Are you looking for a tax-free growth and withdrawal retirement savings plan? Then look no further than the Roth IRA. In this comprehensive guide, we'll cover everything you need to know about Roth IRAs, from the basics of what they are and how they work to more complex topics like Roth conversions including The Backdoor Roth IRA and The Mega Backdoor Roth IRA.
If you're new to Roth IRAs or just need a refresher, we've broken down the video into chapters so you can easily skip ahead to the topics that interest you the most.
We cover the basics of Roth IRAs, including what they are, how they work, and the benefits of opening one. One of the biggest benefits of a Roth IRA is tax-free growth and tax-free withdrawals in retirement. We'll also discuss the differences between Roth IRAs and traditional IRAs, and how to decide which one is right for you.
Once you've opened a Roth IRA, it's important to invest your money wisely. We'll talk about how to create a smart portfolio that factors in asset location and minimizes taxes over your lifetime.
Finally, we'll discuss more complex topics like Roth conversions and strategies for converting traditional IRAs or 401(k)s to Roth IRAs. We'll also cover The Backdoor Roth IRA and The Mega Backdoor Roth IRA, which allow you to get around income limits and contribute more than the annual contribution limits. If you do consider a Roth Conversion, it is very important to remember the Pro-Rata rule.
Whether you're just starting your retirement savings plan or looking to optimize your existing plan, this video will provide you with all the information you need to make informed decisions about Roth IRAs.
If you have questions about whether a Roth IRA makes sense for your retirement plan or whether or not you should convert your traditional accounts into Roth accounts, use the link below to schedule some time to speak with a member of our team where we will put together a customized retirement analysis for you.
Schedule Your FREE Retirement Assessment Today https://www.theoremwm.com/start-here
Timestamps
0:00 Intro
0:40 Roth IRA Basics – Benefits of Roth IRAs, Contributions, Withdrawals, Spousal Roth IRAs
2:17 Investing In Your Roth IRA – Creating a Smart Portfolio
3:06 Roth IRA vs Traditional IRA
5:05 Roth Conversion Strategies
6:50 Roth Conversion Timing Strategies
8:30 The Backdoor Roth and the Pro-Rata Rule
10:25 The Mega Backdoor Roth
12:51 Roth Conversion Mistakes
14:20 When a Roth Conversion is a Bad Idea
Read The Transcript
Are you looking for a retirement savings plan that will give you tax-free growth and tax-free withdrawals? Then you have come to the right place because we are talking all about the Roth IRA. In this video, we'll cover everything you need to know about Roth IRAs, from the basics of what they are and how they work, to the complexities of Roth conversions including backdoor roths and mega backdoor roths, this is the ultimate guide to the Roth IRA.
Depending on where you are in the process of retirement planning and your knowledge level of the Roth IRA we made sure to break this video up in different chapters in case you wanted to skip ahead as we are going to start with the basics of Roth IRAs and towards the end of the video will discuss more complex topics.
What is a Roth IRA?
A Roth IRA is a retirement account where you can contribute after-tax dollars to be invested. The money going in is taxed, but the growth of your investments is not taxed, and the money withdrawal from the account is never taxed either, with a few caveats. You can always withdrawal the money you contributed, but to withdrawal the growth tax free, you must have had the Roth IRA for 5 years and you must be older than 59.5. If you W/D earnings prior to 59.5 and before the account is 5 years old, you may be subject to taxes and penalties. Just like other retirement accounts like a traditional IRA or 401k, there is no such thing as a joint Roth IRA, so if you and your spouse want to contribute to one, you'll have to do it individually. If one of you works and the other doesn't but you file a joint tax return, then the person working can contribute to a Roth IRA, and your spouse can contribute to a Spousal Roth IRA as well. it's a great way for non-working spouses to save for retirement.
Benefits of a Roth IRA
One of the biggest benefits of a Roth IRA is that it provides tax-free growth and tax-free withdrawals in retirement. Other benefits include no required minimum distributions, this allows you to be very strategic in retirement about how much of your income is taxable. You also have the ability to continue contributing past age 70.5 if you're still working.
Roth IRAs have the same contribution limits as traditional IRAs and for 2023, you can contribute 6500 if you are under 50 and 7500 if you are over 50. If your income is too high, you won't be able to contribute to a Roth IRA directly, but you do have an option to get around the Roth IRA income limit with a backdoor Roth IRA which we will get to in a bit.
Investing in a Roth IRA
Once you deposit money into your Roth IRA, you need to invest the money because just opening up an account and contributing to it does not mean it is invested in anything. A Roth IRA itself is an account that you hold investment in and not an investment itself. Some investment options to consider include mutual funds, index funds, exchange-traded funds (ETFs), and individual stocks or bonds. It's important to consider your risk tolerance and investment goals when choosing investments. Because of the tax free growth and withdrawals that come with a Roth, this gives you the opportunity to be strategic about where you hold your investments if you have other investment accounts. By Creating a smart portfolio that factors in the asset location, you can minimize your taxes over your lifetime. To do that, you would use your Roth IRA to hold assets with the most growth potential or biggest tax impact.
Roth IRA vs. Traditional IRA
One question that often comes up when discussing Roth IRAs is whether they're better than traditional IRAs. Traditional IRAs allow for tax-deductible contributions, meaning that the money goes in pre-tax but withdrawals in retirement are taxed as ordinary income. Roth IRAs, on the other hand, don't provide a tax break upfront but provide tax-free withdrawals in retirement. Both accounts have their pros and cons, but to simplify the decision, it ultimately comes down to the answer to the question Will your income tax rate be higher now while you are working or later in retirement?. If you think your tax rate will be higher while you are working, then a traditional IRA or 401k would be best. If not, then a roth may be best. That’s it, that’s all that matters in the decision making process. The whole goal is to pay uncle sam less. Now I know that it is hard to determine whether or not your future tax rate will be higher or lower. On top of that, you might be living in a state that has a high income tax rate today, but ultimately move to a different state in retirement that has a substantially lower tax rate. While the thought of having a large sum of money in an account that will never be taxed sounds appealing, you really just want to think about your tax rate today vs in retirement. If you aren’t in the lower tax brackets or the top tax brackets but instead find yourself in the middle and are unsure of where your taxes will be later in retirement, there is nothing wrong with doing both. There is no rule that you can only contribute to one type of account as long as you meet the IRS criteria. With that said, there is one reason why I typically lean towards the traditional IRA or 401k option as opposed to the Roth. And that is optionality. When you contribute to a traditional account, you can control when you pay your taxes. You have the option over time to convert funds into a roth account and be very intentional about what taxes you are paying.
Which brings us to Roth Conversion Strategies
If you have a traditional IRA or 401(k), you may be able to convert it to a Roth IRA. This can be a smart move if you expect your tax rate to be higher in retirement than it is now. It's important to consider the tax implications of a Roth conversion before making any moves.
The first step when considering a roth conversion is to identify the tax problem, if there is one. For example, if you have a large balance in tax deferred accounts whether that was your 401k or maybe even a lump sum pension that you rolled over into an IRA, eventually you will forced to take mandatory distributions from that account and those RMDs can easily get to the point where they push you into the highest tax brackets automatically.
Step 2: Calculate your tax liability
Once you've identified the tax problem, the next step is to calculate your tax liability. This will give you an idea of how much money you'll need to pay in taxes when you convert your traditional IRA to a Roth IRA. To calculate your tax liability, you'll need to estimate your taxable income for the year, including any other sources of income you may have. Even though you are withdrawaling money from your traditional account, there is no early withdrawal penalty if you are converting assets under 59.5
Step 3: Determine the optimal conversion amount
Once you know your tax liability, you'll need to determine the optimal conversion amount. This is the amount of money you should convert to a Roth IRA each year to minimize your tax liability. To determine the optimal conversion amount, you'll need to consider your current tax bracket, your expected tax bracket in retirement, and your projected income for the year. which is why it is important to think about timing Strategies for Performing a Roth Conversion
There are several timing strategies you can use when performing a Roth conversion, there is the The Traditional Approach where you convert your traditional IRA to a Roth IRA gradually over time. This allows you to spread out the tax liability over several years and minimize the impact on your income tax bracket. There is the Lump Sum Approach where you convert your entire traditional IRA to a Roth IRA in a single year. This approach can be beneficial if you expect to be in a lower tax bracket in the future or if you want to maximize the benefits of tax-free growth. And then there is top off approach where you convert just enough of your traditional IRA to a Roth IRA each year to top off your current income tax bracket. This allows you to take advantage of the lower tax rates in your current bracket and minimize your tax liability.
Each timing strategy has its benefits and drawbacks, and the best strategy for you will depend on your individual circumstances. Here are some of the pros and cons of each approach:
The Traditional Approach
Spreads out the tax liability over several years, it minimizes the impact on your income tax bracket and
Allows you to take advantage of potential tax law changes
The downside is that it limits the amount you can convert each year and may result in a higher overall tax liability if tax rates increase in the future
The Lump Sum Approach
Maximizes the benefits of tax-free growth while simplifying your retirement planning by consolidating your accounts
But it could result in a large tax liability in a single year and can easily push you into a higher income tax bracket
The Top off Approach
Takes advantage of the lower tax rates in your current income tax bracket by allowing you to gradually convert your traditional IRA to a Roth IRA and minimize your tax liability
However it Limits the amount you can convert each year and May result in a longer conversion process
There are 2 very common conversion strategies that help higher earning individuals who are phased out of contributing to a Roth IRA, those are the backdoor roth and the mega backdoor roth
a backdoor roth IRA is where you put after tax money into a traditional IRA and then convert those funds into a Roth IRA. While roth conversions have no limit on how much you can convert, the backdoor roth strategy has the same IRA contribution limits because you are technically making a contribution. There is one very important rule that you need to be aware of if you are considering this strategy and that is the pro-rata rule. You see, the IRS requires that rollovers from your traditional IRAs to Roth IRAs be done pro-rata. Let me show you what I mean. Here we have a traditional IRA that you fund with pre-tax dollars and a Roth IRA that you would like to fund using after tax dollars. In a perfect world, you would put after tax money into the traditional IRA and then immediately roll that money over to the Roth IRA. But because of the pro-rata rule, it is not that simple. Let’s say that you have 100K in your traditional IRA, that includes some contributions, growth and maybe even an old 401k that you consolidated into it and now you decide to contribute the maximum of 6500 if you are under 50. The IRS does not allow you to cherrypick those 6500 dollars to roll over into the Roth. Unfortunately, you have to take an equal amount of the pre-tax as the after tax. So to convert the full 6500 dollars, you have to convert the entire IRA to the roth, which would cost you quite a bit in taxes because the 100k is pre-tax money and will be taxed when you convert it. The IRS aggregates all of your IRA balances, and that is including SEP IRAs. The good thing is that it does not include employer sponsored plans like 401ks, so if you really wanted to leverage the backdoor roth strategy, you could consolidate your IRAs into your 401k if you have one to help neutralize the pro-rata rule.
The last type of conversion strategy known as the mega backdoor roth that is where you do the exact same thing, but inside of your traditional 401k. This allows you to save even more into the Roth account. Unlike a traditional IRA that has the limits of 6500 or 7500 if you are over 50, a 401k allows you to contribute a maximum of 66000 if you are under 50 and 73500 if you are over 50. OF that amount, 22500 or 30000 if you are over 50 can be contributed pre-tax, the remaining amount can be either company match funds or after-tax money that you contribute which is where the mega back door roth comes into play. You would contribute money after-tax to your 401k and then immediately roll over this amount from your 401(k) to your Roth IRA. To make this strategy work, your traditional 401(k) must allow after-tax contributions, which are listed in a separate bucket from your regular contributions. Your employer plan must also allow in-service distributions, allowing you to take your after-tax contributions out of your 401(k) plan while you’re still working and move them into a Roth account. If it doesn’t, you wouldn’t be able to transfer the money into a Roth IRA until you’ve left your job.
Just like the regular backdoor roth IRA, 401(k) withdrawals are generally subject to the pro rata rule. Which says you can’t exclusively withdraw pre- or post-tax contributions from your traditional 401(k). You must take out an amount equal to the ratio of your contribution sources.
For the mega backdoor Roth, the pro rata rule means you can’t exclusively make an in-service withdraw of post-tax contributions if your traditional 401(k) balance includes a mix of pre- and post-tax money. Instead, you may need to rollover your entire 401(k) balance in a mega backdoor Roth maneuver. In a situation like this, it’s best to roll your pre-tax contributions into a traditional IRA.
If your employer tracks pre-tax and post-tax contribution amounts—as well as their growth—you might be able to get around this and simply withdraw the entirety of your post-tax contributions outright.
Roth conversions, backdoor and mega backdoor roths can be great strategies, but they are very complex and you want to make sure you are very careful with doing them
Roth conversions can be powerful tools for retirement planning, there are also mistakes that can significantly impact your retirement savings. Here are some of the most common mistakes to avoid:
Failing to Consider Your Tax Bracket
One of the most significant mistakes you can make when converting a traditional IRA to a Roth IRA is failing to consider your current tax bracket. You'll need to pay taxes on the amount you convert, so if you're in a high tax bracket, you may end up paying a significant amount of money in taxes. It's important to consider your current and future tax brackets before making a Roth conversion.
Converting Too Much Too Soon
Another mistake to avoid is converting too much of your traditional IRA to a Roth IRA all at once. This can push you into a higher tax bracket and result in a significant tax bill. It's often better to spread out your Roth conversions over several years to avoid this issue.
Forgetting About Required Minimum Distributions (RMDs)
If you're over the age of 72, you're required to take minimum distributions from your traditional IRA. However, if you've converted all or part of your traditional IRA to a Roth IRA, you're not required to take RMDs from the Roth IRA. It's important to keep track of your RMDs and make sure you're not taking them from your Roth IRA.
Failing to Consider the Impact on Your Social Security Benefits
If you're receiving Social Security benefits, a Roth conversion can impact your benefits. Converting a traditional IRA to a Roth IRA can increase your taxable income, which can result in a higher tax bill and lower Social Security benefits. It's important to consider the impact on your Social Security benefits before making a Roth conversion.
As great as Roth IRAs and a roth conversion can be, there are also times when it's not the best option. a Roth conversion may not be the best choice:
You're in a High Tax Bracket
If you're in a high tax bracket, a Roth conversion may not be the best choice. Converting a traditional IRA to a Roth IRA will result in a significant tax bill, and it may not be worth it in the long run.
You're Close to Retirement
If you're close to retirement, a Roth conversion may not be the best choice. Converting a traditional IRA to a Roth IRA requires time for your investments to grow and for the tax benefits to be realized. If you're close to retirement, you may not have enough time for the tax benefits to outweigh the costs.
You Have a Short Time Horizon
If you have a short time horizon, a Roth conversion may not be the best choice. Converting a traditional IRA to a Roth IRA requires time for your investments to grow and for the tax benefits to be realized. If you have a short time horizon, you may not have enough time for the tax benefits to outweigh the costs.
You Don't Have the Funds to Pay the Taxes
Converting a traditional IRA to a Roth IRA requires you to pay taxes on the amount you convert. If you don't have the funds to pay the taxes, a Roth conversion may not be the best choice.
Roth IRAs can great accounts, offering tax-free growth and withdrawals in retirement can help save on taxes when you are in the distribution phase. However, it's important to understand how the account fits into your specific retirement picture. Now that you know what a Roth IRA is, how it works and some advanced strategies to fund one check out this video coming up next that covers the top 5 retirement planning myths.
