Several strategies can help you maximize the benefits of Roth IRAs. Learn more about the unique opportunities these accounts provide and explore ways to get the most out of your Roth IRA.
Maximize Roth IRA Contributions
The IRS limits your ability to contribute to Roth IRAs. So, if you have the funds and desire to contribute, it’s wise to maximize your contributions when you can. The annual contribution limit for 2023 is $6,500, but those over age 50 during the calendar year can make an additional catch-up contribution of $1,000. If you forget to fund your Roth IRA during the tax year, you can potentially add money to an IRA the next year. You generally have until April 15th to make contributions for the previous year. And if that date falls on a weekend or legal holiday, you can contribute as late as the next business day. That said, it’s best to avoid waiting until the last minute, and it might be less stressful to set up automatic monthly contributions. You need income to contribute to a Roth IRA, but if your household has too much income, IRS rules might reduce or eliminate the amount you’re allowed to contribute. Married Filing Jointly or Qualifying Widow Limits for 2023
Use a Backdoor Roth IRA If You Can’t Contribute Directly
If your income is too high, you’re not eligible to contribute to a Roth IRA. But a backdoor Roth strategy might enable you to save after-tax funds for potential tax-free income. For a backdoor Roth IRA, you first contribute funds to a traditional IRA. As long as you have taxable income, you’re allowed to contribute to a traditional IRA—but you might not be allowed to deduct the contribution. Then, you can convert the funds in a traditional IRA to your Roth IRA. When the conditions are right, there are no tax consequences for using a backdoor Roth strategy. However, things can get complicated. For instance, if you convert investment gains, you need to account for those earnings, which might add to your tax liability. And if you have any pre-tax balances in IRAs (as opposed to just nondeductible, after-tax IRA contributions), you may also owe taxes on those funds, if you transfer them. If your income prevents you from contributing to a Roth IRA, check if your workplace retirement plan offers Roth contributions. You can contribute a substantial amount with a Roth 401(k), and a high income does not count against you.
Short-Term Gains and High-Growth Assets Make the Most of Tax Benefits
If all goes well, you can avoid paying any tax on withdrawals from a Roth IRA. That gives you an opportunity to be strategic about where you hold investments. With smart asset location you can minimize taxes over your lifetime. To do so, use your Roth IRA to hold assets with the most growth potential or the biggest tax impact. Investors in taxable accounts typically pay the highest tax rates on interest income, short-term capital gains, and some dividends. But you pay lower rates on long-term capital gains and qualified dividends. And assets that have minimal growth, such as cash and similar vehicles, are unlikely to have a big impact on your taxes. Because of that, your Roth IRA is a good place for your most aggressive investments, according to Ryan Phillips, CFP, Founder of GuidePoint Financial Planning. “This will allow you to capture the greatest amount of tax-free growth,” he says. It could also make sense to hold investments that are likely to generate the least favorable types of income—such as short-term capital gains—in your Roth IRA. Meanwhile, investments that produce qualified dividends and long-term capital gains might make sense for a taxable account because of the favorable treatment of those earnings. That said, if you can shelter all investment income from taxation, that’s even better. Ultimately, the right asset location strategy depends on your situation. For example, you might prefer to hold high-growth assets in taxable accounts if you never intend to sell those holdings. After your death, your heirs might receive a step-up in basis, allowing you and your loved ones to avoid taxation on any gains. Likewise, you might be happy to hold growth stocks in a taxable account if they don’t pay annual dividends, and you’ll only pay long-term capital gains (at favorable rates) when you sell.
Enjoy Penalty-Free Access to Contributions at Any Age
Roth IRAs offer flexibility today in addition to potential tax-free income tomorrow. You can withdraw your regular contributions from a Roth IRA at any time without taxes or penalties—which is unique, when compared to other retirement accounts. You already paid taxes on that money, so you shouldn’t need to pay twice. However, that flexibility only applies to annual contributions directly to your Roth IRA. Withdrawing from other sources of money might result in taxes. For example, if you pull from the earnings in your account, you may owe income taxes (and possibly additional penalties) if you’re under age 59-1/2, or you haven’t had the account open for at least five years. Also, any money you converted from pre-tax retirement accounts can have strings attached, so check with your CPA before taking a distribution. Easy access to money in your Roth IRA can be helpful in several ways.Those funds can supplement your rainy day fund if you face an unexpected emergency. Plus, you can use assets from a Roth IRA for a down payment on a home. With a first-time homebuyer exception, you’re allowed to withdraw up to $10,000 of earnings—in addition to your regular contributions—without taxes.
Avoid RMDs If You Don’t Need the Money
With many pre-tax retirement accounts, IRS rules call for required minimum distributions (RMDs) from the account after age 72. However, Roth IRAs do not have RMDs until the account owner dies. Because of that, you can keep a substantial amount in your account and avoid the logistics and deadlines related to RMDs. It may be helpful to keep those funds in a Roth IRA for as long as possible. Doing so shelters any earnings on your assets from taxes and preserves your nest egg. Plus, if you’re fortunate enough to have enough assets to pass on to somebody else after death, beneficiaries can receive a tax-free legacy. If your designated beneficiary is a spouse, that person can take over the Roth IRA and treat it as their own. That way, they continue to avoid taxation and RMDs. However, most non-spouse beneficiaries need to withdraw the funds within 10 years of death. That’s still a long time to let compounding work.
Name a Beneficiary for Your Roth IRA
Retirement accounts allow you to choose beneficiaries who receive the assets after your death. Adding beneficiaries to your accounts makes life easier for loved ones, and it might help your heirs save money. A Roth IRA with a designated beneficiary passes directly to the beneficiary without going through probate. As a result, the assets move quickly, and you can reduce any costs associated with probate. Plus, you make your wishes clear so that survivors know what you want to happen with those assets. Beneficiary designations take precedence over your will, which helps funds move quickly. So, if things change or your will conflicts with your beneficiary designations, it’s critical to understand the outcome. Phillips suggests reviewing beneficiary designations every few years to make sure those instructions still make sense. And he also urges caution when naming minor children as beneficiaries, which may require additional planning and documentation. Speak with an estate planning attorney and a tax expert to ensure things go the way you want after your death.
