Roth IRAs: Know the Facts!

1. Direct After-Tax Contributions: A direct, non-deductible contribution of cash can be made into a Roth IRA. You can contribute the lesser of $6,000 ($7,000 if age 50 or older) or earned income to your combined IRAs (Traditional and Roth) for year 2021. This means that you must have earned compensation to contribute to an IRA, including sources such as wages, salaries, tips, bonuses, and net self-employment income. Earnings from rental, interest, and dividend income, and pension/annuity income are not included in compensation. In the case of a married couple (filing jointly) with only one income earner, both spouses can contribute to his/her separate account if the earned income is sufficient to cover both contributions. Eligibility to directly contribute to a Roth IRA is subject to income limits; modified adjusted gross income (MAGI) must be under $140,000 if a single filer or under $208,000 if married filing jointly, with additional reduction limits. Keep in mind that IRA contributions can be made until April 15th (tax filing date without extensions) of the following year. Due to a unique extension for tax year 2020, you may still be able to contribute until May 17, 2021!
2. Roth Conversions (Taxable): A Roth conversion means that you take all or part of an existing pre-tax retirement account (like a Traditional IRA) and transfer the assets to a Roth IRA. The converted amount is included as taxable income in the year of conversion, so this is a taxable event. It is usually best to elect 0% tax withholding on the Roth conversion itself and pay any additional tax liability from withholding or estimated tax payments; this allows more Roth assets to grow tax-free and avoids the 10% early withdrawal penalty if younger than age 59 1/2 . Unlike direct contributions, Roth conversions do not have income limits nor restrictions on the converted amounts – just be sure you can cover the tax liability on the converted amounts!
3. Backdoor Roth Conversions (Potentially Non-Taxable): A backdoor Roth conversion means that you take after-tax, non-deductible balances from an existing pre-tax account (like a Traditional, SEP, or SIMPLE IRA) and move them into a Roth IRA, owing no taxes on the conversion as long as there are no pre-tax contributions or earnings in the account. If your tax-deferred IRA balances contain pretax and after-tax amounts, a conversion will include a pro rata share of both. Backdoor Roth IRA conversions are valuable for individuals who cannot directly contribute to a Roth IRA due to household income above the limits. Consult a financial professional when considering this method, as there may be unintended tax consequences.
4. Direct Roth Rollover (Non-Taxable): You can transfer other Roth accounts such as Roth 401(k)s into your Roth IRA without a taxable event if initiated as a direct rollover – this means that the money goes directly from one account to the other, without the funds touching your hands. These rollovers are subject to retirement plan rules (in-service distributions). If your employer contributes to your retirement plan, those pre-tax contributions and earnings should be transferred to a Traditional IRA unless you also intend to initiate a taxable conversion. Measure twice to ensure your rollover is truly aligned with your intention.

Now that your head is spinning from the tricky withdrawal rules, I will slow down and share last thoughts:

• The decision to contribute to a Roth IRA should not solely be contingent upon your current income tax rate and your assumption of future tax rates. If you choose instead to contribute to a Traditional IRA and take the tax deduction, be sure to make a plan for how that income will be distributed and fully taxable in retirement. Here are the advantages and disadvantages of both options.
• Roth IRAs have the incredible benefit of providing cash flow flexibility in retirement. Imagine that you only have pre-tax retirement accounts and you want to take an incredible trip with your family to celebrate your first year in retirement. The trip costs $40,000, but may you have to distribute $50,000 gross and withhold 20% for federal income taxes. This taxable distribution may also push you into a higher marginal tax bracket, increase your Medicare premiums, increase taxation of Social Security benefits, or limit future growth in your IRA. If you instead used a Roth IRA to pay for this trip, you would only need to distribute $40,000 and avoid the other potential consequences. Diversifying across different tax locations including Roth IRAs and taxable brokerage accounts can provide future flexibility.
• If you have both pre-tax and Roth options in your employer’s retirement plan, you may also have the option to initiate “in-plan Roth conversions” – this is a way to convert pre-tax assets (including the vested employer contributions) to Roth within the plan. You should pay the taxes from outside of the conversion by adjusting your W-4 withholding or making estimated tax payments.
• Roth Conversion Ladder: Since we learned about taxable conversions and the 5-year conversion clock, we can use this technique in the case of early retirement. Retiring before age 59 1/2 limits the ability to take distributions from most retirement accounts without penalty, but if you convert assets from pre-tax to Roth IRAs in early retirement when your income drops, you can start the 5-year clocks on these conversions each year to slowly gain penalty-free access to your retirement assets. It is best to have enough after-tax savings to cover living expenses and conversion taxes during the first 5+ years.