Even in my late 30s, I still enjoy a good superhero movie. There’s nothing like cheering on the good guys against the latest forces of evil trying to save the planet from ultimate destruction. I will naturally gravitate towards a new Avengers or Spiderman movie if nothing else looks good. You might not have heard of them, but we in the church community even had our own versions of superheroes, including Bibleman and Commander Kellie and the Superkids.
I digress.
In the world of financial planning, there is one superhero that continues to be a consistent hero for investments and taxes. The Roth IRA. While the majority of us understand how a Roth IRA can help to invest for the future through tax-free growth, there are various ways to accomplish this efficiently. Let’s take a look at how to maximize this superhero of an account to the best extent possible.
Maximize Annual Contributions
Plain and simple, either “use it or lose it”. While a simple concept, many people still struggle with the discipline of taking advantage of the IRS annual contribution limits to fully fund their Roth IRA. If you’re still working or otherwise making earned income, this is the quickest and easiest way to invest tax-free for your future.
Keep in mind, if you are married, you can also invest for a non-earning spouse as long as at least one spouse has enough earned income to meet the maximum contribution limit. While the IRS annual contribution income limits begin to phase out at $146,000(single) and $230,000(MFJ), a backdoor Roth contribution might still be viable(keep reading to find out more).
Make Tax-Smart Conversions
If you’ve ever planned out bathroom stops on a road trip, you are very familiar with the concept of “go when you can, not when you have to”. The same principle applies when looking at Roth conversions. It may not always be an urgent issue, but with some forethought and planning it might make sense to use a Traditional IRA to “convert when you can, not when you have to.”
The most common window for many people to make Roth conversions is during “gap years” between retirement and taking Social Security and/or Medicare. The reason for this is that there is usually a drop in earned income that allows the taxable income “bucket” to be filled in at a modest tax rate as opposed to when earnings are high. It is also important to consider converting during gap years because of 1) potentially higher Medicare premiums due to IRMAA surcharges and 2) a larger percentage of Social Security benefits being taxed. Both of these cost increases come as a result of a higher Adjusted Gross Income.
A second advantageous time to convert funds to a Roth IRA is when deductions are higher. This strategy is commonly referred to as “bunching”. Because of the offsetting increases/deductions to gross income as a result of converting/deducting income, a Roth IRA conversion can be done with relatively modest tax implications if planned out properly. Check out our previous post on 3 Tax-Efficient Tithing Strategies for Charitable Giving for additional information.
2024 and 2025 also present good opportunities for Roth conversions due to the expiration of the Tax Cuts and Jobs Act(TCJA) of 2017. As it stands, the currently high standard deduction and favorable tax brackets will be reverting to pre-TCJA levels beginning in the 2026 tax year. Taking advantage of this current tax environment while it’s still available can also be a valuable tool in retirement tax planning and management.
Make Backdoor Roth Contributions When Necessary
As mentioned above, if your income is above the annual contribution limits, a standard Roth IRA contribution might not be possible. However, under current IRS rules, a tax filer not covered by a workplace retirement plan can take advantage of an IRA to make a nondeductible IRA contribution followed by a conversion to a Roth IRA. This is referred to as a “Backdoor Roth Contribution”.
While there is one extra logistical step involved in setting up a Backdoor Roth Contribution, it is usually minor compared to the added advantage of getting money into a tax-free account.
The first step involves making a nondeductible contribution to a Traditional IRA. This essentially gets the money into the IRA “ecosystem”. Because there is no tax deduction allowed based on the income limit rules, the basis in this account must be tracked for future tax reporting. Therefore, it is best to convert the money that is contributed to a Traditional IRA as soon as possible to avoid having excess interest or dividends from accumulating and being taxable.
The second step to the process is the actual conversion itself. As mentioned, if the conversion is done right away or as soon as possible after the non-deductible Traditional IRA contribution is made, the amounts contributed/converted should be identical or very close.
Once you’ve finished the second step, you’ve completed the Backdoor Roth Contribution! Keep in mind that you will receive two tax forms from your account custodian – one showing the non-deductible contribution to the Traditional IRA(Form 5498) and one showing the conversion to the Roth IRA(1099-R).
One final rule to keep in mind when setting up a Backdoor Roth Contribution is the Pro-Rata Rule. Since the IRS views all IRAs(including SEP, Simple, and Traditional) as one aggregate account, any amount that is left in an IRA at the end of the year must be accounted for and used to pro rate the amount of any conversion using the end of year account balances. This involves careful tracking and planning with your tax advisor and financial advisor to make sure you aren’t left with an unexpected tax bill the following April.
Utilize Tax-Free Basis Withdrawals
While most money set aside into a Roth IRA is best used for long-term growth and retirement planning, the feature of being able to make tax-free basis withdrawals has some good potential uses. If you’re under 59 1/2, there can be penalties and additional taxes on retirement account withdrawals. However, since money that was deposited into a Roth IRA through normal contributions was post-tax to begin with, the IRS allows this money to then be taken out tax-free if needed.
I believe the best use case for this strategy is when a small amount of money(preferably under the annual contribution limit) is needed for a short-term purpose. It can be further useful if pulling from another source of funds creates high taxes or penalties as opposed to withdrawing the basis from the Roth IRA. ie – an unexpected car repair bill or home emergency. If the plan is to replenish the funds back into the Roth IRA as soon as the repair is paid for through cash flow, the amount can then be put back into the Roth IRA using a normal contribution.
While it’s always best to have an emergency fund of 3-6 months of expenses set up for potential emergencies, having an additional option to pull from can add to overall financial stability and peace of mind.
Tax-Free Inheritance
The 5th and final strategy to fully maximize your Roth IRA is when deciding who/when to leave an inheritance to. Because Roth IRAs don’t lose their tax-free status when they are passed on to heirs, Roth IRAs create a very valuable estate planning tool to maximize heirs’ after-tax benefits.
Remember that while Required Minimum Distributions (RMDs) are not required for original Roth IRA account owners, RMDs are required for beneficiaries. However, amounts taken out of Inherited Roth IRAs by beneficiaries are counted as qualified distributions, which are not subject to federal income tax.
In conclusion, the many tax-free benefits of Roth IRAs truly make them one of the great superheroes in financial planning. By carefully evaluating and implementing these strategies at the right time, your financial future is an unstoppable force.
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