Roth accounts are a powerful investment tool that can benefit some people. Whether it is the Roth IRS, Roth 401k, Back Door Roth, or Roth Conversion, these options should be selected based on everyone's own specific financial situation. With so many different Roth Accounts to chose from and all of them having their own small nuances, join Johnathan and Melissa Rankin as they go over 5 Roth Account types and strategies.
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- Johnathan Rankin CRPC® CEPA®, Founder & CEO,
- Melissa Rankin - Wealth Management Advisor
- Theorem Wealth Management, Financial Advisor Dallas Texas
- Retire Once Show - 2022 Retirement Podcast Series
0:00 - Introduction
1:48 - What is a Roth Account?
3:37 - Roth Account vs Traditional Account
8:25 - Roth Conversions
12:46 - Backdoor Roth IRA
16:17 - Mega Backdoor Roth IRA
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Disclaimer: Johnathan Rankin is a Registered Representative of Sanctuary Securities Inc. and an Investment Advisor Representative of Sanctuary Advisors, LLC. Securities offered through Sanctuary Securities, Inc., Member FINRA, SIPC. Advisory services offered through Sanctuary Advisors, LLC., an SEC Registered Investment Advisor. Theorem Wealth Management is a DBA of Sanctuary Securities, Inc. and Sanctuary Advisors, LLC.
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Hello, and welcome to the retire. Once show the show designed to help you get to retirement. But most importantly, stair retired. I'm your host, Jonathan Rankin. I'm the founder and CEO of theorem wealth management. And I'm joined today by my lovely cohost. Hi, I'm Melissa Rankin. Thank you for joining us.
We're very happy that you're taking the time to be here, especially with everything that's going on in the world and the markets. I mean, last week we, uh, intraday had a bear market in the S and P 500. So. It's been a lot going on. And so thank you for taking the time to watch this today. We're going to cover everything about Roths.
So Roth IRAs, Roth, 401ks, backdoor, Roths, Roth conversions. If you tuned in last week, last week, we covered 401ks and had a lot of questions on just traditional 401k is and say, we're going to cover the Roth side of things. Absolutely. And before we get into that, if you haven't had a chance to check it out, Jonathan actually did a market update yesterday.
So make sure you check that out because very good information on that. Yeah. We're going to try to put those out a lot more often, especially with everything that's going on right now in the markets. So many questions, concerns about, you know, how far is this leg down going to be? What's going to happen to me.
Yeah. So, uh, we're going to start putting those out on a more regular basis, but, uh, but today we're going to dig all into Roths and, uh, as always most of what we want people to do before that we want you to like subscribe us, um, rate us five stars and. Sure it, oh yeah. I was like, I remember this, this hand motion thing, share it and tell everybody, you know, to watch the show.
That's right. So, uh, thank you for being a part of this community that we're trying to build here. It's our retirement paradise. As we always call it, uh, Let's jump right into Roths with getting into the basics. What is, what is a Roth account? So a Roth account is an account that has after tax dollars contributed to it.
So it's not like a 401k or traditional account money that you put in there came right after uncle Sam took his. Um, all the growth that happens in that account is tax-free. Anytime you take money from that account, once you're in retirement is also tax-free and the benefit is there are no required minimum distributions.
So there are a lot of benefits to a Roth account. It's just the reality is you're paying the taxes in the beginning and it doesn't have that tax deferred status, like a, like a traditional account. Okay. So lots of differences there between a traditional IRA and the Roth. The other thing about Roth IRAs is that there are income limits and you can be phased out of even being able to contribute to a Roth IRA based on how much you make.
So with that in mind, the phase out period for a single person is 129,000 for 2022. And for a married couple it's 204,000. Again, that's the phase out portion. That's where you start to phase out. And then what are the levels where you just can't contribute to it at any rate? Completely eliminated. So as a single person, not much of a difference from the phase out, but 144,000 and for a married couple, 214,000.
Yeah. So after those points, you can't even contribute to a Roth IRA. So the good thing is that some 401k is now offer a Roth 401k. So if you, if it makes sense for you to contribute to a Roth account in general, that might be an option for you, just because now in a 401k, you have that ability to just have that come out of your paycheck, go right into that account.
There are no income limits on Roth 401k contributions, but we get the question a lot. So what's better Roth account traditional account, which one should. Which ones should I be saving? And we get that question all the time, all the time. So what we'll do is we'll walk through an example of how this works.
So if you earn a thousand dollars and you contribute that thousand dollars to a traditional account, so one that is tax deferred, so you pay no taxes. So that thousand dollars you made it goes right into the account. You invest that. And let's say that grows by five times. So by the end, when you're retired, it's at now at 5,000.
And let's say your tax rate is 25%. Now you're left with $3,750. Conversely, in a Roth, if you earn that thousand dollars, let's say our tax rate was 25%, only $750 went to the account. Now the same 5% growth. Guess what? The amounts, the exact same $3,750. There is no difference whether it's a Roth account or a traditional.
If your tax rate is going to be the same. So that's the key point. If your tax rate, this is the same. That is the, that is the total point. You, that you have to start thinking about whether or not a Roth is the right decision or not is if your tax rate today is going to be lower than what it will be in retirement, then a Roth makes sense.
Oh, however, if your retirement is going to be at a lower tax rate, well, then a traditional makes sense. So it's always a matter of the goal is you want a Panchal Sam as little as possible. Absolutely. So whenever you feel like you're going to be in a lower tax bracket, that's when it makes sense to con or to, uh, contribute to a rough.
And didn't you also say that the aside from like your regular income tax isn't state tax, something to consider also, it is, especially if you consider moving in retirement, a lot of people will, if you're living in a state like California or New York with an extremely high state income tax, if your plan is to move to, let's say Florida for retirement.
You're going to be in a lot less of a tax bracket overall because you have no state income tax in that state. So factoring in your total tax rate will be important. Now, if you're in your thirties, it's going to be hard to know if, when you're in your sixties, that you're going to relocate. Yeah. So that is the hard part.
We can't predict what future tax rates are going to be. And people change their minds all the time. So to think that, Hey, in 30 years, you know exactly where you're going to run. It might be tough, but if that is a plan of yours, then yeah, you might want to look at, you know, if I'm going to live in a state where my tax rate is going to be lower than maybe it is important just to go traditional right now, because eventually we'll be in a lower tax bracket.
Okay. So a state tax in mind, when is a Roth better. So a Roth is going to be a better decision when one, if you have the opportunity to take advantage of a Roth 4 0 1. And can just max that out because you can contribute the same amount as you could do a traditional account. However, all of that growth and all the distributions are then tax-free whereas in a traditional account, you don't get the opportunity to contribute more just because it's before tax, you get to contribute the same amount as a Roth 401k.
So if your taxes are the same, you're going to end up with more money in a Roth. If your tax rate the same, just because of the fact that you're contributing after tax dollars. Okay. So then when as a traditional better, so a traditional is better because it does give you that flexibility, which is important because like we were talking about, you don't know when your, what tax rates are going to be, you don't know where you're going to live.
Things happen in life. There might be a year. You know, you have a very low income tax year and that might make a good year for a Roth conversion, which we're going to get into just a few moments, but really a traditional IRA gives you flexibility to choose when you pay taxes. Whereas once you contribute to a Roth, that's it.
You pay uncle Sam. He's not going to just let you undo that just because you feel like it. So it's really about that flexibility to the traditional game. Now there is no rule to say that you can't do both. And obviously there are income limits on the contributions, but the reality is if you're able to do both, there is no rule that you can't even with Roth, 401k is becoming more prevalent.
Having that asset location diversification does make sense because we don't know what future tax rates hold. We don't know, you don't know, know where you're going to live. So there's a lot of unknowns in the future. So having assets in both types of accounts could be a very good one. Kind of covering both sides of it just in case.
Yeah, absolutely. So you mentioned, um, Roth conversions. Can you explain what those are? Yeah, so right now with the market down, there's been a lot of conversation and a lot of headlines that you'll see talking about now being a good time to execute a Roth conversion. So these aren't the same as a contribution.
This isn't you just putting money into an account. What you're doing is you're taking assets that you have that are in a. You know, traditional IRA, or let's say you had an old 401k and you rolled that into an IRA. You've got these assets that are there in pre-tax dollars. What you're doing is then you're converting those into a Roth account, but you're paying the taxes today.
You're doing that to get all the benefits of the Roth. So you get the tax-free growth, tax-free distributions, no required minimum distributions. You're doing that, but you're paying the taxes. So again, that goes back to your tax bracket. It does. Now you can convert. All types of traditional house. So you can convert IRAs, 401ks, SEP IRAs, the one traditional account that you cannot convert is an inherited IRA.
So if you inherited something from a parent or a loved one, you can't convert that into a Roth, um, that has its own rules on it. So let's just imagine that you were saving in your 401k for 40 years. You started when you were 24. You just turned 65 and you're hearing, you know, I really liked this idea of a Roth account.
I want to make sure that I never have to pay tax on this money. Again, you theoretically can convert that entire million dollars into a Roth account today. Now you'll get all the benefits of the Roth. However, we go back to the reason why you want to do it. You want to do it when your tax rates at the lowest.
And I'm pretty sure when looking at the tax chart million dollars pushes you into a much higher tax bracket. So, you know, the goal is to pay uncle Sam as little as possible. That's always what we keep in mind. Um, and one thing to note about Roth conversions is that you can't. So once it's done, it's always just done.
It is done. You can not put the toothpaste back in the toothpaste tube. It's just not possible. Trust me. I've asked our five-year-old to try and see he has, so it's not something that you can do. Doing that you really want to do a lot of planning in advance. You want to make sure that you're understanding your tax rate today.
You know, making sure that you're not going to push yourself into a higher than usual tax bracket this year, that might not be the best time to actually do that conversion. So, um, and the other thing is that if you're using that those converted funds to pay for those taxes today, because if you're under 5,900, You're likely going to be subject to the early withdrawal penalty of 10%.
So you're adding a penalty on top of the taxes that we're paying. Right now if you're under 59 and a half, so that probably doesn't make sense then because you're paying the penalty and the taxes. Exactly. And that's only if you're using the converted funds to pay those taxes. So if you've got money in a savings account that you just want to do this conversion pay uncle Sam with those dollars, there is no penalty on that.
You're just paying ordinary income tax. Um, the other thing to keep in mind is that it's not a good idea. If you need the funds within five. So let's just say that you're 65 years old today. You've got, you want to convert $50,000 into a Roth and you do that. You convert 50,000 and over the next four years, that 50,000 grows to $200,000.
Really good market tripled your money in four years. That sounds great. Yeah, really good market. Now you want to withdraw that entire balance for some unforeseen circumstance, you had a emergency, you need. All of that money. Well, because it's within that, five-year rule for a Roth. Now that $150,000 to growth is now taxable.
And so you miss out on all 150 whole, 150. All of the growth is now considered taxable and you miss out on all the benefits of the conversion. So you shouldn't have done it in the first place, theoretically, you shouldn't have, you should really make sure that if you're doing it, that these funds you can just there for five to five years, plus you don't want to have to tap into those funds within the next five years because of that five-year rule.
Okay. So now we've covered all of the Roth conversions and you mentioned earlier, I'm a backdoor Roth and a mega backdoor. Yep. So, yeah. So these are four individuals who phase out of income limits. So as you talked about the income limits for, uh, for the complete phase out is what 144,000 for a single individual and 214 for married, two 14 for married.
So when you hit those limits, you can't contribute at all. So we're going to, let's talk about the backdoor Roth. So what this allows you to do is you make nondeductible. After tax contributions to a traditional IRA. So you open a traditional IRA. You make after tax contributions. Now right now, 2022, you can contribute $6,000 if you're under 50 and 7,000, if you're over 50 and you can do this for a married couple, so you can each do a traditional IRA contribution.
And then what you do is you immediately can convert those into a Roth IRA. So you're contributing after tax and then immediately convert. Into a Roth IRA this way. There's no, you want to make sure that there's no growth in the account because then that will trigger some taxes. Uh, the other thing that's important to keep in mind is what's known as the IRS pro-rata distribution rule.
So what this does, this is triggered upon Contra, uh, triggered upon conversion. So the IRS looks at all of the IRAs that you have. So everything you've got every, so all IRAs, all simple accounts, all SEP IRAs. So if let's say you had going back to last week's episode, you had four employers and you roll those into four different ones.
The IRS is going to look at an aggregate all of those four IRAs. Yep. So let's go through an example. So you have $5,000 right now in a traditional IRA and you want, and so all of those funds are untaxed. Now, now you want to make a $5,000 nondeductible. Now you want to make a $5,000 non-deductible after tax contribution.
Okay. So because of that, pro-rata rule, they're going to aggregate those IRA. So now you have a total of $10,000 in IRAs, 50% or $5,000 is pre-tax 50% is now that after tax. So you want to do a conversion or that $5,000 a year contributed after tax. I mean, that was why you did in the first place. Right?
However, because that pro. Half of that distribution that, so that $5,000 half of that is now subject to tax. A $2,500 is subject to tax because the IRS doesn't look at it. Like you only have $5,000 of after tax IRA. They look at it as you have $10,000 of IRAs, total, and half of that is pre-tax half that as post-tax.
So if you're wanting to do this, you got to make sure that you're aggregating all those accounts, that you have a full understand. What you have out there in terms of IRAs, uh, because if there is a forgotten about IRA, like we talked about last week, the last thing you want to do is forget about an account.
And then all of a sudden you go to do this contribution and you end up, um, you know, not being able to do it or it doesn't work out as favorably as you want it to. And I assume just like with the Roth conversion, how there's no going back once you've done it, it's done same applies here. Revokable toothpaste, toothpaste tube.
Exactly. So now that we've covered the backdoor Roth, what about the mega backdoor? What is that? So the mega backdoor is the 401k version of a backdoor Roth IRA. So this allows you to make after tax contributions to your 401k. And then what you do is you convert those funds while you're still employed into a Roth IRA.
Okay. This only works if you're employed and your plan allows for after tax contributions and it allows for in-service distributions of those after tax funds. So you want to make sure that your plan allows that first before doing it. And typically what you do is you fund up to the salary deferral. So you essentially max out your 401k either pre-tax or Roth.
Again, we covered this last week on the 401k side, and then you make after tax contributions. To that account because a 401k has much higher contribution limits than an IRA. You can put more away. You know, the salary deferral limit is 20,500 for, uh, someone who's under 50 and 26,500 for someone who's over 50.
Now in a 401k, there are maximum annual contribution limits. Uh, so what they do is you sum up all of the contributions. So whether that's your employer match your employee contribution and you add those. And the total that you can put into every single year is 61,000. If you're under 50 or 67,500, if you're over 50 years old.
So let's just for round numbers, say that you're 40 years old, you've got 20,500 that you put into your 401k. Your company matches you $9,500. So $30,000 is going into your 401k. You can contribute on an after tax basis, $31,000 to get up to that 61,000. So at $31,000, now you can convert that into a Roth IRA is, as you could see, you could put a lot more into a Roth than what you could do on our, you know, just a backdoor Roth.
So assuming your plan allows it that's, that's where it would make the most sense. If you want to kind of maximize what you can actually contribute and put in it is. So this really makes sense. If you just have, you know, if you're just a good saver, you just love saving and that's, you know, what you do.
You've got the ability to do that and you can put away an additional $31,000, assuming that's the match that your company has. Yeah. It's a great place to save now, similar to a backdoor. Distributions are done on a pro-rata basis. So that is typically 401ks. We'll keep track of the after tax count separately.
So hopefully your plan does that and doesn't make you have to clean for you. Yeah. So a lot of plans if they offer this, usually we'll have that separate accounting because your gains, you know, you contribute after tax. And let's just say that you were investing in a brokerage account with those Africa.
Well, you would have capital gains if you buy and you sell things over time. Whereas in a 401k those after tax contributions, all the gains are, those are untaxed until they're distributed. So let's look at an example here. You've got this after tax account, you've contributed $60,000 to it and it grew by 40.
So now you have a hundred thousand dollars of an after-tax account within your form. $60,000. His contributions 40,000 is growth. So let's keep it simple. Say you wanted to do a conversion for half of it, $50,000. So what you can't do, you can't just cherry pick and say, okay, that $50,000, I want that to come from the contribution.
So that's completely tax free. Now what they do is they say, well, 60% of your account is contributions. Sick. 40% is earnings. So out of that 50,000. 60% is going to be contribution. So in this case, $30,000 will be considered contributions 40%. So in this case, $20,000 will be considered earnings. So now that $20,000 of earnings will now be taxable.
So that's where it gets a little bit tricky. It does. And now there is a tax-free alternatives. So you can split the proceeds. You can put that 30,000 into. And then you can actually at 20,000 can be rolled over into a traditional IRA. IRA. Tax-free. Now the reality is though, is that you now have to wait until you're 59 and a half.
It's got the same restrictions as any other traditional account. So that might not be as advantageous to you, but at least you're not coming out of pocket that year to pay those taxes. It is a tax-free option though. With the Roth, the mega backdoor, Roth, that, all of that. I mean, I feel like the, the main point here is your taxes.
It, it all comes down to, when are you paying taxes at your lowest tax rate? That's all that matters. All of this. Sounds fancy. You know, when you're on the golf course with your buddies going, I did a Roth conversion and I did this mega backdoor. Well, if you're in a 37% tax bracket and you're eventually going to be in a 25%, that's nothing to brag about right now.
The goal is that you want to make sure that you're doing a lot of planning around these because a lot of them are irrevocable. Uh, you want to make sure that you are, um, you know, that you're for, you're trying to forecast. When are you going to be in a lower tax? Because that's all that matters. As, as complicated as these things get, it really comes down to when are your taxes going to be the lowest and let's pay taxes in that year and the traditional account.
Like I mentioned, that offers the most flexibility because you can do some of these conversions over time. That gives you the flexibility to try to determine when the best time might be to pay those taxes. But again, it goes back to every individual's personal situation and kind of where that. Tax wise, everybody is different.
And that's where one of the things that we can do, we can help plan this out for you. We can go through some modeling with you and, and build out that retirement analysis. See does a Roth conversion Roth account makes sense for you based on where you're at today, we'd be happy that we're going to link to the ability to schedule that, uh, analysis with us in the show notes below.
Before we get out of here. What do we want people to do? We want you to like us subscribe, share, rate us five stars. And again, tell everybody you know, about the show, tell everybody, you know, join our retirement paradise. Keep your head above water out there. I know there's a lot going on with that. I'm Jonathan Rankin and I'm Melissa Rankin and be on the lookout for our next update.
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