Building Wealth Through Roth IRA’s

With the April 18th deadline for tax filings impending, we discuss the benefits and considerations of an important tax-advantaged account in Roth IRA’s.

We’ve helped numerous clients implement a Roth IRA strategy, which can accrue potentially significant amounts of after-tax wealth for retirement when compared to the same investment in taxable accounts. And as per the old adage in finance, the earlier that money is invested, the longer it has to compound.

However, there is much care needed to implement this successfully, as was highlighted in a ThinkAdvisor piece we contributed to titled “Beware of These Backdoor Roth Dangers: Advisors’ Advice”. Investors should work with a financial / tax professional before considering these strategies to avoid adverse tax consequences, while also helping to maximize the investment opportunities within the account.


Why Roth IRA’s can be beneficial:

  1. While investors don’t receive a tax deduction for Roth IRA contributions, qualified distributions out of the account are tax-free. Compare this to traditional 401k’s and taxable accounts that typically trigger taxes upon withdrawals.

  2. Earnings in your account grow tax-free on the way to retirement, whereas taxable accounts incur taxes on interest received and capital gains on profits.

  3. While 401k plans force investors to take a required minimum distribution (RMD) upon reaching age 72, Roth IRA’s do not have this requirement.

Example: Consider a scenario where Household A invests $12k/year for 30 years into a taxable brokerage account, while Household B contributes the same into a Roth IRA [1]. Assuming each own the same portfolio, we see that Household B accumulates over $120k more wealth.

Source: Ballaster Estimates. Illustration purposes only [1]

Further, assuming both households retire in year 30 and start spending an inflation-adjusted $100k/year from the portfolio. The Roth IRA can sustain these withdrawals for longer as there is no tax drag on the account. Said another way, in this illustration the cumulative amount that the Roth IRA provides to Household B is 18% higher than that of Household A.

Source: Ballaster Estimates. Illustration purposes only [1]


Rules to consider:

  • In 2022 investors can contribute up to $6k ($7k for ages 50 and older) of non-deductible contributions per year. The deadline for 2021 contributions is on April 18th, 2022.

  • You cannot withdraw earnings penalty/tax free until you are age 59½ (other restrictions apply [2]). Evaluate your liquidity needs before investing into Roth IRA’s.

  • IRS rules dictate that for 2022, if your modified adjusted gross income is > $144k/year for single filers or $214k/year for married filing jointly, you cannot contribute directly into a Roth IRA.

  • However, investors earning above these limits have utilized a ‘backdoor’ Roth IRA. This is a highly delicate strategy that requires the guidance from a financial and tax professional to ensure appropriate steps are followed.

Mistakes to avoid

  • Investors with existing pre-tax dollars in a traditional IRA while attempting a backdoor Roth IRA will violate what’s called a ‘pro-rata’ rule. This creates an unnecessary taxable event when transferring proceeds into the Roth IRA.

  • Ensure the appropriate documents are filed with a tax professional, including Form 8606 for applicable investors.

  • When looking at investor’s overall asset allocation, certain lower growth/low ordinary income taxed assets may not be appropriate to hold in a Roth IRA structure

How advisors add value with Roth IRA’s: Working with a financial advisor and tax professional can help: 1) Ensure this strategy is appropriate for your situation 2) Coordinate backdoor Roth IRA steps are done in the correct sequence to avoid unnecessary tax consequences 3) Keep track of tax filings, and 4) Invest Roth IRA assets that optimizes for your tax situation.

For more information about incorporating Roth IRA’s into your financial future, click here to schedule an introductory call with us and we’d be happy to help!


Disclaimer: The article is for informational purposes only and is not intended to be used as a general guide to investing or financial planning, or as a source of any specific recommendations, and makes no implied or express recommendations concerning the manner in which any individual’s investments or assets should or would be handled, as appropriate strategies depend upon each individual’s specific objectives. Opinions expressed in this article are current opinions, which are not reliable as fact, as of the date appearing in this article only and are subject to change. For a comprehensive review of your personal situation, please consult with a financial or tax advisor.

Reference:

  1. The difference in pre-tax and after-tax annual rates of return differ between types of investments. Calculations assume a federal income tax rate of 24.00%, qualified dividend tax rate of 15.00%, and long-term capital gains tax of 15.00%. The results assume that 20% of stock returns are dividends, and the rest are capital gains. They also assume that 100% of taxable bond returns are from ordinary interest income. This is a hypothetical example meant for illustrative purposes only. It does not reflect an actual investment. Returns are not guaranteed and results will vary. Investment returns cannot be predicted and will fluctuate. It is not intended to serve as investment advice since the availability and effectiveness of any strategy is dependent upon your individual facts and circumstances.

  2. Internal Revenue Service. Publication 590-B (2020)

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