Roth IRA: How to Maximize This Wonderful Tool in 2023

Advisor Danielle Woods discusses Roth IRAs in this 5 minute video (direct YouTube link.)

By Danielle Woods, daniellewoods@propel-fa.com

Last year we celebrated the 25th anniversary of the Roth IRA account type.  We recommended them to clients for the entirety of their existence because of their potential for excellent tax savings and liquidity.  It was an uphill climb for a very long time; but after years of pontificating, we finally see a general recognition of the account type and a new interest in utilizing it among our existing and prospective clients.

Unfortunately, for the first time in the history of the Roth IRA, Congress is threatening to create new restrictions.  This makes it even more important to include Roths in your retirement planning sooner than later.

Why we love Roths

In our retirement savings, we want tax diversity, and Roths are a key part of attaining that.

Why? Because Roths are accounts for money that has already been taxed.  Your investments grow tax-free and when you take money out, it’s invisible on your tax return. You don’t pay taxes on it, and it doesn’t increase your taxable income.  

More and more of our tax lives are dependent on our tax return’s Adjusted Gross Income (AGI).  Whether it is qualifying for a one-time stimulus payment, certain medical premiums, or refinancing a mortgage, the AGI is becoming an increasingly important number for other areas of our financial lives.  A Roth IRA gives us the opportunity to control that number on an annual basis. 

For more detail about our love of Roths, consider reading our blogpost Traditional Retirement Savings: Why Tax-Deferred Accounts like 401(k)s May Be the Wrong Choice for Some Taxpayers — Propel Financial Advisors.

What is a Roth?

Roth IRA’s are retirement accounts that are funded with already taxed dollars but the earnings will be tax free (if all rules are followed).  This is the opposite of traditional retirement accounts like 401(k)s and IRAs where the taxes are incurred on the contributions AND earnings upon withdrawal.    

Who Can Contribute?

Any individual with earned income (or any individual whose spouse earns income) may be eligible to contribute. The rules differ whether contributing to a Roth 401(k) offered by your employer or to a personal Roth IRA.

If your earned income is somewhere in the middle of the income limit range, your personal Roth IRA contribution amount will be less than the maximum allowable.  If unsure of your earnings, you can hold off contributions until your Modified Adjusted Gross Income (MAGI) is confirmed.

The contribution deadline for a calendar year is APRIL 15TH OF THE FOLLOWING YEAR!

This gives you time to determine your income for the previous tax year.

What is Modified Adjusted Gross Income (MAGI)?

The magic number when determining your earned income for purposes of personal Roth contributions is your Modified Adjusted Gross Income (MAGI).  For many taxpayers, that number matches the Adjusted Gross Income (AGI).  For others, it is slightly different depending on allowable deductions and tax penalties.  Speak with your tax professional for details.

Examples of Good Candidates for Roth IRAs

These tax rules are confusing.  Rather than list statute information from the Tax Code, we think it’s more helpful to give you examples.  

1. Single Working Taxpayer – direct Roth contribution 

Scenario:  Steve is a young single taxpayer who lives with his parents and earns $25,000 per year.  

Roth Option:  He may contribute $6,500 per year to his Roth IRA.  

2. Married Working Taxpayer with nonworking spouse – direct Roth contributions

Scenario:  Mary is 40 years old and has a full-time job earning $90,000 per year. Her husband Malcolm stays home with the children and does not have earned income.

Roth Option:  Both spouses may contribute $6,500 per year to their Roth IRAs.  

3. Single Working Taxpayer with High Income  - Roth 401k 

Scenario:  Shelly is a single taxpayer aged 51 who earns $200,000 per year.   Her employer offers a Roth 401k option.   

Roth Option:  Shelly may contribute $30,000 to her Roth 401k.  Her employer match will be deposited into a traditional retirement vehicle and subject to taxes upon withdrawal in the future.  

4. Married Working Taxpayer with Nonworking Spouse and High Income – Roth 401k and Backdoor Roth

Scenario:  Mike is a married taxpayer aged 51 who earns $200,000 per year.   His wife Melanie, also aged 51, does not work and has no retirement of her own. Mike’s employer offers a Roth 401k option.  

Roth Options:  Mike may contribute up to $30,000 per year to his Roth 401k. Melanie may contribute $7,500 to a Traditional IRA then convert the full $7,500 to a Roth. The transaction is not taxable because the IRA contribution was not deductible.  This is called a Backdoor Roth.

5. Single Working Taxpayer with High Income and Existing IRA accounts – Roth Conversion

Scenario:  Sally is 40 years old and has a full-time job earning $150,000 per year.  She earns too much to contribute directly to a Roth IRA and her employer does not offer a Roth 401k option.  Sally also has an IRA from previous jobs valued at $200,000.  Sally still wants to be able to invest in a Roth.  

Roth Option:  Sally can do a series of Roth conversions each year from her IRA to her Roth.  She will pay tax on the amount she converts, but she will save the future earnings from taxation.

These are very general examples.  While one of these may apply to you this year, that may not be the case next year.  Your specific situation will determine what makes sense for you and should be carefully planned with the help of a financial and/or tax professional.

Roth Withdrawal Rules and Potential Taxes

While Roth IRA’s are wonderful savings vehicles, there are a lot of rules that need to be followed to maximize their advantages.  In the previous section, we discussed how to get your money into a Roth IRA.  Below we will use the same scenarios as we did above; but this time, we will illustrate the consequences for withdrawing from the Roth. (We do not include state income tax consequences as each state is different.)

1. Single Working Taxpayer – direct Roth contribution 

Scenario: Steve contributed $6,000 per year to his Roth for the past 5 years for a total of $30,000 in contributions.  The market value of the account is now $40,000.  Sadly, Steve is hurt in a car accident and must leave his job for an extended period of time. Steve decides to withdraw all of the funds from his Roth IRA against the advice of his advisor. 

Consequences:  Steve’s contributions of $30,000 will not be taxable upon withdrawal. However, the earnings that total $10,000 will be subject to income taxes as if they were earned income and a 10% penalty of $1000 will be assessed.  It is very important that Steve has records to prove his contributions and that a knowledgeable tax preparer can properly report the taxable portion of the income on his tax return. Steve will also lose all future earnings on the account.

2. Married Working Taxpayer with nonworking spouse – direct Roth contributions

Scenario:  Mary and Malcolm each contributed $6,000 per year for the past 5 years for a total of $30,000 each. They realize that they failed to create an emergency fund and now need $5,000   to pay for some major plumbing repairs and want to withdraw $2,500 each from their Roths.

Consequences:  Both spouses may distribute $2,500 from each of their Roths and will not be taxed on it.  They should also hire Steve’s tax preparer to make sure it is properly reported to  the IRS.  They will lose future earnings on the withdrawal amounts.  

3. Single Working Taxpayer with High Income  - Roth 401k 

Scenario:  Shelly contributed $27,000 to her Roth 401k plan for 10 years and passes away at age 61 due to cancer.  Her beneficiary is her son, Bob, who is 25 years old.  

Consequences:  Bob inherits Shelly’s Roth IRA.  Because Shelly’s Roth was more than 5 years old, Bob will not pay any taxes on his withdrawals.  However, under the SECURE ACT, Bob is required to withdraw the total amount of the Roth within 10 years of Shelly’s death.  If Bob is eligible to contribute directly to a Roth, he may do so to the maximum extent.  Anything else may be invested in a taxable account to continue earning, but he will lose the benefit of the Roth on that portion.

4. Married Working Taxpayer with Nonworking Spouse and High Income – Roth 401k and Backdoor Roth

Scenario:  Mike and Melanie get divorced.  Melanie needs some cash fast and decides to take it from her Roth IRA.   She contributed $7,000 per year for the past 6 years via a Backdoor Roth for a total of $42,000 in conversions.   The account is now worth $50,000.   Melanie wants to distribute $20,000 from her Roth to pay her attorney and cover her car payment.

Consequences:  Conversions from an IRA to a Roth cannot be withdrawn for 5 years without penalty.  The only nontaxable portion available to Melanie is the $7,000 she contributed 6 years ago.  The additional $13,000 will be subject to a 10% penalty, but it will not be subject to income tax.

5. Single Working Taxpayer with High Income and Existing IRA accounts – Roth Conversion

Scenario:  Sally converted $100,000 from her IRA to her Roth over the course of 25 years and paid the tax on those conversions each tax year.  Sally is now 65 years old and wants to distribute $5,000 per year from her Roth to cover living expenses and reduce the amount she has to withdraw from her IRA.

Consequences:  Sally’s Roth distributions are completely tax-free and will not impact her tax return.   

In closing

We are eternally grateful to former Senator William Roth of Delaware (Roth IRA - Wikipedia) who sponsored the law that created Roth IRAs in 1997.  Roth IRAs have been an integral part of a retirement plan for over 25 years, and there are a lot of ways to utilize one regardless of your situation.   As you can see from this article, there are a lot of rules, and we know them all.  Let us know what we can do to help you maximize your savings and more efficiently manage your tax burden with these types of accounts.