Broker Check

Tax Strategies

April 04, 2023

Imagine an account you can lock the IRS out of for the rest of your life, then watch as Albert Einstein’s 8th wonder of the world – compound interest – grows exponentially over the decades without paying taxes. This is the power of Roth.

Typically, Americans can work for about 40 years. With the current Roth limit of $6,500, you could save $260,000 without increases/catch-ups, etc. Using 8% for compound interest, your Roth would grow to $1,683,867.37. That’s $1,423,867.37 of tax-free growth. Eureka. That's hundreds of thousands in tax savings!

Roth strategies are relatively new - established with the Taxpayer Relief Act of 1997. The beauty of a Roth is that once the money’s in, it's tax-free forever with a few minor stipulations: 1) Your account must be more than 5 years old, 2) Each conversion must be held for at least 5 years, and 3) Gains may have a 10% tax penalty if used before 59.5. The amount contributed (basis) can be accessed anytime (tempting but don't…).

The next question is “How do you get money into a Roth”?

For most, if you have income, it’s often a great choice given lower taxes now and no taxes later. There are 2 typical options:

  1. Roth IRA – In 2023, if you make less than $138k individually or $214k married, the maximum allowable is $6,500 each + a $1,000 catch-up if age 50+.
  2. Roth 401k – In 2023, with no income limits, you may contribute up to $22,500 of your wages + a $7,500 catch-up if age 50+. Note that for high-income earners, a current tax deduction is often more valuable than the Roth treatment.

For option 1, high income is a disqualification. However, we have some hoops you can jump through.

  • Hoop #1 – Convert a Traditional IRA to a Roth by declaring it as income on transfer. Beware of the tax bill here! It’s best to pay the taxes out of pocket instead of from the transferred account so you have more assets ending up in Roth. And don’t forget the 5-year rule.
  • Hoop #2 – Back-door Roth contributions. Contribute to an IRA without taking a deduction, then convert it to Roth. The devil is in the details here. Don't fall victim to the aggregation rule which could add cost basis to your IRAs!
  • Hoop #3 - 401k Voluntary After Tax (Or After-Tax Post 1986). This is a great, albeit rare, way to get into a Roth. This uses the gap in deposits to your 401k and the total limit. A VAT contribution can be converted much like a back-door Roth.

The teaser from Secure Act 2.0 - 529 plans received an interesting update. After holding the plan for 15+ years, up to $36,000 lifetime can be converted to Roth. There’s more to consider here, however, it is yet another way to get into Roth.

While building wealth, having a portion of it treated as tax-free is a great strategy. Just know that there are often avoidable pitfalls to getting it there and costs may outweigh the benefit. This is a great topic to bring up with your Financial Advisor. And if you’re not working with Prosperity yet, this would be a great ice breaker to get the conversation started!