By Andrew J. Tapparo, MSF, RICP®
Saving for retirement involves more than just building a decent nest egg; it’s also about gaining an advantage when it’s time to withdraw your money. This is where the Roth IRA truly shines.
The Roth IRA is an individual retirement account that offers unique advantages not found in traditional IRAs. Its most significant benefit lies in its tax-friendliness. In retirement, a Roth IRA provides a tax-free income stream, enabling you to retain more of your hard-earned money. Read on to consider how a Roth IRA may support your financial success and the overall performance of your portfolio.
1. Tax Benefits
It can be tempting to think short-term and only invest in a traditional IRA for a tax deduction now, but the Roth’s tax-free withdrawals in retirement (after the age of 59½) could be an even greater benefit to you. A Roth is an incredible tool to help you limit and manage your tax liability in retirement. Instead of being forced to pay income taxes on all the money you need to live on, you can decide how much to take from a taxable account and how to supplement it from a tax-free account in order to manage your tax brackets and minimize your tax burden.
A Roth IRA offers tax deferral on any earnings in the account. Qualified withdrawals of earnings from the account are tax-free. Withdrawals of earnings prior to age 59 ½ or prior to the account being opened for 5 years, whichever is later, may result in a 10% IRS penalty tax. Limitations and restrictions may apply.
2. No Required Minimum Distributions
With most tax-deferred retirement accounts, the owner must begin taking required minimum distributions (RMDs) when they reach age 73, regardless of whether or not they need the money to live on. Why does this matter? Essentially, not taking RMDs means you can leave the money in your Roth to grow for your lifetime, even making more contributions after you retire if you earn an income. You can then use this nest egg as an estate planning tool to provide tax-efficient income for future generations.
While the primary goal of a Roth is to save for retirement, the way it is set up allows for plenty of flexibility if you need to access your funds. Keep in mind that if you want to avoid tax penalties, you can only withdraw your contributions, not your growth. This flexibility allows you to save for retirement without worrying about your money being tied up if you need it for an emergency.
If you need to dip into your earnings as well, you could face a 10% early withdrawal penalty unless you qualify for certain exceptions, such as:
- If you are older than 59½ and have held the account for at least five years
- You are purchasing your first home (there is a $10,000 lifetime limit for this exception)
- You will use the funds to pay for medical expenses that are more than 7.5% of your AGI
- The withdrawal is for qualified education expenses
- You are permanently disabled
- You are using the money for a qualified birth or adoption expense
4. Reduce the Impact of Medicare IRMAA
Another benefit of having a Roth IRA is to reduce the impact of Medicare Income-Related Monthly Adjusted Amount (IRMAA) surcharges in retirement. IRMAA surcharges represent an increase to Medicare Part B and Part D standard monthly premiums; more simply, IRMAA is a surcharge that Medicare enrollees have to pay each month if they make too much money. And it is a cliff tax, which means if you make even $1 too much, you are subject to the monthly surcharge for an entire year! (And it applies to both spouses.)
IRMAA surcharges are based on your Modified Adjusted Gross Income (MAGI) from two years ago. For example, the 2023 IRMAA brackets are based on your MAGI from 2021. In 2023, if your 2021 MAGI was greater than $97,000, you would be hit with IRMAA. Joint filers with income greater than $194,000 would each be subject to IRMAA. Since Roth distributions are not included in MAGI, they can be a great tool to limit the impact of the IRMAA surcharge.
5. What if I’m Not Eligible?
There’s no doubt that Roth IRAs boast many pros, but one limitation is that most high-income earners don’t qualify for a Roth IRA. As of 2023, you’re not eligible to contribute to a Roth IRA if you make at least $153,000 as an individual or $228,000 as a married couple. Thankfully, you aren’t out of luck. Here’s how you can still reap the rewards of a Roth IRA.
A Roth IRA conversion is when you move funds from a traditional IRA into a Roth IRA. If you have a traditional IRA but believe you’ll ultimately be in a higher tax bracket once you’re ready to withdraw your funds, then a conversion may be for you. Remember, the contributions made to a traditional IRA have not been taxed; so when you convert, you will be required to pay taxes on everything coming out of the traditional IRA before it’s deposited into the Roth IRA.
With the taxes paid, the conversion can occur. Your funds can now grow tax-free regardless of how high you climb up the tax bracket ladder. The primary goal of a Roth IRA conversion is to lower your tax bill in the future.
Roth conversions can be performed a little bit at a time. That way, you can convert just enough of your account to bring your taxable income for the year to the top of your tax bracket without pushing it into a higher one. A Roth conversion strategy can be used over a span of years to move money from a traditional IRA to a Roth IRA while limiting your tax liability. In many cases, it is important to have outside funds available to pay the income tax on a Roth conversion.
Traditional IRA account owners have considerations to make before performing a Roth IRA conversion. These primarily include income tax consequences on the converted amount in the year of conversion, withdrawal limitations from a Roth IRA, and income limitations for future contributions to a Roth IRA. In addition, if you are required to take a required minimum distribution (RMD) in the year you convert, you must do so before converting to a Roth IRA.
A backdoor Roth IRA is an IRS-sanctioned loophole that lets high-income earners reap the benefits of a Roth without violating the income limits.
Let’s say your income exceeds the legal limit for a Roth IRA, but you still want to fund an account. First, you will need to open a traditional IRA and fund it with non-deductible contributions. Then you will immediately convert your non-deductible IRA to a Roth IRA and repeat this process each year in order to take advantage of tax-free growth. In this scenario, you can avoid the IRA income limits, but you cannot avoid the annual contribution limits. For 2023, you can fund a maximum of $6,500 (or $7,500 if over the age of 50). This may seem small, but over time you can amass a sizable retirement savings, especially when combined with other tax-advantaged retirement vehicles.
There’s some fine print to keep in mind if you are considering a backdoor Roth. There are two five-year rules: The first rule says that you must wait at least five years from your first contribution before you can make a penalty-free withdrawal from your Roth IRA—even if you’re over age 59½. The second five-year rule states that each of your backdoor Roth conversions has its own five-year period. For example, if you do a conversion in 2021 and another in 2022, you’ll have to wait until at least 2026 to access the first conversion and 2027 to access the second.
As with anything tax-related, consult a wealth advisor to position your money in a way that minimizes tax liability and maximizes growth.
Looking for More Information?
It’s natural to have questions regarding the most ideal retirement account for your specific needs. If you’re seeking a personalized review of your retirement accounts and are interested in exploring the possibility of a Roth conversion or backdoor Roth, we at Tapparo Capital Management are ready to assist you.
We believe that experiencing financial freedom is a journey, not a one-time event, and we’d be honored to partner with you on that journey. To schedule a “Get Acquainted Call” to see if we are a good fit for each other, call 978-887-1121 or email email@example.com and take one step closer to realizing your financial future.
Andrew Tapparo is a fee-only financial advisor at Tapparo Capital Management, a financial planning firm in Topsfield, MA, helping clients turn their savings into a retirement income that lasts. Inspired by the quote “Choose a job you love, and you will never work a day in your life,” Andy founded Tapparo Capital Management in 1997 with a passion for helping clients enjoy a truly worry-free and fulfilling retirement and experience financial freedom. As a Retirement Income Certified Professional (RICP®), he designs retirement strategies along with sound money management to help clients retire with confidence.
Andy holds a Bachelor of Science in Industrial Engineering from Rochester Institute of Technology in Rochester, New York, and a Master of Science in Finance from Bentley University in Waltham, Massachusetts. Specializing in retirement income planning, Andy completed a comprehensive financial industry education program at The American College of Financial Services and was awarded the Retirement Income Certified Professional® designation. He is frequently quoted in the media as a financial expert.
Andy and his wife, Susan, live in Topsfield, Massachusetts, and have two beautiful daughters. Outside of work, he is an automobile enthusiast, enjoys taking road trips, and loves the Outer Banks of North Carolina. In his spare time, he volunteers with the local high school varsity girl’s basketball team as the team statistician and runs the team’s website. He is passionate about supporting charities that serve our veterans and their families. To learn more about Andy, connect with him on LinkedIn.