How to Maximize Roth IRAs: Everything You Need to Know

Roth IRAs – The Swiss Army Knife in Your Financial Belt

There are many vehicles for saving money, but few are as flexible as a Roth IRA. One can have retirement savings, emergency money, and college savings in one convenient place. Let’s explore these options in more detail.

Key Takeaways:

• Roth IRAs provide financial flexibility
• Proper planning may help navigate tax burden (i.e. taxes now versus taxes in retirement?)
• Techniques exist for individuals whose income exceeds Roth IRA contribution limits

Retirement Savings

What is a Roth IRA?

In its most basic form, a Roth IRA is a retirement savings account where contributions are made with after-tax money and all qualified withdrawals are tax-free.

What is a qualified withdrawal?

• The account holder is at least 59.5 years old in the year they begin withdrawals
• The first contribution was made at least five tax years ago

Failure to meet these stipulations results in ordinary income tax and a 10% penalty on any growth above and beyond the sum of contributions.

Roth IRAs are appealing to those who have relatively lower tax brackets now compared to what they would expect in retirement. This could be young professionals or somebody worried about the future of tax rates in general.

Additionally, having Roth money available for retirement provides flexibility for those looking to manage their tax burden during their non-working years. For example, tax rates and income levels can change on a dime. How is one supposed to project what their tax rate will be sometimes 20 or 30 years down the road? Having money that is both taxable (traditional IRAs or 401(k) plans) and non-taxable (Roth IRAs and Roth 401(k) plans) allows the taxpayer to deftly maneuver around uncertain future tax rates.

Who can contribute?

Although contributions to a Roth IRA are not tax-deductible, the IRS sets rules on who can contribute and how much. In 2024, contributions are limited to $7,000 per year ($8,000 for those age 50 and older) for individuals whose income (or income combined with their spouse’s income) falls below certain thresholds. For tax year 2024, those thresholds begin at $146,000 of Modified Adjusted Gross Income for singles and $230,000 if you are married and file a joint tax return.

Are you unsure if you qualify? Check with your tax professional.

Emergency Money

A lesser-known fact about Roth IRAs is that you can always withdraw your contributions at any time for any reason – no questions asked and, best of all, no taxes or penalties.

I made a point to highlight “contributions” in that last sentence because these rules do not apply to Roth conversions. We’ll get into them later.

Let’s assume over the past five years you have made contributions totaling $20,000 into a Roth IRA and the account has grown to $30,000. If your house needs some emergency repairs, you can withdraw up to $20,000 and the remaining $10,000 will continue to grow tax-free until retirement.

This hybrid feature is attractive because typically emergency money is tied up in a savings account earning pennies of interest a year. Being able to grow that money in case you don’t use it is a nice benefit. Of course, don’t put all of your emergency money into the stock market. Those boring savings accounts come in handy during market corrections.

I know I said “no questions asked” but the IRS might have a few questions if you are not reporting your contributions correctly when you file your taxes. Make sure all your numbers are in order every year by April 15.

Qualified Educational Expenses

Is it better to use a Roth IRA or a 529 to save for your kids’ college?

As we like to say around here, “It depends.”

Roth IRAs are geared more towards retirement purposes, but they have the flexibility to be used for college. As mentioned earlier, a non-qualified withdrawal of the growth portion of the Roth IRA would result in taxes and a 10% penalty. Using Roth money to pay for college is an exception to this rule. You would still owe ordinary income taxes on any earnings drawn upon, but you would avoid the penalty.

Let’s go back to our example of $20,000 of contributions and $10,000 of growth. If the tuition bill is $25,000, you would be able to withdraw $20,000 tax-free and pay ordinary income tax on the remaining $5,000 withdrawn from the Roth IRA.

529 plans allow for tax-free growth assuming the money is used for qualified educational expenses, but they are limited with investment options and inflexible if money needs to be used for something else.

There is also the opportunity to set up a Roth IRA in the child’s name before they reach college. This can be a great way to kickstart their retirement savings if the money does not need to be used for college. The only stipulation is that they must have at least as much earned income as the amount being contributed for that year – tell them those papers are not going to deliver themselves!

Advanced Strategies

For those whose income is too high, the only option might seem like using the Roth 401(k) feature via a company-sponsored retirement plan.

However, if your income is high, chances are your tax rate will be higher now than during your retirement years. This might dissuade you from making Roth contributions in lieu of pre-tax.

Fear not, other options exist.

Roth Conversion

The IRS permits holders of traditional IRAs to convert to a Roth IRA by recognizing the untaxed portion of the conversion as income. Doing this means you write a check to Uncle Sam based on your tax bracket, but growth from there on out is tax-free.

“Wait, this doesn’t solve my issue of potentially paying higher rates now versus later.”

The math does not change if the entire conversion is from pre-tax dollars. However, if there is after-tax money on your retirement balance sheet, now there is something to work with. More on this in the next section.

Before we get into the fun stuff, think back to the earlier section where we talked about contributions coming out tax- and penalty-free. I was saying something about addressing the different rules for conversions later? Well, here we are.

Any money converted to a Roth IRA has to “season” for at least five tax years before being eligible for a qualified withdrawal. This applies to each separate conversion and the 59.5 age minimum also has to be met.

“Backdoor” Roth IRA

The act of contributing to a non-deductible IRA and converting it shortly thereafter is referred to as a Backdoor Roth Conversion. The “non-deductible” qualifier is key here.

First, by not deducting the contributions from your taxes, the money in that IRA has already paid its dues, so to speak, to the tax man. This means it won’t get taxed again when you convert it. Second, there is no income limit on non-deductible IRA contributions nor on their subsequent conversions – meaning, Elon Musk could execute this transaction if so desired. Although, at a limit of $8,000/year (he's already eligible for catch-up contributions), I’m not sure how much of an impact it would make on his personal finances.

Here is the catch.

If you have any money in a pre-tax IRA, typically from a rollover of a 401(k), the conversion amount will be partially taxable depending on the ratio between pre- and after-tax.

For example, assume you have $93,000 in an IRA that is all pre-tax. You read a blog about doing backdoor Roth conversions and decide to contribute $7,000 to a non-deductible IRA with the intention of converting it. Unfortunately, the IRS won’t allow you to cherry-pick the dollars to be converted, so converting that $7,000 to Roth will result in 94% of it being taxed and only 7% not. 

Consequently, backdoor Roth IRA conversions work best with no outstanding pre-tax IRAs. 

Mega Backdoor Roth Conversion

A very little-known opportunity exists for those with access to after-tax contributions in their 401(k). Within a 401(k) there are three potential buckets of money:

• Pre-tax contributions
  • Save taxes now, pay upon withdrawal
• Roth contributions
  • Pay taxes now, growth is tax-free
• After-tax contributions
  • Pay taxes now, growth is tax-deferred, pay tax on growth portion of money upon withdrawal

The maximum allowable contribution into some combination of the first two options is $23,000 for 2024 ($30,500 if age 50 or over). The first two options are the most common form of contributions. After all, if you choose to pay taxes upfront, why would you want to pay taxes on the growth?

If you don’t plan on saving more than the maximum, we would suggest you stick to the first two. However, if you have extra cash flow that is instead being used to fund a taxable brokerage account, keep reading.

Money going into a taxable brokerage account is subject to capital gains taxes and dividend taxes. There is potentially a better way.

Before getting into the steps, know that the maximum contribution from any source into a 401(k) is $69,000. This is a combination of the following:

1. Pre-tax or Roth Contributions ($23,000/$30,500)
2. Employer Contributions (i.e. any match they provide)
3. Employee After-tax (the remaining balance after 1 and 2 up to the maximum limit)

Example: You are 55 and contribute the maximum amount to your pre-tax 401(k) and your company matches up to $10,000.

1.  Your contributions = $30,500
2.  Your company match = $10,000
3.  Additional amount available to contribute after-tax = $28,500
   1. The Math: ($69,000 - ($30,500 + $10,000))

Now, for the fun part: the after-tax contributions can be rolled out into a Roth IRA assuming your plan allows for in-service withdrawals.

That’s right:

After-tax money can go directly to a Roth IRA at larger contribution limits than a direct contribution.

There are some nuances here – you can’t take just the after-tax. Your in-service withdrawal will be pro-rata between after-tax and pre-tax. For example, if you contributed $10,000 after-tax to your 401(k) and that money grew to $11,000, the $10,000 in-service withdrawal would be 90.1% after-tax and 8.9% pre-tax ($10,000/$11,000 = 90.1%). The after-tax money would be converted to Roth and the pre-tax money would be rolled into a traditional IRA. 

Disclaimer: This feature is less attractive if your company's 401(k) doesn't separately account for the after-tax portion, but still worth exploring.

I’ll admit, this last section is a lot to digest. For further exploration, it would make sense to have a conversation as it relates to your situation. If you have questions about any of the material covered here, reach out to us and see how to leverage this valuable tool!

Author:  David Rath, CMT, CFA