, one can contribute up to $7,000 annually to a Roth. For those who are at least age 50, one can contribute up to $8,000 for 2024. Note that this amount is set by the IRS and factors in cost of living adjustments. This year’s limit is $500 more than last year.
However, if you earn too much during the year, you are not allowed to directly contribute to your Roth IRA. For 2024, you are not allowed to contribute if you earn more than 161,000 as a single filer or $240,000 if you are married and file jointly. Basically, the IRS says if you earn too much, you cannot take advantage of the tax breaks of a Roth. However, there is an option! Enter the Backdoor Roth.
The Backdoor Roth IRA
Beginning in 2011, the Backdoor Roth IRA has allowed high income earners the ability to make Roth IRA contributions. Prior to 2010, any taxpayer that had income above $100,000 was not allowed to perform a conversion of pretax IRA funds to Roth. Therefore, you were not allowed to realize tax-free gains and income. Distributions from a traditional IRA are always a taxable event.
The 2009 financial crisis caused a change in law because the Treasury was in desperate need of tax revenue and Roth conversions are a simple way to accelerating tax payments. Hence, the Backdoor Roth IRA was born.
By contributing after-tax funds to an IRA and then converting them, you can skirt the income restrictions. You will still owe taxes on your contributions, however, all qualified distributions will be without tax. Your heirs will also benefit from the tax break .
Roth 401(k) Employee Deferrals
Another way to boost your Roth IRA is making employee deferral Roth 401(k) plan contributions that can later be rolled into a Roth IRA. If your employer has a 401(k) plan, or, if you’re self-employed and utilize a Solo 401(k), you can choose to make Roth 401(k) contributions assuming the plan allows for them. Similar to a Roth IRA, you can contribute up to the annual limit, including a generous catch-up contribution.
For 2024, up to $23,000 per year can be contributed by the participant through employee elective deferrals. An additional $7,500 can be contributed for persons who are at least age 50.
In addition, through the role of the employer if you are eligible for a Solo 401(k), a profit sharing contribution can be made to the plan in an amount up to 20% of the participant’s self-employment compensation (25% in the case of a W-2 employee). The sum of both contributions can be a maximum of $69,000 (for 2024) or $76,500 if you are at least age 50.
According the U.S. Department of Labor, the average person will change careers five to seven times during their working life. Approximately 30% of the total workforce will now change jobs every 12 months. This is important because in order to gain access to your Roth 401(k) funds so it can be rolled into a Roth IRA, a triggering event needs to happen. Essentially, you can use your 401(k) funds if you leave your job, the plan is terminated, or you reach the age of 59 1/2.
Roth IRA Conversion
One of the most popular ways to help boost your Roth IRA is via the conversion. A Roth conversion occurs when you take savings from a traditional IRA or employer-sponsored retirement plan, such as a 401(k), 403(b), or governmental 457(b), and convert them to Roth. Roth IRA and Roth 401(k) conversions are subject to ordinary income tax – not capital gains rate. The tax rate is based on all net income reported on your IRS Form 1040.
As we touched on previously, there are no limits on who can perform a conversion since there are no income restrictions. Of course, there are tax implications with a conversion. Since funds that are being converted have not been taxed, you will owe the taxes during the year for which the conversion is completed. Furthermore, if an asset is converted, the fair market value of that asset will be used during the conversion process.
For example, if one purchased a home for $200,000 in 2024 and on the date of the conversion the home was worth $350,000, the tax due on the conversion would be on the fair market value at the date of the conversion ($350,000) and not what the asset was purchased for. Hence, it is far more tax-advantageous to do a Roth conversion when the underlying asset has seen its value depleted. Of course, it is hard to know what the future price of an asset will be, but the goal when doing a Roth conversion is electing to do the conversion when the underlying asset’s value is lower than what the perceived value will be in the future.
Should I do a Roth IRA or Roth 401(k) Conversion?
There is generally no right or wrong answer as to whether one should do a Roth conversion. Below are a few key points to keep in mind:
- Your Age The younger you are the more tax-free deferral opportunities you will have and the more favorable a Roth IRA conversion is perceived to be.
- Can You pay the Tax Due? It makes more tax sense if you had the ability to pay the tax due with personal funds (funds outside of the Roth IRA); using some of the converted funds could prove to be counterproductive.
- Belief in the Investment Does the investment have upside? How risky is it? Will there be cash flow? In most cases, ones who believe their investment will lead to a significant gain would be more inclined to engage in a conversion in order to lock in the tax-free gains. The downside to this strategy is that is the investment falters, then you have just paid tax at an inflated price and are left with an asset at a lower value. Not an optimal situation to be in!
- Future Income Tax Rate Expectation What do you expect your income level to be at when you reach age 73? If you expect to be in a high-income tax bracket, then doing a Roth conversion may make more sense than if your tax bracket will be in a low-tax bracket which would make taking taxable distributions less costly.
In sum, the key is to consider the liability of paying tax up-front on potential gains vs. the benefit of having tax-free income at a later time. The major Roth conversions risks are:
- Memories of Enron, Lehman, Silicon Valley Bank, etc. Convert at a high value and now the asset is worth less.
- Need to take premature Roth IRA distributions? You lose benefit of tax-free growth.
Mega Backdoor Roth 401(k)
The “Mega Backdoor Roth” option is the ultimate strategy for Roth lovers, and the best way to help boost your Roth IRA. It combines the Backdoor IRA along with the high contribution limits of the Solo 401(k). Therefore, it’s a strategy that can only be utilized by the self-employed. The strategy allows you to reach your maximum contribution quicker, and it can all be in an after-tax IRA.
After-tax contributions are one of the few exceptions to the prohibition on in-plan service distributions. In other words, after-tax 401(k) contributions are not treated as either an employee deferral or employer profit sharing contributions and can be made on a dollar-for-dollar basis. Plus, the after-tax contributions can be moved to a traditional IRA and then converted to a Roth IRA without tax or a plan triggering event!
An example: An individual under the age of 50 earns $100,000 annually in self-employed income. He can contribute roughly $45,000 to his Solo 401(k) in 2024. However, if he was utilizing the Mega Backdoor Roth, he can contribute up to the maximum of $69,000 since the contributions are after-tax and can be used on a pro rata basis. He can then roll over the entire amount into an IRA, and immediately convert it to Roth.
Conclusion
The Roth IRA is the ultimate tax shelter, enough said! The difficult part of taking advantage of the enormous tax benefits of the Roth IRA is finding a way to get more funds into the account. Hopefully, this article educated you on the best ways to boost your IRA.
The Roth IRA conversion, whether you need to use the “backdoor” or not, can be a powerful tool for retirement planning but it requires careful consideration of your current financial situation and future expectations. Working with a financial planner or other professional can help steer you in the right direction.
