Financial Geekery

Roth accounts for high earners

April 9, 2018

You may have heard that Roth accounts are an excellent way to save for retirement, providing you tax-free income in your post-working days, but you may not have delved further, knowing that your income is above the contribution limit (as of 2018, $133,000 for single taxpayers and $186,000 for married couples filing jointly). Of course, that's a great problem to have -- but it's not necessarily the last word in terms of Roth contributions. 

 

First: why a Roth?

 

Before we get into that, though, let's back up and talk about why you'd be interested in a Roth account. Tax-advantaged accounts generally come in two flavors: Traditional and Roth. With a Traditional account, money you contribute is "pre-tax" -- that is, any money you contribute is subtracted from your income for the purposes of calculating your taxes -- but withdrawals in retirement are taxed as ordinary income. With a Roth IRA, you don't get a tax benefit when you make the contribution, but withdrawals are tax-free. In both cases, the contributions grow in the account grow untaxed, which is why they're both excellent places to put your retirement investments.

 

Now, if that were the end of the story, the question of whether to invest in a Roth or Traditional account would be relatively straightforward: are your tax rates going to be lower or higher in retirement? If lower, then the Traditional will save you more money overall; if higher, the Roth. (Of course, I say "relatively" -- it's nearly impossible to predict what tax law is going to be thirty years in the future, much less your tax bracket. But you can make some educated guesses.) 

 

However, that isn't the end of the story. Roth accounts have three distinct advantages over Traditional ones:

 

  1. There is no such thing as a Roth Required Minimum Distribution -- the money can grow untaxed for as long as you like.

  2. A subtle one: the maximum dollar amounts for contributions are the same between Roth and Traditional accounts. This means that if you contribute the maximum allowed amount, more total money will end up growing tax-free in a Roth than in a Traditional. For example, if you contribute $5,500 to a Roth IRA, that money will never be taxed; if you contribute the same to a Traditional IRA, it will eventually be taxed. Of course, if you're contributing to a Traditional IRA, you could invest the tax deduction you get this year...but since you're at the maximum (assuming you're under 50), it would have to go into a non-tax-advantaged account -- the total contributions to your Roth and Traditional accounts have to be under the maximum allowed amount, so once you've maxed out one, you can't contribute to the other.

  3. If you have a Roth account for five years, you can then withdraw the principal -- your contributions, but not the investment growth on them -- at any time, at any age, with no penalty or tax. This is why Roths are an excellent vehicle for early retirement.*

"That's great. So -- how do I invest in a Roth account if I'm over the income threshold for contributing to a Roth IRA?" I'm glad you asked.

 

Roth 401(k)'s

 

It's becoming increasingly common for 401(k)'s to offer the ability to make Roth contributions -- and when I say "increasingly common", I mean "the vast majority of clients I work with now have this option". Note that you can choose whether and how much of your contributions are Traditional or Roth, but your employer's contributions are always Traditional. (So if you work at a company with an employer match and you're looking for an arbitrary way to hedge between Traditional and Roth contributions, one option is to make 100% of your 401(k) contributions Roth.)

 

There is no limit to income for contributing to a 401(k), Roth or otherwise, so this is a great option for high earners. Sure, your 401(k) may not have the investment options that you'd prefer, and may have higher fees than you'd like (and that's may -- 401(k)'s are getting better every year at lowering fees and offering better options), but it's still better to put your better than a brokerage account once you take the tax benefit into account.

 

Some things to be aware of regarding Roth 401(k)'s. For one, note that Roth 401(k)'s are  subject to RMD's, so you should strongly consider rolling your 401(k) over into a Roth IRA upon retirement or changing jobs. Also, Roth 401(k) withdrawals are taxed in a prorated fashion between earnings and principal; you can't "just withdraw the principal" the way you can with an IRA. Both of these are reasons to consider rolling over a Roth 401(k) into a Roth IRA at first opportunity, but read to the end of this article; there's more on that front later.

 

Backdoor Roth IRA contributions

 

If you don't have access to a Roth 401(k) -- or even if you do, but have maxed out that option and are still looking for tax-advantaged retirement vehicles -- there is also an option that involves rollovers into Roth IRA's, colloquially known as a "backdoor Roth IRA contribution".

 

Here's how they work: while contributions to a Roth IRA are unavailable at a certain level of income, rollovers to a Roth IRA may happen at any time. Now, if you roll over a standard Traditional IRA into a Roth IRA, you'll get a huge tax hit; for some people, it might be worth it, depending on their available cash and what the A/B analysis says, but let's assume in this case that it isn't. However, if you roll over a non-deductible Traditional IRA -- an IRA funded with "after-tax" dollars -- there is no penalty. So the theory behind a backdoor Roth IRA is this: contribute the maximum amount to a non-deductible Traditional IRA, then immediately roll over that amount to a Roth IRA.

 

There is a caveat to this: the "pro-rata rule", combined with the IRA aggregation rule. I won't go into the details of the calculation here -- you can read IRS Form 8606 for that -- but the pro-rata rule states that a portion of your contribution is taxed, based on the percentage of your non-deductible (after-tax) Traditional IRA contributions versus all of your pre-tax Traditional IRA funds, in all of your IRA accounts, due to the IRA aggregation rule. In other words, if you have a large rollover IRA anywhere and try to make a backdoor Roth IRA contribution, much of that Roth IRA conversion will be taxed as income.

 

If you don't already have a Traditional IRA, you're in the clear. But what if you do? One option is to roll that IRA into your current 401(k) -- the IRA aggregation rule doesn't apply to 401(k)'s. Of course, as I mentioned above, 401(k)'s may have a "drag" on their returns as compared to IRA's, due to fees, limited options, etc., but with creativity you can overcome that. At the very least, it's worth running the numbers -- a good financial advisor could even tell you exactly how much drag (1%? 2%? 5%?) it would take before rolling your existing IRA into the 401(k) isn't worth the tax savings. However, most financial advisors -- even fee-only ones -- are paid entirely based on Assets Under Management, which means that they are highly incentivized to keep as much of your funds out of your 401(k) as possible. Something to bear in mind!**

 

Update: until 2018, I advised caution here, as backdoor Roth IRA contributions weren't officially sanctioned by tax law, and thus could potentially run afoul of the "step-transaction doctrine". However, the 2018 tax law update made it clear that these kinds of rollovers are perfectly valid.

 

Some final notes on the 5-year rule

 

Recall the 5-year rule that I mentioned back at the beginning of this article: you have to have a Roth account for at least 5 years before you can withdraw the principal penalty-free. A couple of things to bear in mind:

 

  1. When dealing with IRA's, the account aggregation rule works in your favor here. In other words, funding any Roth IRA starts the 5-year clock ticking. Another reason to start making Roth IRA contributions ASAP, even if you can only contribute a few hundred bucks a year.

  2. When dealing with 401(k)'s, the account aggregation rule does not apply. It resets every time you open a new 401(k), with one exception: rollovers. If you roll over Roth funds from one 401(k) to another, the funds take on the "holding period" of whichever account has been around longer. 

 

Consider both of these when changing jobs -- it's worth doing some analysis before determining what you do with a your prior employer's retirement accounts! 

 

As always, these articles are "80/80" -- appropriate for 80% of my audience, 80% of the time. If you have an interesting situation, question, or idea, don't hesitate to leave a comment or send an e-mail!

 

* Some people also use Roth IRA's for college savings, for this reason. I'm not a fan of this, but that's an article for another day.

** Yeah, that was a shameless plug for flat-fee financial planning, of the kind Seaborn offers. Be aware, though, that no fee structure is without conflict of interest of some kind, which again is a topic for another day.

 

 

Britton is an engineer-turned-financial-planner in Austin, Texas. As such, he shies away from suits and commissions, and instead tends towards blue jeans, data-driven analysis, and a fee-only approach to financial planning.

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