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The Four Essential Strategies For Building Tax-Free Roth Assets


4 Essential Strategies for Building Roth Assets

Do you like tax-free money? Of course you do! Who doesn't? 

Unfortunately, there aren't many avenues for tax-free money. The government, as I'm sure you've heard, likes you to pay taxes. Deferred retirement accounts, like Traditional IRAs and 401ks, save you on taxes now, but the bill comes due in retirement when you withdraw from the account. Taxable accounts can be managed in a tax-efficient manner, but you'll pay taxes on any bond interest or realized capital gains. 

But, how about Roth IRA accounts? Well, these are truly tax-free, and you should absolutely want more money in these accounts when the opportunity exists.1

So, let's talk about how to get more money into your Roth IRA and reduce your lifetime tax bill in the process. 

Note: Some of the below strategies can be quite complex from a tax perspective. 

Roth IRA Strategy #1: Make Roth 401k Contributions 

Did you know that many employer-sponsored 401k's now offer the option of making Roth-style employee contributions? If you have this opportunity, instead of making a $6,000 annual contribution to your Roth IRA (or $7,000 for individuals age 50 and above), you can contribute up to $20,500 ($26,500 for individuals age 50 and above) in 2022. Any employer match on top of this will still be in tax-deferred accounts, but holy smokes that's a big chunk of money to get into a Roth IRA.   Let's look at an example: 

Shae is 30 years old and chooses to max our her Roth 401k. She sticks to this plan over 20 years and earns, on average, a 9% annualized return. At age 50, Shae has $1,145,571 in Roth assets in her 401k. Wow! 

Roth IRA Strategy #2: BackDoor Roth IRAs

Caveat: The Build Back Better plan that passed the House (but not the Senate) disallows BackDoor Roth IRAs on a go-forward basis. 

Individuals with Modified Adjusted Gross Income over $144,000 and married couples filing jointly with Modified Adjusted Gross Income over 214,000 are unable to make Roth IRA contributions.

Enter the BackDoor Roth IRA. The Backdoor Roth IRA is essentially a multi-step process that allows high earners to continue to make Roth IRA contributions. Here's how you process the contribution: 

  1.  Make sure you don't have a current balance in any existing Traditional IRA, SEP-IRA, or SIMPLE IRA accounts. 
  2.  Make a non-deductible Traditional IRA contribution. 
  3.  Convert the Traditional IRA to your Roth IRA on a timely basis. 
  4. Now you have money in your Roth IRA and it is never taxed again. 

Please note, if you have existing funds in a Traditional IRA account you may need to convert the account to a Roth IRA (and pay taxes on the conversion) or roll the account over to an existing 401k plan that accepts rollovers prior to implementing the Backdoor Roth IRA strategy. You should consult with a tax or financial professional prior to enacting this process as the nuances can be quite complex. Additionally, there are tax forms to file annually when making backdoor Roth contributions. Once again, you should coordinate with your tax advisor on the specifics. 

Roth IRA Strategy #3: Roth Conversions

Roth conversions are a fantastic way to get more money into Roth IRA accounts. A Roth conversion essentially transfers money from a Traditional IRA to a Roth IRA account. You pay income tax on the conversion amount, but once the money hits the Roth account any future growth is entirely tax-free. In other words, you are realizing tax today, for the opportunity to have tx-free money in the future. 

Roth conversions are best implemented in years with lower expected taxable income. For example, many retirees start Roth conversions in the early years of their retirement to reduce the tax impact of required minimum distributions in their 70's and 80's and increase tax diversification. 

Roth conversions can be quite complex in their use cases and implementation, but the opportunity can be extremely advantageous from a tax or estate perspective for many individuals and families.

Roth IRA Strategy #4: Accumulating Assets within a Health Savings Account (HSA) 

Though technically not a 'Roth' style account, HSA's pose an incredible opportunity to create tax-free future income. Individuals and families who are on a high deductible health care plan have the opportunity to contribute to an HSA. Importantly, you do not have to use that money in the year of contribution. Instead, you can invest it for long-term growth. 

In other words, HSA's present the triple whammy of tax minimization: 

  1. Contributions reduce your taxable income. 
  2. You can invest your HSA principal for long-term, tax-deferred growth. 
  3. As long as you use the money for a qualified medical expense, withdrawals are tax-free. 

Though not technically a 'Roth' style account, saving and investing in an HSA does create more tax diversification for your household balance sheet which is an incredible advantage, especially in retirement! 

Interested in learning how you can create more tax diversification in retirement? Schedule a free introductory call with a Trailhead financial planner below! 

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1As a reminder, you will be assessed penalties if you withdraw money from your Roth IRA prior to age 591/2.  Though you can technically remove the principal (your contributions) at any time tax-free, any gains will be assessed a 10% penalty for early withdrawal. We should note that we do not recommend touching the principal except under extreme need.  


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