In last week’s article I discussed the tax-free feature of the Roth IRA, along with the fact that Roths do not require RMDs (Required Minimum Distributions). Roths provide attractive estate planning benefits, so they are great to leave to children or grandchildren. They can reduce taxes during retirement, and the contributions are always accessible without penalties. In my view, the Roth IRA is the most powerful type of investment account. I hope you will work to build — and maximize — your Roth IRA.
Today’s article discusses ways you can build a Roth IRA.
Open an Individual Roth IRA: This is the most straightforward way. If you have earned income below $198,000 as a married couple, or $125,000 as a single person, you can contribute up to $6,000 per year in a Roth IRA. If you are age 50 or over, you can contribute up to $7,000. Roth IRAs can be opened at many brokerage firms and some banks and credit unions. They can be funded for the current tax year until the tax filing deadline (typically April 15 of the following year).
Contribute to a Roth 401(k) or 403(b): Most employers offer retirement plans to their employees, and these were historically traditional 401(k)s or 403(b)s. However, in recent years, most employers began providing a Roth option. I encourage everyone to choose the Roth option. You can contribute up to $19,500 if you are under 50, and up to $26,000 if you are age 50 or over.
When you contribute to a Roth 401(k) or Roth 403(b) your contributions are considered income (they are from your salary), so you will pay income tax (that year) on the amount contributed. This is why Roth contributions are categorized as “after-tax,” and it is also why the amount in your Roth — including the earnings over many years — will be tax-free when you take withdrawals.
Let’s use an example. A single woman earns $80,000. In 2020 she contributed $10,000 to her traditional 401(k) at work. Her tax return for 2020 would have shown $70,000 as income. If she started contributing the $10,000 to the Roth 401(k) in 2021, her tax return will show $80,000 as income. Many years later, when she retires, she will pay taxes on all withdrawals from the traditional 401(k). She will not pay taxes on any withdrawals from the Roth 401(k).
One important factor is that an investor can contribute to an individual Roth IRA and a Roth 401(k) or 403(b) simultaneously. This allows you to grow the Roth portion of your investments even faster. Also, contributing to a Roth 401(k) or 403(b) does not have income limitations. That only applies to an individual Roth IRA.
Mega-Contributions: Some employers are now allowing employees to contribute more than the standard IRS limits ($19,500 for those under 50 and $26,000 if you are 50 and over). These plans allow the employee to contribute more after-tax dollars, up to $58,000 if you are under 50 and $64,500 if you are age 50 and over. You will need to check with your employer to see if its plan allows the additional contributions. The Wall Street Journal recently reported that Vanguard stated that about 40% of its 401(k) plans allow “mega” contributions, and Fidelity reported that 90% of the plans it administers allow them. This strategy will not work if cash flow is tight in your household. However, if you have significant savings that can cover your living expenses, being able to contribute aggressively to an account that will help you quickly build a Roth IRA is attractive.
Convert a Traditional IRA to a Roth IRA: This strategy is getting more attention than ever in 2021, because many people expect taxes to increase. If you agree, then considering converting a portion of a traditional IRA to a Roth IRA (before taxes increase) makes sense. Many years ago, if you had over $100,000 in income, you could not convert to a Roth. That rule is no longer valid. Anyone can convert to a Roth as long as they are willing to pay the taxes on the amount converted in the year of the conversion.
Let’s assume you have a $100,000 traditional IRA, and you want to convert $50,000 of it to a Roth in 2021. You would fill out the necessary paperwork for the Roth conversion, and the $50,000 would be added to your income for 2021. Although I used an example of $50,000, you can convert any amount.
An important rule: If you have started taking Required Minimum Distributions (you are over age 70.5), you must withdraw the full RMD before the Roth conversion. The conversion cannot replace taking the RMD.
The best conversion strategy is to look for a window of opportunity when your tax bracket will be low for the year. This may be immediately after retirement, but before starting to receive Social Security benefits. Or it may be a year when your income is lower than normal. Or you may decide that tax brackets are low now (due to the changes in tax brackets passed by former President Donald Trump). The timing on Roth conversions needs to be up to each investor.
Keep in mind: If you are already in a very low tax bracket — and you expect to continue to be in a very low tax bracket throughout retirement — then a Roth conversion may not make sense.
Invest in a Roth Solo 401(k): If you are a small-business owner, you may have access to a Solo 401(k). Through a combination of contributions and profit-sharing, this plan may allow you to contribute up to $58,000 for persons under 50 and $64,500 for persons 50 and over. Some brokerage firms provide Roth Solo 401(k)s. Other small-business employer retirement plans include a SEP IRA and a SIMPLE IRA. These are also available in Roth versions. These plans all have their own rules, and details are available online or through the plan administrator.
A Back-Door Roth IRA: This strategy only applies to a small group of investors. It can work if your income prevents you from directly funding an individual Roth IRA, and you do not have a traditional IRA. You may have a large 401(k), but not a traditional IRA. The limits for 2021 are $6,000 if you are under 50, and $7,000 if you are 50 or over. The details are too complex for this article, but you can find more information online or by talking with an investment professional.
You may have read recently about Peter Thiel’s $5 billion Roth IRA. Thiel was the founder of PayPal. He reportedly invested $2,000 of PayPal’s shares before their IPO in 1998, and it grew to $5 billion. It is unknown whether he continued investing $2,000 each year until 2002 when PayPal went public. Members of Congress are now looking into whether this was legal.
I suspect we will never have to worry about accruing a billion-dollar Roth IRA. However, by using some of the above strategies, you can build a healthy Roth IRA and minimize your taxes for the future.
Donna Skeels Cygan, CFP, MBA, is the author of “The Joy of Financial Security.” She has been a fee-only financial planner in Albuquerque for more than 20 years, and is the branch manager for the Mercer Advisors office in New Mexico. Contact her at firstname.lastname@example.org.