When you open your toolbox, you will see several tools you can choose from to help you get the job done. In retirement, it’s just as necessary to choose your tools wisely to help you achieve your goals. Regardless of age, a Roth 401(k) or Roth IRA, also known as a Roth Individual Retirement Account (IRA), are great tools to have in a personal investment portfolio.
There are two types of Roth accounts. The first is called a Roth IRA and the second a Roth 401(k). There are numerous benefits that come from contributing to a Roth account, but before discussing those, there are some important caveats worth mentioning.
Roth IRA Caveats
First, you cannot contribute more to a Roth IRA than the greater of either a) your annual net earned income, or a maximum of $6,000, if you are under 50 years old, or b) a maximum of $7,000, if you are 50 years old or older (under catch-up provisions in 2022).
Second, the account needs to exist for at least five years for the interest to be tax-free. (Notice how I say the interest cannot be taken out tax-free in the first five years. However, you can take out the sum of your contributions at any time without penalty or taxation.) To best utilize a conversion or the interest within a Roth account, one younger than 59.5 should not take a distribution within five years of a conversion if they want to have that distribution be tax-free and penalty-free.
It is important to note that when taking a distribution from a Roth IRA, it is counted as contributions first, followed by conversions, and lastly, interest earned. It is also worth noting that each conversion has its own five-year clock, and the oldest conversions are the ones that are taken from first. This means that there is a time commitment to this financial vehicle that is important to understand prior to making the investment. There are some exceptions in which one may not get penalized or taxed for taking the money out sooner than 59.5, but in general: if one is younger than that age, they should look to either using just the principal from your Roth IRA or use a different investment account altogether for withdrawing income.
Third, if a person or couple earns over a certain amount of income ($144,000 for single income tax filers and $214,000 for married, filing jointly couples in 2022), they are not eligible to contribute directly to a Roth IRA. The government, in their great wisdom, is essentially saying that this caliber of earners makes too much money to be candidates of a Roth IRA during their accumulation years. However, this earner can do a back-door conversion in which they pay the taxes during the conversion year on the portion of their pre-tax money they wish to convert, and then can shift that money into a Roth IRA — hence the term “back-door conversion.”
Benefits of a Roth IRA
Now that we have cleared up some of the caveats, we can move on to some of the benefits of this financial vehicle. A Roth IRA account can have outstanding tax advantages that are not found in traditional IRAs or pre-tax 401(k) accounts. The main advantage is that since you’re using after-tax money to contribute to the Roth from the beginning, you will not be taxed on the interest that is being generated when distributed. This is especially advantageous for mid-level income earners, such as recent graduates, who are generally in lower income tax brackets coming out of college.
It is also valuable for younger people in general because of the time value money and compound interest accruing within their accounts. A Roth IRA is treated differently than a taxable non-qualified brokerage account; in the taxable non-qualified brokerage account, the gains would be subject to taxation, while in the Roth IRA account, they are not (given you stay within the legal parameters set forth by the IRS). Distributions from a Roth account in retirement years are also not counted in the provisional formula the IRS uses to determine how much in taxes you owe when you receive your Social Security benefits, which is not the case with municipal bonds which claim to be “tax-free.”
Not only is a Roth beneficial for the younger generation as an accumulation vehicle, but it can also be beneficial for higher-income workers who are likely unable to contribute to a Roth IRA due to their higher wage income, but they can still attain a Roth IRA through a back-door conversion.
Roth 401(k) Option
The other type of Roth is called a Roth 401(k). Some employers offer a Roth 401(k) option within their current 401(k) plan. This can be a terrific option because there are higher contribution limits on the amount you can save into the Roth 401(k) compared to the Roth IRA. For instance, if you are under the age of 50, you can save a maximum of $20,500 per year into a Roth 401(k) plan through work, and if you are 50 or older you can use the catch-up provision to save up to $27,000 per year into a Roth 401(k) plan (in 2022). These numbers are subject to change each year with inflation.
If I am retired, is it too late for me to have a Roth in my portfolio?
This information is great if you are just starting out and have the option to choose between a traditional 401(k) plan or a Roth 401(k), but many who have been in the workforce for a long time and are now looking to retire never had the option to contribute to a Roth 401(k). For many pre-retirees and retirees, the majority of their portfolios are typically invested in pre-tax accounts like traditional IRAs or 401(k)s. Even when this is the case, it is still not too late to take advantage of the benefits of a Roth.
In fact, when someone becomes newly retired, this is one of the best times to consider utilizing an IRA to Roth conversion. An ideal time to seek this type of transaction is between someone’s retirement date and the date they turn on their Social Security benefits.
How this works from a tax perspective is: you could convert a portion of your traditional IRA or 401(k) money to Roth IRAs over a period of calendar years, pay the taxes during the conversion year (which hopefully is at a lower tax bracket than when you were working), and then convert it to a Roth IRA. This allows someone to tap into the current principal as needed, and the interest accumulates tax-free after the five-year period has been met. With tax brackets at lower rates today than they were prior to the Tax Cuts and Jobs Act of 2017, it makes sense to do these Roth conversions while the taxes are on sale or while we have lower tax brackets, since current legislation has the tax brackets set to go back up in 2026.
Another difference between a Roth IRA and a traditional IRA or pre-tax 401(k) account is there are no Required Minimum Distributions (RMDs) needed to be taken out of a Roth IRA. In any pre-tax account, you will be required to start taking distributions once you reach the age of 72 (in 2022) and every year thereafter, and you will be taxed at your ordinary income level on those distributions.  Making conversions of an IRA to a Roth IRA can give you the financial freedom to withdraw as much, or as little, as you want from your investment accounts in retirement.
Uncle Sam understands compound interest, and that is why traditional 401(k) plans are such a mainstream trend. Uncle Sam is not stupid; he would rather earn compound interest after the investment gains have been accrued for many years allowing him to share in your accumulated wealth. By understanding how compound interest works, you can use that knowledge to pay some of the taxes along the way instead and allow your Roth IRA/401(k) “harvest” to be accessible to you tax-free when it comes time for retirement. The sooner you start, the better off you’re going to be.
For these reasons, this accumulation option may be something you want in your financial toolbox during your retirement years. Roth IRAs are the right tool for the job for so many people, but in order to decide if this is the right tool for you, you should meet with a fiduciary financial adviser to develop and implement an investment and tax strategy to help you best plan for your financial future in the most tax-efficient manner.
Investment advisory services offered through A Better Way Financial, LLC, a registered investment adviser. Insurance and annuities offered through Frank Guida and Frankie Guida, PA Insurance License #301779 and #932281.
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