Maximizing Tax Free Growth in a Variety of Ways

Understanding the basics of Roth IRAs

When looking at investment vehicles geared towards long-term growth, a Roth IRA is a particularly attractive option. Roth IRAs are considered an after-tax retirement vehicle due to the fact that contributions into the account are made on an after-tax basis. Once funds are inside the Roth IRA, all future growth is tax-deferred and when taken out in retirement after age 59 ½ (assuming the account has been opened for a minimum of 5 years) all withdrawals are 100% tax-free.

The main challenge with a Roth IRA is that contributions are limited based on AGI (Adjusted Gross Income) so high income earners may not be able to make a direct contribution to a Roth IRA. For the 2022 tax year, contribution phase out limits for a Single Individual are $129,000-$144,000 and for a couple Married Filing Jointly $204,000-$214,000. So individuals or couples with incomes over these limits would be phased out and unable to make a direct contribution to a Roth IRA.

My income is too high. Is there a work around?

Potentially, yes. For high income earners that are not eligible to make a direct Roth IRA contribution, there are a few more potential action steps to review. First, does the individual already have a Traditional IRA with a balance in it? If the answer is yes, then any further steps could result in additional tax implications which we would recommend consulting with your tax professional on prior to any further action.

If the answer is No, an individual is eligible to open up a Traditional IRA in their name and make a contribution up to $6,000 annually ($7,000 is over age 50). Since their income is above specific thresholds, this will be considered a non-deductible IRA contribution as there will be no tax-deduction for the contribution. Once the funds are in the Traditional IRA, you can then convert those proceeds to a Roth IRA in that same individual’s name. By utilizing the conversion feature, you can convert 100% of the Traditional IRA contribution to a Roth IRA without any penalty and taxes paid only on the growth (which if the funds were held in cash for a short time, there would be minimal growth, if any). Then, once the funds are in the Roth IRA, all future growth would attain tax-deferred status and tax-free withdrawal at retirement age of 59 ½ or later.

Before utilizing a strategy like this, we strongly recommend working with your financial planner and your CPA to ensure all rules and requirements are met and that the transactions will be in your best interest.

Mega Back-Door Roth IRA

Some larger companies offer an additional option for their employees which can be looked into by discussing options with your financial advisor and 401(k) provider. The basis of this strategy is saving additional funds on top of your pre-tax 401(k) contribution into an “after-tax” account inside the 401(k) plan. The current pre-tax 401(k) limits for 2022 are $20,500 (and $27,000 if over age 50 using the annual catch-up provision). By doing so, you are saving in a tax-deferred account but not receiving a tax-deduction on these additional contributions.

If the company plan allows for this, you can then call your 401(k) provider and have them convert 100% of the after-tax proceeds to your outside Roth IRA account or inside to your Roth 401(k) plan. There will be no penalty for doing so and taxes would only be owed on any growth in the after-tax account at the time of conversion to the Roth vehicle. There is an additional workaround to even avoid those taxes upon the conversion.

We advise talking with your financial team and 401(k) provider together to determine if this option exists inside your employer’s plan. If it does, then we recommend working through your financial plan to determine whether the strategy makes sense for your individual goals and how to properly fund this vehicle.

At Cleveland Wealth, we take pride in only acting in our clients’ best interests – because we know it’s the right thing to do, not just because it’s our Fiduciary Duty. We strive to provide education around your situation, so you are confident the advice provided is the highest quality that assists you in reaching your financial goals.

Cleveland Wealth, LLC is a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.