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No Roth IRA? No Problem.
Tax Free Growth is Possible.

Posted February 2021

Most people would love to have the benefits that are associated with a Roth IRA – tax deferred growth and qualified distributions will be tax free. However, not everyone is eligible.

If you fall into the category where you’re not eligible for Roth IRA contributions, and your workplace retirement plan (401(k), 403(b), 457(b), etc.) does not have a Roth option… this article / white paper is for you.

We’ll explain how you could contribute $100,000+, and achieve that tax free growth you may be looking for.

If you’re unsure if you fall into that category, your eligibility to contribute to a Roth IRA is based on your income level (Modified Adjusted Gross Income (MAGI)). The following table is based on the Roth IRA contribution limits for the 2021 tax year. This can be a quick guide to see if you are eligible, and how much you may be able to contribute.

If your income exceeds the limit – keep reading, we’ll talk about strategies specifically for you next.

Goldfinch Wealth Management does not provide legal or tax advice. You should consult a legal or tax professional regarding your individual situation.

Strategies to Consider if Your Income is Above the Modified Adjusted Gross Income (MAGI) Limit:

Use your workplace retirement plan.
According to the 2019 annual Plan Sponsor Council of America Survey 1 , “Roth contributions are now permitted in three-fourths of plans, up from 69.1 percent in 2018.”

Thus, the chances are relatively high that your employer offers a Roth 401(k), Roth 403(b), Roth 457(b), or some other workplace retirement plan with a Roth option. These workplace retirement plans are not subject to income limits of a Roth IRA, but have the contribution limits of a retirement plan.

Thus, in a 401(k), you can contribute up to $19,500 per year plus a catch-up contribution of $6,500 for anyone over the age of 50.

The grid below will highlight some key differences between a Roth 401(k), a Roth IRA, and Pre-Tax contributions to a 401(k) plan. 2

* This limitation is by individual, rather than by plan. You can split your annual elective deferrals between designated Roth contributions and traditional pre-tax contributions, but your combined contributions can’t exceed the deferral limit – $19,500 in 2021 and in 2020 and $19,000 in 2019 ($26,000 in 2021 and in 2020 and $25,000 in 2019 if you’re eligible for catch-up contributions).

Convert assets from Traditional to Roth.
The tax code allows you to shift an unlimited amount from a Traditional IRA to a Roth IRA, regardless of your income. However, you will be required to pay taxes in the year of conversion at ordinary income rates. This strategy/conversion is appropriate if you believe that you will be in a higher tax bracket in the future, than you are in the year of conversion.

Often, retirees will find that they have retired before they are required to satisfy their Required Minimum Distributions (RMDs) and can find themselves in a lower bracket for a number of years. This period in time may be an appropriate time to review if a Roth conversion is appropriate for you. Also, there are some workplace retirement plans that allow for in-plan conversions; this may be worthwhile to consider as well, based on your financial situation.

Backdoor Roth IRA.
In short, you’re completing a Roth contribution in a two-step process. If you have earned income, you’ll be able to make a non-deductible contribution to a Traditional IRA, up to the contribution limits. ($6,000 or $7,000 for those aged 50+ in 2021).

The first step is to make a non-deductible contribution to your Traditional IRA. From there, you can complete a Roth conversion. Since the assets were after tax and there were no earnings – no tax is owed on the conversion. Please be aware though, if you have other IRA assets you will trigger the Pro-Rata rule. The IRS will view all of your IRA assets as a collective whole (Traditional, SEP, or SIMPLE IRAs, etc.)

Thus, if you had multiple IRA accounts that totaled $500,000 ($350,000 of taxable (deductible) contributions, $50,000 of nontaxable (nondeductible) contributions, and $100,000 of taxable earnings), you can’t convert only the $50,000 nondeductible (nontaxable) contributions to a Roth, and have a tax-free conversion. Instead, you’ll need to prorate the taxable and nontaxable portions of the account. Using the example above, 90% ($450,000/$500,000) of each distribution from the IRA (including any conversion) will be taxable, and 10% will be nontaxable.

You can’t escape this result by using separate IRAs. Under IRS rules, you must aggregate all of your IRAs when you calculate the taxable income resulting from a distribution from (or conversion of) any of the IRAs.

Although, one way to get around this pro-rata rule is to roll your IRA assets into an employer retirement plan (assuming the plan accepts rollovers), and then roll over (convert) the remaining balance (i.e., the nontaxable dollars) to a Roth IRA. The IRS has not yet officially ruled on this technique, so be sure to get professional advice before considering this.

The Tax-Free Growth Strategy for the Wealthy

While the strategies mentioned before can be beneficial and prudent for the right person, the following strategy is generally only used by the wealthy.

Use a Mega Backdoor Roth IRA.
Only a select few will be in a position to apply this strategy. Generally, implemented by the wealthy and high-income savers. This strategy will allow you to contribute an additional $38,500 annually to a Roth IRA.

First, your workplace retirement plan must allow you to make after-tax contributions, as well as allow for in-service distributions. If the plan does not allow for in-service distributions, then you must have a triggering event; such as termination of employment or reaching the age 59 ½.

For plans that allow after-tax contributions, once you have utilized your first $19,500 ($26,000 age 50+) of employee deferrals, you want to elect after-tax contributions until you have met your Section 415(c)(1)(A) limit of $58,000 in 2021. This limit includes all employee and employer contributions to your retirement plan, so if you contributed $19,500 and your employer contributed $10,000, you would only be able to make an additional $28,500 in after-tax contributions. Rather than leaving this money in the plan where all the growth will be taxed at ordinary income rates upon withdrawal, you make an in-service transfer to move the after-tax contributions to your Roth IRA where all future growth is tax free!

Due to pro-rata rule, you cannot just do a partial distribution and just roll over the after-tax basis. The custodian of the 401(k) plan must also be willing to issue (2) checks; one for a Roth IRA, and one for a Traditional IRA.

An example is listed below:

A husband and wife, both of whom are over 60 and working for employers who allow after-tax contributions could theoretically contribute $130,000 to their Roth IRA accounts:

They could each contribute $7,000 ($14k total) to their Roth IRA accounts via regular contributions or Back Door Roth contributions (if their income exceeded limits.) They could each contribute an additional $26,000 ($52k total) to their Roth 401(k) and each make $32,000 ($64k total) of after-tax contributions to their 401(k) which they move to their Roth IRAs using the Mega Backdoor Roth IRA strategy.

If they still wanted to get more money into their Roth IRAs, they could convert an unlimited amount from their tax deferred retirement accounts to Roth with the understanding that every dollar converted will be taxed in the current year at ordinary income rates. That’s how you supercharge your Roth IRA!

As always, it is important to talk with your trusted financial professional about the pros and cons, tax implications, and to make sure these strategies are appropriate for you.

This is a hypothetical example and is for illustrative purposes only. No specific investments were used in this example. Actual results will vary. Past performance does not guarantee future results.