I talked with a client this week about a few items concerning Roth IRAs and thought it was worth revisiting these topics as the deadline for 2024 IRA contributions approaches

Roth Refresher

As a reminder, there are two main categories of retirement savings in the US

(1) Traditional savings, which provide for an immediate tax deduction on contributions and defer that taxation until ultimate distribution and

(2) Roth savings, which do not provide a tax deduction but allow for no future taxation on any growth, earnings, etc.

As you can clearly see, these are very different options and fit nicely into that category of investment Q&A people find frustrating – the “it depends” category! Deciding between traditional and Roth, or a combination of the two, truly depends on your specific fact patten

Here are a few things to keep in mind regarding Roth savings. Read and learn but as always, consult your own advisors before taking any action.

Diversity of Savings

In most cases, investors are well served by having multiple types of savings (traditional retirement savings, Roth retirement savings, after-tax/non retirement savings, health savings accounts, etc). Why? Because it provides you optionality. Current traditional retirement savings helps managed taxes and may allow you to add more to savings today as current cash flow will increase by the tax savings. Current roth retirement savings allow you to grow funds tax free and better manage future taxes as those distributions will not be taxed. After-tax savings allows you to have access to liquidity as needed and save beyond the dollar restrictions for retirement accounts. All serve a role in your financial journey.

Current versus Future Taxation

This is one of the ultimate items to consider – and the one that is hardest to predict. Again the main distinction between the two retirement structures is their tax treatment. If you are in a very elevated tax bracket today, the current tax deduction from traditional/pre-tax retirement savings may be very valuable to you. However, if you believe you will earn more in retirement (due to required distributions, pension income, ongoing career plans, etc), the ability to withdraw funds tax-free later on may be of more value to you. This analysis should not be taken lightly and it’s worth discussing it with your financial and tax advisor. There will always be unknown variables (like future tax rates, your life expectancy, etc) so make the best decision you can with the available information at the time.

Roth IRA Funding

Due to the attractiveness of Roth savings, there are limits to be aware of. While Roth contributions to an employer plan (ie: 401k, 403b) can be made regardless of income levels, contributions to a Roth IRA are restricted for high earners. For instance in 2024, single filers need to earn less than $140,000 and married couples less than $230,000 to make the full Roth IRA contribution.

If you exceed those income limits, there is one alternative still available to you and that is a Backdoor Roth transaction (see more on this below). It’s important to note that in order to get the most benefit from this transaction (ie: be able to contribute the max amount to a Roth each year), you will ideally want to have no pre-tax IRA accounts (pre-tax employer plan funds are not an issue). This may lead some investors to convert traditional IRA funds (also discussed below)

Backdoor Roth Funding

A way to get funds into a Roth IRA (if you are above the income limit) 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.)

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 or inherited IRAs). 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

Roth Conversions

Investors with funds in pre-tax accounts have the ability (at any age, not just after 59.5) to convert their pre-tax dollars into Roth dollars. Upon conversion, you will pay tax in the current year on the converted amount (to maximize Roth funds, it’s wise to pay the tax with other money and not from the converted funds). However, after that time, the funds grow tax free, there are no required distributions, and distributions are not subject to income tax.

Roth conversions can be done strategically over many years/decades. Again, the converted amount is added to current income so you need to evaluate that tax impact versus your future likely tax impact of pre-tax withdrawals. A few example times to consider a conversion in our opinion include: use them to “fill up” a lower marginal tax bracket, complete them in years in which you have lower income or higher deductions, use them if you have a small amount of pre-tax IRA funds that prevent you from doing a full backdoor Roth transaction, or complete them if there is a sudden market downturn and value of account declines.

In most cases, some level of Roth conversion will likely be beneficial for many reasons, including but not limited to – allowing tax free growth of those funds, diversity in retirement funding (allowing you to manage tax brackets), permitting you to fund Roth IRAs annually moving forward, and reduces RMDs when that time comes. But again, talk with your advisors about your own unique fact pattern.

Hopefully this was a helpful refresher on all things Roth! Happy saving!