Roth IRAs are a powerful savings tool. Unlike traditional IRAs, Roth IRAs are composed of post-tax contributions, which means that investors can make tax-free withdrawals in retirement. As such, Roth IRAs are a popular investment vehicle for individuals who may be at a higher tax bracket in retirement.
In retirement, you’ve got to look out for No. 1: your taxes. Roth dollars offer immense flexibility and freedom to your overall income plan.
Traditionally, investors wait to tap their Roth IRA until they’ve exhausted most other investment vehicles. Why? Because Roth IRAs are great long-term, tax-free compounding vehicles. That said, there are various unique strategies that savvy investors can use to maximize the utility of their Roth accounts both before and during retirement.
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Most experts recommend that individuals have an emergency fund containing three to six months’ worth of expenses stashed away in a savings account before they start investing. Young people can also use Roth IRAs as de facto savings accounts while also kick-starting their retirement savings.
Because Roth IRAs are composed of post-tax savings, young investors can withdraw contributions from the account without penalty, making it a great savings vehicle even for investors who don’t yet have a robust emergency fund. Keep in mind that while you can withdraw contributions tax-free, you can’t withdraw earnings before 59½ without a 10% penalty.
For 2021, you can contribute up to $6,000 to a Roth IRA, and if you’re 50 or older that limit is $7,000. There are income limits to qualify, though. You must make less than $125,000 if single or $198,000 if married filing jointly to contribute the maximum amount.
An important caveat for those doing a Backdoor Roth IRA, which is a way to contribute money to a Roth IRA when you earn too much to qualify: Those contributions will still have a five-year rule, since they were conversions, not direct contributions. The “five-year rule” we are referring to here (there are technically three different five-year rules with Roth IRAs to be aware of), notes that each conversion has its own five-year period. For example, if you converted your traditional IRA to a Roth IRA in 2021, the five-year period for those converted assets began Jan. 1, 2021, and that conversion would not be accessible without a penalty before Jan. 1, 2026 (five years later).
Roth IRAs may also be an attractive investment option for small-business owners. Under the Tax Cuts and Jobs Act, business owners can take a qualified business income (QBI) deduction on their personal income tax return. This deduction presents unique opportunities for retirement savings since pre-tax contributions might be taxed at a higher rate when withdrawn in retirement.
Because of this deduction, it makes sense to invest in post-tax retirement accounts, such as a Roth IRA, instead of solely investing in pre-tax retirement accounts, such as 401(k)s or traditional IRAs. Business owners can also execute Roth conversions to increase their taxable income and fully utilize this deduction.
When converting pre-tax assets (for example, traditional IRA or 401(k)) to a Roth, this would increase their taxable income. However, with the increasing income, they would now have access to a larger QBI tax deduction. Just be sure to watch your income levels so that you don’t remove the QBI deduction altogether!
Another investment strategy worth considering is transferring funds from taxable brokerage accounts into Roth accounts. This would be used if you didn’t have cash on hand to fund a Roth IRA outright in a given year. It’s essential to remain conscious of your taxable accounts when considering long-term tax planning. Moving more funds into a Roth IRA, especially early on, reduces the risk of unfavorable tax law changes and increases asset protection for retirement funds.
You could also use your taxable accounts to help pay the tax bill on a larger traditional IRA to Roth IRA conversion, which is a fully taxable event.
If you retire early, chances are you’ll face some unique challenges when it comes to retirement income, health care costs and more. For example, many early retirees need to buy individual health insurance on the marketplace if they are not yet old enough to qualify for Medicare.
Because Roth distributions don’t count as income for the purposes of health insurance premium tax credits, early retirees can use Roth distributions to provide cash flow while also taking advantage of lucrative tax credits on their health insurance premiums. This approach can save retirees thousands of dollars on health care expenses — an area where costs are consistently on the rise.
The Medicare Income-Related Monthly Adjustment Amount, also known as IRMAA, is the amount you have to pay in addition to your Part B premium if your income crosses certain thresholds.
IRMMA can result in income “cliffs” where policy costs increase dramatically after only a slight increase in your income — as little as $1 can bump your policy up by as much as $90 per month. Using Roth distributions to supplement your other income streams can help keep your overall income level lower from a health care premium perspective.
Roth IRAs are a great investment vehicle, no matter your age. Because they are composed of post-tax contributions, they offer unique tax advantages, especially for high-income individuals who expect that their tax rate will be even higher in retirement than present day. They’re also a great complement to pre-tax retirement accounts, such as traditional IRAs and 401(k)s, as well as other tax brokerage accounts.
While you can use your Roth IRA as a straightforward retirement account, there are some unique strategies for maximizing your Roth IRA’s potential under certain circumstances. Depending on your age and financial situation, this can include doubling as a savings account, lowering your health insurance premiums before and during retirement, or reducing your tax burden.
Founder, WealthKeel LLC
Chad Chubb is a Certified Financial Planner™, Certified Student Loan Professional™ and the founder of WealthKeel LLC. He works alongside Gen X & Gen Y physicians to help them navigate the complexities of everyday life by crafting streamlined financial plans that are agile for his clients' evolving needs. He helps them utilize their wealth to free up time and energy to focus on their family, their practice and what they love most.