Client Question: Roth IRA Funding

March 30, 2023

We’re in the homestretch of the 2022 tax season and as a result, I’ve been fielding questions about IRA and Roth IRA funding. I recently helped a few clients contribute to Roth IRAs (despite being over the income limit) and thought it may be a useful item to touch on this week

Wait, what’s a Roth IRA again?

A Roth IRA is a type of Individual Retirement Account. It gets its name from Senator William Roth who helped institute the account type in the late 1990s. What makes a Roth unique is its tax treatment. Unlike a traditional IRA, taxpayers do not receive a deduction for their contributions to a Roth IRA (you do get a deduction with a traditional/pre-tax IRA). However, also in contrast to a traditional IRA, once inside the Roth accounts, funds grow tax free in perpetuity. In a Roth structure, there is no taxation as income/gains are realized and no taxation when funds are withdrawn. This tax-free appreciation of savings can be very powerful, especially with an extended time horizon. It also becomes a nice complement to pre-tax savings in retirement (which will be taxable upon withdrawal), allowing you to better manage income levels and tax brackets.

Are there limits on contributions?

Given the material tax advantages of Roth accounts, there are limits set annually by the IRS – both in terms of contribution amounts and contribution ability. For tax year 2022, the contribution limit was the lessor of $6,000 or your earned income total (plus $1,000 catch-up if over 50). That limit increased to $6,500 in 2023 (catch-up remained at $1,000).

Further, the IRS places restrictions on who can contribute to a Roth IRA via income limits. You can find the full details of the limits on the IRS website, as it varies by your tax status and tax year. As an example, a single tax filer in 2022 could max out their Roth if their modified adjusted gross income (MAGI) was below $129,000 and could make no contribution to a Roth if their MAGI was over $144,000, with a phased out amount if income fell in between those values.

Are there other ways to fund a Roth-type account?

With a Roth account being an important component of retirement savings and the relatively low income limits for making such contributions directly, it’s important to know there are other ways to get funds into a Roth account structure.

One such way is via an employer plan such as a 403b or 401k. Many of these plans now offer a Roth option and contributions to Roth employer plans are not subject to income limitations and have higher annual limits (for example, the 401k max in 2023 is $22,500). If your employer plan offers a Roth option, you may wish to consider using it. However, keep in mind that the contributions will not be tax deductible now, so a change to Roth from traditional may impact your take home pay and other tax related items.

Another way is to convert funds from a traditional IRA into a Roth IRA. There is no income limits for conversions. However, these are taxable events with the total balance converted being treated as ordinary income and subject to taxation so as always, proceed with caution. Opportunities may present themselves over time where such a move makes sense (ie: material market correction that lowers your IRA balance, a year in between jobs where you have no other income, etc). Your tax situation, time horizon, and many other factors dictate whether a conversion makes sense, so work closely with your advisors on this approach.

The third way to get funds into a Roth IRA is a two-step transaction that has been given the slang name of “backdoor” Roth transaction. Despite the rather nefarious sound of its name, this transaction is currently permissible under current tax legislation and is widely used. (Please note that it is often debated in various congressional bills and may be eliminated at any time. However, as of the date of this post, it remains a viable strategy.)

How does a backdoor Roth IRA transaction work?

It is two separate and distinct transactions. First, you make a non-deductible IRA contribution to a traditional IRA (up to the annual maximum). Again, you are only going thru these steps if your income exceeds the limits for a direct contribution to a Roth IRA. Those income limits also determine whether you get a tax deduction for a contribution made to a traditional IRA. When you are over those income limits in relation to a traditional IRA, you are still able to make a contribution but do not get a tax deduction for it. This is called a nondeductible IRA contribution.

While there is no formal guidance on the timing between step 1 and 2, it’s commonly suggested that you wait a few days to make it clear these are two distinct transactions.

In the second step, you convert the non-deductible contribution from your traditional IRA to your Roth IRA. As noted above, conversions to a Roth are taxable. However, since you did not get a deduction on the contribution to the IRA (you made it with after-tax dollars/non deductible), you will not be taxed on those dollars again. This results in no tax upon conversion and the funds are now in the Roth IRA.

Note: This is very important – the above assumes you do not have any existing pre-tax/deductible balances in any pre-tax IRA accounts (which includes SEP and Simple IRAs, but does not include pre-tax 401ks). If you do, the calculation for conversion becomes a bit more complicated and is done on a pro-rata basis, which greatly limits your ability to convert funds tax-free into the Roth and may defeat the purpose. As always, consult with your advisors and proceed with caution

A Roth IRA can be a powerful component of a retirement portfolio. It’s worth evaluating your options for funding such an account and seeing if any of the above strategies make sense for you and your situation. As with any suggestions we make, work closely with your advisors and tailor a plan that’s right for you. Happy savings!

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