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Roth and Traditional IRAs

With a Roth Individual Retirement Account (IRA), money is put in after paying income tax on it, and then you get the best benefit of any retirement account: TAX-FREE GROWTH & TAX-FREE WITHDRAWALS (once you reach age 59 and a half and have had the Roth for 5 years). As I tell every person I talk to, imagine taking money out of your checking account, which you have already paid tax on, making a contribution to your Roth IRA, and sitting back to enjoy the tax-free growth for the rest of your life.

For example, you are 35 and will max out your Roth IRA in 2023, so you contribute $6,500. Click HERE to see contribution limits (based on age, how you file your taxes, and how much money you make). You are planning to retire at 65, so you let the money grow in the stock market over the next 30 years. Assuming a 7% annual growth rate over those 30 years, the $6,500 you put into your Roth IRA will be $52,757. * That’s $46,257 of tax-free growth you never have to pay taxes on.

With a Traditional IRA, you get an immediate tax break on your contribution, your money grows tax-deferred, and you pay income tax when you take a distribution in retirement. So, using the same example above, you make a $6,500 contribution into a traditional IRA, let it grow tax-deferred over the next 30 years, and the numbers are the same – you still have $52,757. The difference is that now you have to pay income tax on all of it as you take distributions in retirement. I don’t know about you, but scenario one sounds much better since it means I am paying less in taxes.

Backdoor Roth IRA

A backdoor Roth IRA is the way that high-income earners can benefit from the tax-free growth of the Roth IRA. Click HERE for the 2023 Roth IRA income phaseout to see if you must use the backdoor Roth to take advantage of tax-free growth. If Dave Ramsey can use it, I bet you can too.

How to execute a Backdoor Roth?

To take advantage of the backdoor Roth IRA, you must make a non-deductible contribution to a traditional IRA, then convert that money to your Roth IRA.

WARNING – if you have a Traditional IRA, SEP-IRA, SIMPLE IRA, or another pre-tax non-employer sponsored retirement account, you will be held to the pro-rata rule unless you convert all of your pre-tax dollars to Roth. Talk to a Whitaker-Myers Wealth Managers SmartVestor Pro or Tax ELP if you have questions about the backdoor Roth IRA.

401(k)’s and 403(b)’s

All 401(k) and 403(b) plans allow employees to make pre-tax contributions up to the annual limits. Click HERE to see a summary of the changes from 2022 to 2023. Most employers also offer employees the option to make Roth contributions to their employer-sponsored retirement plans. This allows your payroll-deducted contributions to be taxed now and grow tax-free moving forward.

There is a third bucket of contributions that are rarely seen inside employer-sponsored retirement plans known as after-tax deferrals. These additional contributions are not taxable upon withdrawal, but the growth of the funds will be taxed upon distribution.

If this option is available in your plan, you can make after-tax contributions above and beyond the normal contribution limits of $22,500 (under age 50) or $30,000 (50 or older). In 2023, the contribution limit for combined employee and employer contributions is $66,000 (under age 50) and $73,500 (50 or older).

If you contribute after-tax contributions to your employer plan, then you will likely want to convert them to Roth using the Mega Backdoor Roth strategy.

What Is a Mega Backdoor Roth?

The Mega Backdoor Roth is a financial strategy that allows individuals to contribute significant amounts of money to their employer plan and then convert the after-tax funds to a Roth IRA.

This technique lets you take advantage of the tax benefits and potential growth opportunities a Roth IRA provides, even if your income exceeds the limits for direct Roth contributions.

How Do I Know If I Can Take Advantage of the Mega Backdoor Roth?

· Make sure your 401(k) or 403(b) has a Roth option, allowing you to make Roth contributions. If yes:

· Confirm that your 401(k) or 403(b) allows after-tax contributions. If yes, you have two questions to ask that could potentially allow two options for you:

1. Does the plan allow for “in-service withdrawals?” This allows employees to roll over after-tax contributions into an outside Roth IRA at a custodian of their choice like Charles Schwab.

2. Does the plan offer the ability to make “in-plan conversions” to Roth?

· Choose which option best fits your situation. Your employer-sponsored retirement plan has limited investment options, so we suggest choosing the “in-service withdrawal” option if available. This will open up the investment universe for your hard-earned dollars.

· Max out your Roth 401(k) for the year ($22,500 if under age 50; $30,000 if 50 or older).

· Max out the after-tax contributions, then convert those funds IMMEDIATELY to Roth. If you don’t convert immediately, you will have to pay taxes on the growth of the after-tax portion.

If you have questions on what is the best way to invest for yourself, reach out to one of our financial advisors. They can help answers questions you have, and help you decide which option is best for your situation.

*The annual rate of return given in this article is used for informational purposes to illustrate an example. This is not a guarantee of return.

All Things Roth: IRAs, Employer Plans, Backdoor Roth IRA & Mega Backdoor Roth

August 17, 2023

Stephen Armstrong

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