Unlocking the Power of Roth IRAs: Maximize Your Returns with One of the Best Tax Shelters!
First introduced in 1998, the Roth IRA was a new retirement account that expanded the tax-advantaged saving options for middle-class households. While the “Traditional IRA” had existed since 1974, subsequent tax reform in the mid-1980s (in particular, limiting the deductibility of IRA contributions for workers covered by a 401k plan) diminished its appeal.
The Roth IRA offered a unique new value proposition: non-deductible contributions in exchange for tax-free growth on future investment earnings. Because Roth contributions were income-restricted (and initially capped at just $2K per year), it took a while for this account type to gain traction with investors.
However, over the last 25 years, annual contribution limits and income caps increased (partly adjusting for inflation). At the same time, more permissive rules for Roth “conversions” broadened the utility of this account type for aggressive savers of all income levels.
Today, there are five ways for investors to boost their exposure to a Roth account and maximize the benefits of tax-free compounding.
Traditional Roth IRA Contributions
The original Roth IRA remains an income-restricted account. To make the maximum contribution in 2024 ($7K for individuals < 50 years old; $8K for those 50+), an investor’s income must be below $146K (single filers) or $230K (joint filers). Above those income thresholds, only a partial contribution is allowed. Investors making more than $161K (single filers) or $240K (joint filers) are excluded from direct Roth IRA contributions altogether.
Roth IRA Conversions
Before 2010, single filers making over $100K could not convert their traditional IRA into a Roth IRA. That year, Congress amended the law to remove income or filing status restrictions on Roth conversions. Moreover, lawmakers provided an additional nudge: the taxes due on a Roth conversion in 2010 could be deferred into the subsequent two tax years (2011-12).
Simply put, a Roth conversion gives an investor discretion over the timing of an embedded tax liability in their traditional IRA account. Ideally, the investor elects to convert when they are in a relatively low tax bracket and pay the taxes associated with conversion from an outside (taxable) account. Thus, the entirety of the conversion amount can continue growing, with all future gains exempt from taxation.
“Backdoor” Roth IRA Contributions
Removing income restrictions on Roth conversions opened another planning opportunity: the “Backdoor” Roth Contribution. An investor who earns too much to contribute directly to a Roth IRA can instead make a non-deductible contribution to a traditional IRA and execute a Roth conversion of that (post-tax) balance, ideally without triggering additional taxes. One big caveat with this strategy is that Roth conversions are subject to a “pro-rata” rule, whereby any converted amount is considered pre- or post-tax in the same proportion as the aggregate of all the investor’s IRA accounts.
Practically speaking, the Backdoor Roth Contribution is typically only viable for investors who do not already have substantial (pre-tax) IRA balances. Otherwise, much of the conversion amount is recorded as a taxable distribution.
Roth 401K Contributions
Since 2006, Congress has authorized 401k plans to offer a Roth (post-tax) option for elective payroll contributions. However, individual plans are not required to offer the Roth option. In practice, the administrative burden & legal expense associated with changing plan documents meant employers were slow to make the Roth option broadly available. These days, Roth 401k options are more common. This can be attractive given the higher annual contributions limits for 401ks ($23K in 2024 for workers < 50 yrs of age; $30.5K for workers age 50+). Younger workers (who expect to be in a higher tax bracket later in their careers) often find the Roth 401k option especially attractive.
“Mega Backdoor” Roth Contributions
This is perhaps the most attractive option for high earners with significant discretionary savings—assuming their employer’s plan allows additional post-tax contributions. The IRS sets an annual statutory limit on the total combined employee and employer contributions to a 401k account. In 2024, this statutory limit is $69K. As mentioned, the employee salary deferral is limited to $23K ($30.5K for those aged 50+). Many employers also match employee deferrals to some extent (ex, 4% of salary), and this matching counts toward the statutory limit as well.
If the sum of these two deferrals is less than $69K (and if the 401K plan allows for it), the employee may be able to make additional post-tax contributions, which are then invested alongside the rest of the 401k assets. For example, if the employee defers $23K from their salary, and the employer matches an additional $10K, then the employee could contribute as much as $36K more in post-tax contributions to the 401k plan. These post-tax contributions would grow tax-deferred while in the 401k plan.
When the employee eventually changes jobs or retires, the principal amount of the accumulated post-tax contributions ($36K in the example above) could then be rolled directly into a Roth IRA. At the same time, any growth from that $36K would be rolled into a (pre-tax) IRA rollover account. Even better, some 401k plans allow for “in-service rollovers,” which means that the employee would not have to wait until a job change or retirement to complete the rollover to a Roth.
Why Would an Investor Want More Assets in a Roth Account?
There are several reasons why an investor may rationally elect to pre-pay taxes (or forego deductions) to increase the proportion of their portfolio in tax-exempt accounts. These include:
Tax Arbitrage
An investor who is in a lower marginal tax bracket today than they expect to be in the future would be better off pre-paying taxes at that lower rate in exchange for untaxed future withdrawals. This is often the case for younger workers or early retirees who have yet to commence RMDs or claim Social Security.
Tax Diversification
An investor uncertain about their future marginal tax rate—whose portfolio is already heavily skewed toward tax-deferred accounts—may find it prudent to increase the proportion of tax-exempt assets to improve financial flexibility in retirement. Having multiple pools of assets with different tax treatments allows the retiree to manage better the tax liability associated with generating a stream of retirement income from their investments.
Reducing Future RMDs
Investors with pre-tax IRA accounts are subject to Required Minimum Distributions (RMDs), generally beginning at age 73. These distributions are counted as taxable income (regardless of whether the investor needs the money) and can push the investor into a higher marginal tax bracket in retirement. Fortunately, both Roth IRAs and 401Ks are exempt from RMD requirements, helping the retiree maintain a lower adjusted gross income (AGI)—potentially preserving eligibility for income-based tax deductions/credits or avoiding income-based investment taxes or surcharges.
Estate Planning
A Roth IRA is ideal for leaving a financial legacy to individual heirs. It is exempt from RMD requirements during the original owner’s lifetime and for ten additional years following the owner’s death (a long runway for tax-free compounding). Moreover, named beneficiaries inherit the Roth IRA assets directly (bypassing probate) and owe no taxes on the inheritance.
Conclusion
The Roth IRA is a powerful yet frequently under-utilized investment vehicle for building and transferring generational wealth. Many high earners mistakenly presume they are ineligible for a Roth when, in reality, there are many ways to build an allocation to this type of account over time—all it takes is some patience and careful planning. If you’d like to learn more about which Roth funding strategies best suit your financial situation, please don’t hesitate to book a free consultation with one of our principals by clicking the button below.
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