There is often a debate between whether 401k/IRA contributions should be made on a pre-tax or Roth basis, but at EWA we generally recommend maxing out all possible Roth accounts each year. Since first allowed in 2010, the back door Roth IRA has become popular for high income earners, that are over the income limit to contribute directly into a Roth IRA, to take advantage of getting money into Roth.

On top of the limit of $6,000 per year ($7,000 per year if over the age of 50), that can be contributed into an IRA each year, there could also be an opportunity to contribute to a mega back door Roth through your employer retirement plan or set this up if you are self-employed. This could allow for an additional $61,000 per year to be contributed into Roth ($67,500 if over the age of 50).

Here are a few of the benefits to accumulating money inside of Roth accounts:

1. Roth IRA accounts are funded with after-tax dollars, all the growth is tax free, distribution is tax free (after age 59 ½ and assuming 5-year rule has been met) and is passed on to beneficiaries’ tax free.
2. There are no required minimum distributions for Roth IRAs, so you have complete autonomy and control on when you take the money out.
3. Since there are no RMDs, this helps eliminate the sequence of returns risk once in retirement since you are not forced to take withdrawal if funds are operating at a loss.

On top of Roth IRA contributions, many employer retirement plans allow for Roth contributions into 401ks/403bs/457b/etc. There are two IRS limits that are important to be aware of with employer retirement plan contributions. The first is the 402g limit. This is the salary deferral that can be contributed into an employer plan each year ($20,500 if under the age of 50 and $27,000 if over 50). If the plan allows, this can either be pre-tax of Roth. If Roth is allowed, there are no income limits to this like there are on contributing into a Roth IRA. This 402g limit can only be done once per taxpayer, so if you have multiple income streams (W2 and 1099 for example), you are only allowed one 402g deferral.

The second limit to be aware of is the 415c limit. This is the maximum that is allowed to be contributed into a 401k employer retirement plan each year ($61,000 if under the age of 50 and $67,500 if over 50). This is also a limit for each income stream. For example, if a physician was a W2 employee making $500,000 per year, they would be able to max out the entire $61,000 into their hospital’s retirement plan (if the plan allows). If the physician also did consulting work, generating 1099 income of $100,000 per year, they could open a second 401k plan and contribute an additional $61,000.

So how would this physician best maximize Roth contributions?

With their hospital retirement plan, they could contribute $20,500 into Roth (if the plan allows). Let’s assume there is no employer match, but the plan allows for after-tax contributions. This would allow them to contribute an additional $40,500 into the plan. Here’s where the mega back door Roth comes into plan. If the plan allowed for in plan Roth conversions, this $40,500 could be immediately converted to Roth (tax free if done the same day and no growth but would pay taxes on the growth if gains were present), allowing for all $61,000 to be Roth contributions. Some plans even allow for the after-tax contributions to be rolled into a Roth IRA while still employed.

If this physician also had a solo 401k plan for their 1099 income, they could make another $61,000 of after-tax contribution to the solo 401k. If the plan allows, the same steps could be completed, and this could be converted to Roth as well.

In this example, this physician would be contributing a total of $128,000 per year into Roth accounts. Although they are giving up the tax deduction of making pre-tax 401k contributions, all of this will grow and distribute tax free.

Here is a chart that shows historical marginal tax rates:

This shows up to 2015, but as of 2022, this highest marginal rate is 37% and the lowest remains at 10%. Between the 1940s and 1970s, the highest marginal rate was over 70%. Who knows what tax rates will be in the future, but the highest bracket of 37% is much lower than we have seen in the past. And given concerns around social security, Medicare, national debt, etc., one could assume that eventually taxes could be increased.

Having money inside of a Roth account mitigates this risk since the money would not be subject to taxes if the marginal tax rates increase in the future (since all distributions are tax free assuming conditions are met).

The argument against Roth would be contributing into pretax now, receiving a tax deduction, and then taking the money out at a lower rate when expenses are less in retirement.

This is a great thought process, but if your net worth is high enough and income streams are big enough, then the Required minimum distributions from a pretax account may be what puts you back in the highest marginal tax bracket during retirement.

For example, let’s look at a retired couple that is 75 and has a net worth of $10 million, 1M in real estate, with $0 in Roth IRAs, $5 million in pre-tax IRAs, $4 million in a taxable investment account, and social security is paying them $80,000 per year. We could estimate RMDs to be around $203,500 per year, dividends on their taxable account would be an estimated $100,000 per year, so with social security they will have taxable income of $357,600 per year (after MFJ standard deduction) without taking any additional withdrawals. This would put them in the 32% tax bracket. This runway would get cut in ½ if one spouse passes, and the survivor moves into a single tax bracket. In this example, the single tax payer would be stuck in a 35% marginal rate on a good portion of their income.

As a general rule of thumb, we recommend having a minimum of 1/3 of retirement assets in Roth (or tax-free assets such as basis in a brokerage account), and 2/3 in pre-tax entering retirement. If this same couple had 1/3 on their retirement accounts in Roth, they would now have $1,650,000 in Roth IRAs, $4 million still in taxable accounts, and $3,350,000 in pre-tax IRAs. RMDs would now only be around $136,345 per year, bringing their taxable income down to $290,445 (after MFJ standard deduction). This would keep them in the 24% tax bracket (up to $340,100) and avoid higher tax brackets. This would also position a surviving spouse with a bigger insulation against higher Medicare rates, and higher tax rates during retirement.

Having Roth assets gives much more flexibility in the distributions phase and can save a substantial amount on taxes.

What can you do to maximize Roth contributions?

1. Check your employer’s plan description summary for your employer retirement plan to see if Roth contributions or in plan Roth conversions are allowed.
2. If you are self-employed or have any 1099 income, consider setting up your own retirement account.
3. A married couple under age 50 without aggregation problems could potentially:
4. Fund 6k/year each or total of 12k/year into backdoor Roth IRA’s.
5. Fund 61k/year each into a mega backdoor Roth 401(k) for a total of 122k/year.
6. Convert existing pretax accounts into Roth (unlimited each year, but should take into consideration marginal tax brackets and if market is at discount to make timing appropriate).

There are many factors to consider when thinking about Roth vs pre-tax (tax bracket now vs in retirement, etc.), but most clients prefer to maximize Roth accounts for the tax-free growth/distribution and autonomy over distributions.

Equilibrium Wealth Advisors is a registered investment advisor. The contents of this article are for educational purposes only and do not represent investment advice.

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