Four Roth Strategies to Save on Taxes in Retirement.

The Roth IRA has become one of the more popular retirement accounts. Roths are funded with dollars that have already been taxed and give the benefit of tax-free withdrawals of both your contribution and earnings during retirement. There are a few requirements, though. You need to be 59 1/2 or older and have held the account for at least five years to enjoy the tax-free withdrawals. Another benefit is that there is no need to take required minimum distributions (RMDs) starting at age 73, unlike other retirement accounts.

However, there are limits to who can contribute to a Roth IRA. In 2023, individuals with incomes at or below $153,000 ($228,000 for those married, and filing jointly) can contribute to a Roth IRA. The maximum contribution amount is $6,500 per year ($7,500 if you’re 50 or older), though that limit is reduced if your income falls between $138,000 and $153,000 (between $218,000 and $228,000 if married).

The income limits on Roth IRAs make it difficult for high earners to contribute to these accounts directly. With some planning, even high earners can benefit from funding Roth accounts.

Here are some strategies to direct retirement funds to Roth accounts.

1. Utilize the Roth Option in Your Workplace Retirement Plan.

If your employer offers this option, which has no income limits, you can put aside up to $22,500 ($30,000 if 50 or older) in after-tax contributions in 2023. Just note that leaving funds in your 401(k) requires you to take minimum distributions at age 73. It may be beneficial to work with a financial planner to attempt to avoid this.

2. Employ a Roth Conversion Strategy.

For those who have funds in pre-tax accounts like a traditional IRA, or 401(k), you can convert some or all of the balance to a Roth IRA and pay ordinary income tax on the converted amount. The benefit of this transfer is to pay the tax now and let the remainder of the funds enjoy tax-free growth in the Roth. Often times you might choose to spread out the conversion over multiple years to better manage your tax bill.

If your retirement account has both pre-tax and post-tax contributions, the converted amount will be taxable in proportion to the pre-tax value of the account. This is known as the pro-rata rule. It’s important to note that Roth conversions are irrevocable.

3. Make Backdoor Roth Contributions.

This is a strategy for individuals who are not eligible to contribute directly to a Roth IRA due to income limits. It allows high-income earners to convert funds from a traditional IRA into a Roth IRA by taking advantage of a loophole in the tax code. Here’s how it typically works:

1. Contribute to a Traditional IRA: Make a non-deductible contribution to a traditional IRA. Since you are ineligible to contribute directly to a Roth IRA, you can still contribute to a traditional IRA regardless of income limits.

2. Convert to a Roth IRA: After making the non-deductible contribution to the traditional IRA, you can initiate a conversion of those funds into a Roth IRA. This is typically done by transferring the funds from a traditional IRA to a Roth IRA.

3. Beware of Tax Implications: Although the non-deductible contribution itself is made with after-tax dollars, the conversion is calculated based on the ratio of your pre-tax and after-tax funds within your traditional IRA. Any tax owed on the conversion will need to be paid in the year of conversion.

4. Enjoy Tax-Free Growth: Once the funds are in the Roth IRA, they can grow tax-free, and qualified withdrawals in retirement are not subject to income taxes.

The backdoor Roth strategy is especially attractive for individuals who expect to be in a higher tax bracket in retirement or want the benefit of tax-free growth potential.

4. Execute Mega-Backdoor Roth Contributions.

The mega backdoor Roth strategy is a super-advanced retirement savings strategy that allows individuals with high incomes to contribute significant amounts of after-tax money to a Roth IRA, or Roth 401(k), beyond the normal contribution limits. This strategy is best for individuals who have already maxed out their regular contribution limits. Here’s how it works:

1. Confirm Plan Eligibility: You need to confirm that your employer’s plan allows for after-tax contributions and in-service withdrawals.

2. Maximize Pre-Tax Contributions: Contribute the max amount allowed to your workplace plan with pre-tax contributions ($22,500 for 2023, with another $7,500 in catch-up contributions for those 50 and over. This will reduce your taxable income for the year by the amount contributed.

3. Make After-Tax Contributions: As long as your employer’s plan permits after-tax contributions, contribute additional funds above the pre-tax contribution limit. After-tax contributions are made with after-tax dollars and are not tax deductible. For 2023, the limit for these after-tax contributions is $43,500. This is above and beyond the annual employee contribution limit of $22,500, plus catch-up.

4. Perform an In-Service Withdrawal: depending on the rules of your plan, you may be able to do an in-service withdrawal to rollover funds into a separate Roth IRA. When you make this withdrawal the after-tax contributions will be tax-free, but any gains on the contributions may be subject to taxes, depending on the timing of your conversion.

5. Watch out for the Pro-Rata Rule: This comes into play if you have pre-tax and after-tax funds in a traditional IRA or 401(k). The rule states that when converting funds to a Roth IRA, you may owe taxes on a portion of the conversion based on the percentage of pre-tax funds in the account.

Enjoying the tax-free growth benefits of a Roth IRA could make a major difference in your retirement income plan. These strategies can be complex, and it’s crucial to fully understand the rules and implications specific to your retirement plan and tax situation. Before considering any of these strategies I recommend you consult with a financial advisor or tax professional for guidance.