Money Girl

Too Rich for a Roth IRA? Use 3 Legal Ways to Have One

Episode Summary

Lately, I've been thinking a lot about how my various retirement accounts will affect my future income, specifically the taxes I'll have to pay.

Episode Notes

Laura covers three legit ways to have a Roth IRA–even if you’re technically ineligible because you earn too much–and why their tax-free benefits are so powerful for young owners and retirees.

Money Girl is hosted by Laura Adams. A transcript is available at Simplecast.

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Episode Transcription

Hello, friends, and thanks for joining me on another weekly Money Girl episode!

My name is Laura Adams–I'm a personal finance expert and author of several books, including Debt-Free Blueprint: How to Get Out of Debt and Build a Financial Life You Love and my most recent title, Money-Smart Solopreneur–A Personal Finance System for Freelancers, Entrepreneurs, and Side-Hustlers. Money-Smart Solopreneur was a #1 Amazon New Release and is available as a paperback, ebook, and audiobook. It's an essential read for anyone self-employed or building a small business.

Since 2008, I've been bringing you personal finance and small business tips that boost your financial wisdom, wellness, and security. I cover a range of topics and also interview subject matter experts and interesting folks from time to time.

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Lately, I've been thinking a lot about how my various retirement accounts will affect my future income, specifically the taxes I'll have to pay. That’s because my investments are spread among the three basic account types: taxable brokerages, tax-deferred or traditional retirement accounts, and tax-free or Roth retirement accounts.

Since I'm self-employed and always have a hefty tax bill, I've enjoyed making deductible SEP IRA contributions that significantly reduce my taxable income for many years.

However, as that tax-deferred account grows, it's a reminder that I'm simply delaying an inevitable tax bill.

When I withdraw voluntarily and eventually get forced to take required minimum distributions (RMDs) from my tax-deferred accounts, taxes will catch up with me. That is unless I make some strategic moves ahead of time.

While it won't be true for everyone, I believe my income tax rate will likely be higher in the future than it is today. That's because I'll have fewer tax deductions and will likely continue earning an income well into my "retired" years.

So, instead of keeping most of my retirement funds in a tax-deferred bucket, I plan to shift most of it to a Roth IRA over multiple years down the road. And that's the case even though I'm technically too "rich" to qualify for Roth IRA contributions.

If you're wondering how that's possible or want to boost your Roth account, stay with me. This show will explain Roth IRA benefits, rules, and, most importantly, ways to boost a Roth IRA even if you're like me and aren't eligible for one.

What is a Roth IRA?

First, here's a quick Roth IRA review. If you've been listening to the show, you probably know that it's a retirement account for individuals that requires nondeductible (after-tax) contributions. The tax goodness comes in retirement because it allows tax-free withdrawals if you've owned the account for at least five years and are over age 59.5.

Plus, you can withdraw your original Roth IRA contributions before age 59.5 penalty-free because they were previously taxed. However, taking earnings from a Roth IRA would be subject to income tax and an additional 10% penalty if you are younger than 59.5. That means you get a lot of flexibility with a Roth IRA, which isn't possible with other retirement accounts.

For 2023, the maximum IRA contribution is $6,500 or $7,500 if you're over 50. And you can make IRA contributions if you have earned income, no matter your age, up to your tax filing deadline for the prior year.

SEE ALSO: 10 IRA Facts Everyone Should Know

Who qualifies for a Roth IRA?

Since a Roth IRA offers many excellent benefits, the rules were created to shut out high-earners. If you exceed an annual threshold, you're considered too "rich" and become ineligible for regular "front door" contributions. And by the front door, I mean directly contributing to a Roth IRA using an after-tax source, such as your checking or savings account.

For 2023, the Roth IRA income cutoff for singles happens when you have a modified adjusted gross income (MAGI) of $153,000 or above. And married couples filing joint taxes can't contribute when their household MAGI is $228,000 or above. But I'll explain ways to get around the income thresholds and legally boost your Roth funds anyway!

Note that if you have a Roth at work, such as a Roth 401(k) or 403(b), income limits don't apply. There are no income thresholds to qualify for a Roth at work, which is why I always encourage you to use it for all or a portion of your retirement contributions when it's available. The long-term tax benefits of a Roth are just too darn good to pass up.

RELATED: When Is the Roth 401(k) Right for You?

What are Roth IRA benefits in retirement?

I mentioned that I plan on shifting much of my traditional retirement money to a Roth IRA. Let me explain if you're wondering why I'm so enthusiastic about boosting a Roth.

A huge tax advantage of a Roth is that, unlike traditional retirement accounts, they have no RMDs at any age. You can take tax-free money out as needed or let it grow tax-free for you or your heirs. That could ultimately save a bundle in taxes, especially if the account value grows substantially over the long term.

By eliminating RMDs, you, not the IRS, have control over when and how much to take

out of your account in retirement. Plus, tax-free income allows you to keep and spend more of your hard-earned money in retirement, when you likely need or want every penny, instead of handing over a chunk to the government.

For example, if you're single with a taxable income of $80,000 for 2023, you're in the 22% tax bracket. But if you're a great saver and accumulate a healthy nest egg, your voluntary or required minimum distributions starting at age 73 (or 75 beginning in 2033) could be $100,000, pushing you into the 24% tax bracket.

LISTEN ALSO: 5 Roth Account Rules Changes in 2023

Depending on the size of your traditional retirement accounts, RMDs for super savers could be hundreds of thousands of dollars per year. That means paying lots of income tax at your highest marginal tax rate for RMDs, and any other income like pensions and annuities. Additionally, having more taxable income strains your benefits because it may trigger taxes on most of your Social Security income and increase your monthly Medicare costs.

Even if your income in retirement won't be higher than today, you might strongly believe tax rates for all Americans will rise in the future. Or perhaps you don't want the hassle of paying income taxes to the federal and state governments (depending on where you live) on your future retirement income.

Those situations or beliefs are reasons to favor putting as much money as possible into tax-free Roth accounts. However, if you expect your retirement tax rate to be lower, using a Roth may not be wise because you'd pay more taxes today than in the future. While you can't control the financial markets, you can manage your tax bill with sound strategies and planning.

3 Legal Ways to Boost Your Roth IRA Balance

What can you do if you want to make Roth contributions but don't have a Roth retirement plan at work or are self-employed and earn too much? Well, let's review three legal ways to boost a Roth IRA.

1. Max out a Roth IRA when you qualify.

If your income is below the 2023 Roth IRA thresholds, MAGI of $153,000 for singles and $228,000 for married joint tax filers, you can partially or fully max one out. I said "partially" because there's a phase-out range below the thresholds when you can contribute less than the maximum.

The 2023 Roth IRA income limits are higher than in previous years, so look at it or consult with a tax pro toward the end of the year. Assuming you're ineligible could mean missing a Roth opportunity.

Remember that if your income dips for any reason, such as getting laid off, not receiving a bonus, or having a less profitable business or side gig, you might qualify for a Roth IRA. And if your income increases above the threshold in future years, you won't be allowed to make "front door" contributions.

While Roth IRA contribution limits are relatively low, every little bit helps boost your balance. Over time, that can add up to significant growth by the time you need to tap the account in retirement.

2. Make backdoor Roth IRA contributions.

Everyone qualifies to make backdoor Roth IRA contributions from after-tax funds you first contribute to a traditional IRA. You typically make pre-tax contributions to a traditional IRA–but nondeductible, after-tax contributions are also allowed. And it works for high-earners because a traditional IRA has no income limit; a Roth IRA is the only retirement account with income limits.

You make a nondeductible (after-tax) contribution to a traditional IRA and then roll it over to a Roth IRA. Since you pay tax upfront, no additional tax is due when moved to a Roth. However, the annual contribution limits, $6,500 or $7,500 if you're over 50, still apply.

So, a backdoor Roth is a legitimate way to move small amounts of after-tax money from a traditional IRA to a Roth IRA, even if you earn too much for front-door contributions.

If you put after-tax money in a pre-tax account, you must file IRS Form 8606, Nondeductible IRAs, to keep up with which funds in the account are taxable and nontaxable.

But you don't owe taxes on backdoor contributions, except on any investment growth earned between the time of your nondeductible traditional IRA contribution and the Roth rollover. If you do it quickly, your earnings and resulting income tax should be small.

However, there's a big backdoor downside if you already have a traditional IRA with pre-tax funds called the pro-rata rule. It requires you to lump all your IRAs together when you make a distribution and doesn't allow you to cherry-pick one account to convert.

RELATED: Roth IRA vs Roth 401(k)--10 Differences Investors Should Know

The bottom line is that backdoor Roth contributions work best if you have no pre-tax IRA balances. Otherwise, a portion becomes a taxable conversion based on the percentage of your nondeductible and deductible IRA balances.

There is a potential workaround to eliminate the pre-tax conflict if you have a retirement plan at work, such as a 401(k), that allows incoming rollovers. In theory, you could roll over pre-tax IRA funds into it. Or, if you're self-employed, you could move pre-tax IRA money into a SEP IRA or solo 401(k) that allows it.

As always, speaking to a tax pro or financial advisor before making big retirement account moves is best. Get guidance on whether paying taxes now is worthwhile in exchange for future tax-free Roth benefits.

Again, if you don't have any pre-tax IRA funds, you could move any amount (up to the annual contribution limit) from a nondeductible IRA for a backdoor Roth IRA contribution without triggering taxes.

SEE ALSO: Your Complete Guide to 401(k) Retirement Accounts

3. Do Roth IRA conversions.

A Roth IRA conversion differs from a contribution because funds come from a pre-tax source, such as a traditional IRA, 401(k), or SEP IRA, instead of an after-tax source. That means doing a Roth conversion triggers income taxes you must be prepared to pay.

Another difference is that unlike Roth IRA contributions, which come with an income limit, Roth conversions have no income limit. Additionally, Roth conversions have no contribution limit. You can convert as much as you like from traditional to Roth accounts each year, and the IRS will happily take your income taxes, no matter how much you earn!

For example, if you want to convert $50,000 from your traditional IRA to your Roth IRA, your annual taxable income increases by $50,000, increasing your tax liability. If you're in the 22% tax bracket, you'd owe up to $11,000 on the conversion–but it could be more if the extra income pushes you into the next higher tax bracket.

That's why it's wise to do Roth conversions when you have a lower-income year and even when the value of your investments is down. Many people do conversions in the so-called "gap" years after they retire and earn less but before their RMDs begin.

Also, paying taxes on a Roth conversion from a non-retirement account, such as savings or a brokerage, is best to maximize the amount going to the Roth. Remember that if you're younger than 59.5, you can't use converted funds to pay taxes without paying an additional 10% early withdrawal penalty.

Everyone's situation and retirement plans are different, so you should seek guidance from a financial advisor or tax professional before converting because you can't reverse them if you change your mind.

Knowing if a Roth conversion is right for your situation depends on many factors, including the expected future benefits for you, a surviving spouse, beneficiaries, or charities you leave money to.

While you can't be 100% sure, you should be very confident that your tax rate in retirement will be higher than today and that you have the cash to pay federal and any applicable state conversion taxes.

That's all for now. I'll talk to you next week. Until then, here's to living a richer life.