Taxes are just as corrosive to your nest egg as high investment fees. The low-hanging fruit of tax-efficiency include employer-sponsored tax-deferred savings vehicles. What happens after you’ve maxed out your employer-sponsored plan? There are many suboptimal tax-avoidance options with exorbitant fees and commissions, like annuities and whole life insurance policies, that are rarely worth considering. Fortunately, there are still options that are cheap and easy to implement if you take the time to learn the rules. These include the Roth IRA, the 529 Plan, the Traditional IRA, and the “side gig” 401k/SEP. Here we will consider the Roth IRA.
The Roth IRA is a unique type of retirement account in which you pay taxes on money going into the account but pay no taxes on money coming out of the account, regardless of how much the account has grown. You can set it up yourself online with Vanguard, Fidelity, or Schwab. The maximum contribution for 2016 is $5,500 per person per year ($6,500 > age 50). Unfortunately, there are income limits and contributions are quickly phased out for Modified Adjusted Gross Incomes > $118,500 ($184k, married).
BENEFITS OF THE ROTH IRA
- tax-free growth
- tax-free distributions
- no required distribution at age 70 1/2, unlike a Traditional IRA or 401k
- can continue to contribute beyond age 70 1/2
- pass along your Roth IRA through the generations tax-free
- withdraw without penalty starting at age 59 1/2
- withdraw earlier for permanent disability, medical expenses >10% of income, back taxes, and health insurance premiums while unemployed
If you earn more than the income limits, there’s still a way. You can get around the income limits through a “backdoor Roth IRA conversion” by contributing post-tax money to a Traditional IRA and then rolling over the money from the Traditional IRA into a Roth IRA. There is no limit to the amount you can rollover from a Traditional IRA to a Roth IRA. The IRS allows this as a way of incentivizing people to pay taxes today rather than defer those taxes for decades.
THE PRO-RATA RULE
Is this a free lunch? Not quite. For the backdoor Roth IRA conversion, the IRS applies the “pro-rata rule” which says that you must consider all money in all IRA accounts (except Roth IRA), including money that is pre-tax and money that is post-tax, when figuring out if you owe taxes. For example, if you have a IRA assets with $5,000 post-tax money and $45,000 pre-tax money (that you rolled over from an old 401k), you cannot cherry-pick and just rollover the $5,000 post-tax money. The IRS says that you must pay taxes on the rollover in proportion to all your IRA assets. So, only 10% of your rollover will be tax-free. You will owe income taxes on 90% of the rollover.
But do not fret. There is a way to get around the pro-rata rule! Some 401k and 403B plans allow you to roll your rolled-over IRA assets into your current workplace plan. After you have transferred your pre-tax IRA assets into your workplace plan, you can now minimize taxes as you fund your backdoor Roth IRA. In the example above, after you transfer that $45,000 into your employer 401k, 100% of your $5,000 rollover will be tax-free.