William Roth did a great thing by creating the Roth IRA for Americans in 1997. The Roth IRA allows for tax free growth and tax free withdrawals. He also caused a lot of confusion ever since. Quite a few investment vehicles now carry the Roth name but mean different things. The unifying theme here is after tax dollars growing tax-free that remain income tax-free on withdrawal. So read on to learn all about Roths.
The original OG Roth. This is a special IRA (individual retirement account) with a 2019 contribution limit of $6,000. This is preferable over a traditional IRA (pre or post tax) due to the signature Roth tax-free treatment.
In 2010 the income limit no longer posed a barrier for higher earners with the introduction of the “Backdoor Roth IRA”. This easily confused method involves a few steps: contribution to a non-deductible traditional IRA. Then converting this traditional IRA to a Roth IRA. This, like any IRA contribution, needs to be reported on form 8606 with your annual taxes.
The main caveat here is that in order to do a backdoor Roth IRA “cleanly” you must have no other IRA accounts with balances. Otherwise you are subject to the “pro rata” rule. Long story short – if you have non-zero balances in any other IRA account, you'll owe taxes on this otherwise non-taxable event.
So, what do you do if you have IRA accounts with money in it? You have two options: convert the entire amount to a Roth IRA (see below – this NOT doing a backdoor Roth IRA) or rollover the IRA into a 401(k) or 403(b) that accepts rollovers.
The good news is that many brokerage accounts make it very easy to do this “backdoor Roth IRA.“ I use Vanguard and they have an option to “Convert to Roth IRA.” Check out Physician on FIRE's step-by-step tutorial on how to do this at Vanguard.
If you’re 50 and older you can contribute an extra $1,000 into a Roth IRA. Roth IRAs require that you have enough earned income in the amount of the Roth IRA. So if you made $1,000 as a high school student babysitting you cannot contribute the full $6,000, you’re limited to $1,000. The exception to this earned income rule comes into play if you’re married. This is known as the spousal Roth IRA. As long as one spouse earns enough to fund both Roth IRAs, the non-working spouse may also open and fund his or her own Roth IRA.
Another beauty about the Roth IRA is there are no required minimum distributions or RMDs. This means that when you turn 70.5 you are not required to start taking distributions. Most other tax advantaged retirement accounts require a minimum distribution starting at age 70.5.
Most of us have access to a 401(k) and/or a 403(b). Most are “traditional” or pre-tax meaning that our contributions reduce our taxable account by the amount we contribute. These accounts grow tax-free and we pay taxes when we withdraw the money in retirement.
Many plans also have a Roth option. The Roth option means you can contribute after-tax dollars that grow tax-free and are tax-free on withdrawal. Doesn’t that sound awfully like a Roth IRA in disguise? It basically is except there are RMDs on Roth 401k(s) and 403(b). To get around this simply rollover the Roth 401(k) into a Roth IRA. There are no tax consequences for this rollover.
Many people ask if they should use the Roth option or the traditional option. It depends. I favor the traditional option for those folks in high marginal tax brackets and/or high income tax states such as NY and CA otherwise most folks should consider the Roth option.
The Mega Backdoor Roth IRA
It’s a bummer that the awesome Roth IRA is limited to an annual contribution of $6,000. But, some really lucky folks have access to a way to contribute even more to a Roth IRA.
First, you need access to either a 401(k) or 403(b) that allows non-Roth after-tax contributions or NRATs. These are contributions beyond your standard $19,000 employee contribution (that may be either pre-tax or traditional, or post-tax or Roth). This is also separate from what your employer may contribute. Remember the total limit of the 401(k) is $56,000 in 2019.
So, if your plan allows for NRATs – then you’re able to do the coveted Mega Backdoor Roth IRA.
Pearl: Log on to your work 401(k) and see if there is an option for after-tax contributions.
For example: Let’s say you max your $19,000 employee contribution and your employer contributes $5,000 as a match or contribution. You’re left with $56,000-24,000 or $32,000 of available NRAT contributions. Contribute this $32,000 (after-tax) to your 401(k). Then once a year or more (depending what your plan allows) you move this NRAT money into a Roth IRA! This is completely separate from the $6,000 Roth IRA.
$19,000 employee contribution
$5,000 employer contribution/match
$32,000 non-Roth after-tax contribution —> Roth IRA
With the ability to contribute NRATs and rollover to a Roth IRA, you’re contributing not just $6,000 but a total $38,000 (using the above illustration) into a Roth IRA. Money that will never be taxed ever again. This is way better than a traditional brokerage account. But alas not many plans allow NRATs and even the plans that do may not let you actually move the money out of the plan unless you leave the employer or limit you to annual withdrawals. It’s still worth it to use it in these cases but you will owe taxes on the growth of the NRAT money.
Finally, we have Roth conversions. The term itself is confusing since the backdoor Roth IRA involves a conversion. Roth conversions refer to converting pre-tax accounts such as rollover IRAs, 401(k)s, etc into a Roth IRA. You’re changing from a pre-tax account (where you saved taxes when you contributed) to a Roth IRA. You will owe taxes on the amount converted at your current marginal tax rate.
Current marginal tax rate is the key thing here. This is why Roth conversions are often done in low income years such as a year where job loss occurred or the first few years of retirement.
For example let’s say you were in the 35% married marginal tax bracket during your peak earning years. The year after you retire you’re in the 12% marginal tax bracket. The strategy is to convert some pre-tax dollars into a Roth IRA since you will only pay 12% on this conversion vs. 35% if you converted during your peak earning years (and any applicable state and local taxes).
Often retirees will plan to institute a “Roth Conversion Ladder” to migrate pre-tax assets into Roth IRAs so that the money will never be taxed again.
Note that the word rollover is usually used in the context of moving from like to like such as rolling over a traditional (pre-tax) 401(k) to an a pre-tax IRA.
Phew! That’s probably more than you wanted to know about all of Mr. Roth’s accounts.
Were you aware of all the possible Roth accounts besides the Roth IRA?