Why Build Up a Roth Portfolio and How Best To Do It

In our last post, we discussed how the SECURE Act, which Congress passed in late December, changed a key rule on inherited IRAs:  non-spouse beneficiaries now need to withdraw (and pay taxes on) the full amount of an inherited IRA within 10 years, rather than being able to spread out the withdrawals over their lifetimes.  In some cases, needing to withdraw the full amount that quickly could push beneficiaries into a higher tax bracket, resulting in a bigger tax bite out of their inheritance.  For this reason, one consequence of the new law is that it increases the desirability of having some retirement assets in a Roth IRA or Roth 401(k), rather than just a traditional IRA or pre-tax retirement account.*  Non-spouse beneficiaries of a Roth account would still need to withdraw the assets within 10 years, but they wouldn’t owe any taxes on it.**

How then can you build up your Roth portfolio?  We discuss the primary strategies below.

Direct Roth IRA Contributions.  If your income is below a certain level, you can contribute after-tax dollars directly to a Roth IRA.  In 2020, the ability to contribute directly to a Roth phases out for single tax filers when their Adjusted Gross Income is between $124k and $139k; for married filing jointly, the phase out is between $196k and $206k.  The trade-off, however, is that most earners cannot afford to contribute the maximum to their employer retirement accounts and contribute to a Roth IRA as well.  Therefore, choosing to save to the Roth means foregoing the current-year tax benefit of saving pre-tax dollars, e.g., to a 401(k) or 403(b).  It may make sense to save to a Roth instead of an employer plan (or traditional IRA) if you are in a low tax bracket (e.g. 10% or 12% bracket) or if you expect that you will be passing on most of your retirement assets to your heirs rather than using them yourself in retirement.  Otherwise, saving pre-tax dollars to an employer plan or traditional IRA is generally more advantageous over the long run.

Roth 401(k) Contributions.  Some employer retirement plans have a Roth option, so you can contribute after-tax dollars to a Roth 401(k), e.g., rather than pre-tax dollars to a traditional 401(k).  There are two main advantages to this option:  1) There are no income limits, so you can contribute to the Roth 401(k) even if your income is higher than the limits for Roth IRA contributions.  2) The annual contribution limits for a Roth 401(k) are higher than the limits for a Roth IRA ($19,500 versus $6,000 for those under age 50 in 2020).  The drawback, again, is that by contributing to the Roth instead of a traditional 401(k), you forego current-year tax benefits, and if the after-tax amount that you are able to save is less than the pre-tax amount (due to the loss of the current-year tax benefit), you will miss out on the growth from compounding on the higher dollar amount over the course of years— or even decades— until retirement.

Roth Conversions.  Another option is to convert pre-tax dollars saved in an IRA into a Roth IRA.  The value of the funds moved from the IRA to the Roth IRA will be added to your taxable income for that year, but if you are in a low tax bracket, this might be accomplished at a relatively low cost.  This can be a desirable option for retired clients, who have significant taxable account assets and do not have much (or any) pension income, in the years between retirement and when they start taking RMDs and/or full Social Security benefits.

Backdoor Roth Conversions.  For those who are still working and in a relatively high tax bracket, backdoor Roth conversions might be a viable way of building up a Roth portfolio.  The key factor is whether you have no (or negligible) assets in a traditional IRA, e.g. if you have worked for the same employer your whole career and therefore have all retirement assets saved in your employer retirement plan.  If so, you can make a non-deductible contribution to a traditional IRA and then do an immediate Roth conversion thereafter.  Since the IRA contribution includes only after-tax dollars, you won’t owe any tax on the conversion.  This allows you to contribute to a Roth indirectly if your income is too high to do so directly.  It is ideal for those who are already contributing the maximum to their employer retirement plans but still have additional funds that they want or need to save each year.

After-tax 401(k) Contributions.  Similarly, for those who are still working and are already contributing the maximum pre-tax amount to their employer retirement plans, some employers permit you to make after-tax contributions to your 401(k) or other qualified plan.  The plan sponsor tracks these contributions separately, and when you separate service, you can roll over the after-tax portion of your 401(k) into a Roth IRA.  This is another way to build up Roth assets when your income is too high to contribute directly to a Roth IRA.

If you are wondering about the benefits of Roth assets for your particular situation and whether you would be a good candidate for any of these strategies, please feel free to contact us, and we’d be happy to discuss them in more detail.

*Please note that this discussion is based on current tax law. Congress could change the rules surrounding the tax status of Roth or other retirement accounts in the future, which could impact the value of the strategies outlined above.

**For a quick recap on the difference between Roth IRAs and traditional IRAs or retirement accounts, please see below: