Maximizing Roth savings for high-income earners

Maximizing your Roth savings is a terrific way to save for retirement for both high-income earners and professionals at all levels. Roth IRA is a tax-free retirement savings account that allows you to make after-tax contributions to save towards retirement.

Key Roth benefits for high earners

  • Roth IRA offers tax-free retirement growth. All contributions are pre-tax. In other words, you pay taxes before you make them. Once your dollars hit your Roth IRA, they grow tax-free.
  • You won’t pay any taxes on future capital gains and dividends.
  • Roth IRA is not subject to required minimum distributions at age 72.
  • You can always withdraw your original contribution tax and penalty-free.
  • Maximizing your Roth savings, especially for high-income earners, is an effective way to diversify your future tax exposure
  • High earners can incorporate their Roth savings as part of their estate planning strategy

How much can I contribute to my Roth IRA?

You can contribute up to $6,000 to your Roth IRA in 2022 or $7,000 if you are 50 years or older.

Income limits for Roth contributions

Roth IRA contribution limits for 2022 are based on your annual earnings. If you are single or a head of household and earn $129,000 or less, you can contribute up to the full amount of $6,000 per year. If your aggregated gross income is between $129,000 and $144,000, you can still make contributions with a lower value.

Married couples filing jointly can contribute up to $6,000 each if their combined income is less than $204,000. You can still make reduced contributions if your aggregated gross income is between $204,000 and $214,000.

If you are a high earner, you will not meet the income limits to make direct Roth contributions. However, you still have some options. Here are some ideas that can help you boost your Roth savings

Speak with a financial advisor to find out what Roth strategies make sense for you

Backdoor Roth IRA for high-income earners

The Backdoor Roth IRA is a multi-step process that allows high-income earners to bypass the Roth Income limits. The strategy comes with some conditions. While the IRS has kept the rules vague, it’s easy to make mistakes while following the process. I had seen more than one client who had made some mistakes when they followed the backdoor steps.

Here are the general guidelines. Remember that everyone’s circumstances are unique, and this article may not address all of them.

Backdoor Roth IRA steps

  1. Contribute to a non-deductible IRA. Roth IRA and Traditional IRA have the same income limits. If you do not qualify to make direct Roth contributions, you don’t qualify for tax-deductible IRA savings. When you contribute to a non-deductible IRA, you are making an after-tax contribution to an IRA. Theoretically, you will pay taxes on your future gain but the original amount.
  2. Convert your contribution to a Roth IRA. In the second step of the process, you must transfer your assets from the non-deductible IRA to your Roth IRA. Your IRA administrator or financial advisor will give you the instructions and paperwork. Every broker requires a slightly different process.
  3. File your taxes and submit Form 8606. You must file form 8606 to report your non-deductible contributions to traditional IRAs. Please consult your CPA or tax accountant for the exact requirements for filling out and submitting the form. Pay attention to this form when you file your taxes using tax software.
  4. The Pro-Rata Rule. The pro-rata rule has one of the biggest implications in the backdoor process. The rules stipulate that ALL Roth conversions must be made on a pro-rata basis. In other words, if you have an outstanding Traditional RA, SEP IRA, or Simple IRA, your Roth conversion must be pro-rated between all existing IRA accounts, not just the non-deductible IRA from which you want to make the transfer. In other words, the Backdoor Roth strategy could trigger a substantial taxable event for you if you own tax-deferred IRA savings.

Roth conversion from IRA and 401k

Roth conversion involves the transfer of the tax-deferred savings in your IRA or 401k accounts into tax-exempt investments in your Roth IRA. Roth conversion can be a brilliant move for high-income earners in the right circumstances.

Your current and future taxes are critical elements of any Roth conversion decision-making. The strategy becomes viable during low tax years or whenever you expect higher tax rates in the future. Higher future tax rates make a Roth IRA more appealing, while lower future tax rates would make a traditional IRA more attractive.

With some proactive planning, Roth IRA offers substantial tax-free benefits. Due to income limits, many high-income savers end up with significant amounts in tax-deferred accounts such as 401k and Traditional IRA. These plans give you initial tax relief to encourage retirement savings. However, all future distributions are fully taxable and subject to required minimum distributions.

Learn more about Roth conversion here

Roth 401k

Most corporate 401k plans allow you to make either traditional tax-deferred or Roth 401k contributions. Roth 401k is similar to Roth IRA as both accounts are funded with after-tax dollars.

The contribution limits for 2022 are $20,500 per person. All 401k participants over the age of 50 can add a catch-up contribution of $6,500.

Roth 401k vs. Roth IRA

Roth 401k and Roth IRA are very similar, but Roth 401k has major advantages for high-income earners

  1. No income limits – Unlike Roth IRA, the Roth 401l doesn’t have income limits. Anyone eligible to participate in their company’s 401k plan can make Roth 401k contributions.
  2. Higher Contribution limits – You can save a lot more in your company’s Roth 401k plan versus a personal Roth IRA. You can save up to $20,500 in your Roth 401k and $6,000 in your Roth IRA. If you are 50 or older, you can stash $27,000 vs. $7,000
  3. Company match – You are eligible for a company match even if you make Roth 401k contributions. All employer matching contributions will be tax-deferred and placed in a separate account
  4. Investment options – Roth IRA offers a broader range of investment options vs. 401k plans with a limited list of funds.
  5. Distributions rules – Roth 401k savings are subject to required maximum distributions at age of 72. You can avoid this rule by rolling over your Roth 401k into a Roth IRA once you stop contributing to the plan.

What Is a Mega Backdoor Roth 401k?

Mega Backdoor 401k is an acronym for after-tax Roth conversion within your 401k plan. Many high-income earners cannot make direct Roth contributions. At the same time, they may prefer traditional tax-deferred 401k contributions, which reduce their current taxes. Mega backdoor 401k allows you to get the best of both worlds. There is one caveat — your 401k plan must allow for after-tax contributions and in-plan conversions. Depending on your plan design, setting up a Mega backdoor 401k can be pretty complex or relatively simple.

For 2022, maximum 401k contributions of any kind (tax-deferred, Roth, after-tax, and employee match) is $61,000, up from $58,000 for 2021. If you’re 50 or older, the limit is $67,500, up from $64,500 in 2021. If you maximize your 401k allowance and receive an employee match, you can choose to make after-tax contributions up the annual limit. Without any conversion, you will pay taxes on all your gains. Since your original contribution was after-tax, you don’t pay taxes on that amount. Furthermore, the IRS limits the compensation eligible for 401k contributions to $305,000 or 2022. Depending on your specific circumstances, the final contribution amount to your 401k plan may vary,

Here is how Mega Backdoor Roth 401k works

  1. Maximize your 401k contributions for the year
  2. Opt-in for after-tax 401k contributions. Your plan must allow for this election
  3. Convert your after-tax contributions into Roth 401k as soon as possible to avoid possible taxable gains. Some plans may allow you to choose automatic conversions versus manual.
  4. Watch your Roth savings grow tax-free

Final words

Maximizing Roth savings can be highly advantageous for high-income earners and hard-working professionals. Since Roth IRAs have strict income limits, not everyone will qualify automatically for direct contributions. You will need careful planning to maneuver all the different rules and a long-term view to enjoy the benefits of your Roth savings.