Arthur R McPherson – President and CEO of McPherson Financial Group LLC.
Roth IRAs are little-used “tax-free buckets” for retirement.
Most high-income employees have after-tax contributions go into their 401ks after they have maxed out on their deductible contributions. In my business, I see many people with $1 to $3 million in their 401k accounts, 20% to 25% of which is after-tax money. Where does this after-tax money come from when they never contributed to a Roth IRA? Most likely from contributing more than they could deduct in the 401k platform.
401ks do have contribution limits if you are under age 50. For the tax year 2020, you were allowed to contribute up to $20,500. If you are over age 50, you can add an additional $6,500 as a catch-up provision, providing a total pre-tax contribution of $27,000. Many 401k plans will allow for higher contributions, up to $58,000 in 2022, but the contributions above $27,000 will be after-tax contributions. They are separated by your employer and are kept separate till the day you are ready to roll over your funds.
This is where you must be careful. Many 401ks can be rolled over to an IRA with no trouble, and many times this is in your best interest. But you need to make sure your advisor knows to keep the funds separate.
Rules For Withdrawals
There are a few rules to follow when it comes time to make withdrawals from Roth IRAs. First and foremost, the principal, your contributions, are not taxed on withdrawal. Second, you must wait five years before you can take the earnings out without being subject to tax. And third, you must be over 59 1/2 to avoid the 10% early withdrawal penalty on those funds.
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The first rule can easily be overlooked. Your contribution is not only not taxed on withdrawal; it is also not subject to the 10% early withdrawal rule. In other words, you can contribute to a Roth IRA and take the principal out whenever you want and not be taxed. That makes sense because you have already paid tax on that money. The second part of this rule is also key: Your principal will not be taxed even if withdrawn within five years and before age 59 1/2 because you tell the IRS whether you have withdrawn earnings or principal or both.
A Rollover Example
Let’s use an example to illustrate. George is a retired doctor who decides to roll his 401k into his personal IRA. This normally makes perfect sense: By combining the accounts, it becomes easier to calculate RMDs when you turn 72. An IRA also has infinitely more investment options than a traditional 401k. George calls his 401k plan and requests the funds to be rolled over into his IRA. The rollover went smoothly: no tax on the transfer, all funds were rolled over and it was considered a direct rollover.
Except George lost a big tax benefit. Unfortunately for George, he didn’t understand the tax implications of combining the two accounts. George had been making nondeductible contributions for all those years. By combining the two accounts, George eliminated the ability to withdraw those contributions. Now every time George took a dollar out, about 5 cents was a tax-free return for his principal.
But George has a dilemma: He needs to withdraw $200,000 to buy his retirement home in Florida. Now when he withdraws those funds from the IRA, he will lose 32% of his money to taxes.
Backdoor Roth IRAs
If George had known he could split the after-tax portion of his funds into a Roth IRA, those funds would have been separated during the rollover and provided plenty of tax-free dollars to purchase his retirement home. This is called a backdoor Roth IRA and can make a huge difference to tax-free retirement income. Funds that are rolled into the Roth IRA this way would be allowed to grow tax-free throughout George’s retirement, so any time George needed money, he could withdraw from his Roth IRA with no tax due.
The backdoor Roth can also be done another way, similar to what George could have done if he had correctly rolled his after-tax 401k funds to a Roth IRA. If you can’t contribute into a 401k and you are limited by Roth contribution limits of $6,500 plus $1,000 for catchup, it’s hard to get enough funds into a Roth. But there is a trick to getting more funds into Roth dollars. You can always contribute to a nondeductible IRA with no income limits. So, after you have made your contribution, you can immediately convert the nondeductible IRA into a Roth. For conversions, there are no income rules. This means that anybody, regardless of income, can convert a traditional IRA into a Roth IRA. This immediately turns a taxable IRA account into a lifetime of tax-free income for you and your heirs.
The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.