BlogTop 10 List: Roth IRA & Tax Incentives
Posted about 2 years ago

Top 10 List: Roth IRA & Tax Incentives


It pains me to watch savers miss out on tax incentives, but it happens all the time. By being more tax-efficient, your retirement savings can perform better, with less risk.

Meanwhile, Peter Thiel, Facebook’s initial outside investor is doing just fine with his wealth strategy: Forbes reported that he invested in Facebook with his Roth IRA. His PayPal cofounder, Max R. Levchin, held millions of shares of Yelp in his Roth IRA. As of the date of that article in 2012, there were about 300-400 IRA accounts worth $25+ million.

Thiel and Levchin will be able to withdraw tens…hundreds of millions of dollars of Roth IRA earnings tax-free at age 59½. And they could always have withdrawn their initial contributions, tax/penalty-free — not that they would have wanted to lose the protection.

I wrote this article to help you guys play catchup — by answering the question:

“How can I get more of my taxable savings protected from taxation — in a Roth IRA — for free?”

You have until May 17th this year to take advantage of any under-utilized 2020 tax incentives: Roth/IRA/401(k) contributions. If you are an entrepreneur considering the solo-401(k) options, you have until your file your business taxes to establish the plan and make 2020 contributions, up to the properly extended due date.

#WealthStrategy #TaxAvoidance #BackdoorRoth #MegaBackdoorRoth #SpousalIRA #CustodialIRA #RothConversion #SelfDirectedIRA

If you learn something from this top-10 list and decide it is worth pursuing–or you conclude that something should be avoided–I strongly encourage you to do so only under the guidance of a CPA and a qualified financial advisor who are familiar with your complete tax profile and the nuances of Roth/IRA rules. For the brevity of this article, many important rules have been simplified or ignored.

Taxes, Time, and the Roth IRA

It is essential in wealth strategy to embrace the effects of taxes and time:

TAXES: A proper wealth strategy includes a solid game plan for tax avoidance.

  • The #1 drag on investment performance is the tax hit which, after years of massive, unsustainable bipartisan deficit spending, only gets worse from here.
  • With a Roth IRA, qualified distributions are tax-free, eliminating the #1 drag on your savings.
  • Tax avoidance is a different concept than tax evasion.

IRS: “Taxpayers have the right to reduce, avoid, or minimize their taxes by legitimate means. One who avoids tax does not conceal or misrepresent, but shapes and preplans events to reduce or eliminate tax liability within the parameters of the law.” read more on Tax Avoidance vs. Evation at

TIME: Retirement planning is a marathon, spanning decades: small moves make a big difference over time.

  • Funding a Roth IRA takes time.
  • The compounding of interest takes time.
  • If you read the 2012 Forbes article and started to fund your Roth IRA each year, you would have moved $49K-$58K of taxable savings to your tax-free Roth IRA valued at $110K-$130K today if invested in the S&P 500, depending on your age.
  • If you and your spouse started 20 years ago and you’re age 59 today, you each could have moved $99K of taxable savings into Roth IRAs, now worth a combined $650K. This is on top of maxing out their 401(k) — else could have moved even more if they did not want to max out their 401(k) pretax contributions.

If you have taxable retirement savings, I encourage you to look for any under-utilized tax incentives below. Your earned income can qualify you to move more of your taxable savings under the Roth IRA umbrella.

☑️ unprotected savings + ☑️ earned income + ☑️ a desire to reduce taxation

Top-10 List — Things to Know about the Roth IRA

Roth IRA Contributions

1. Withdraw your Roth IRA contributions penalty-free, anytime.

  • Roth contributions are deposits via check or electronic transfer into the Roth IRA account. The annual limit is $6,000, or $7,000 if age 50+.

Roth IRA withdrawals come out in this favorable order: (1st) contributions, (2nd) conversions: penalty-free after 5 years or age 59½, (3rd) earnings: penalty/tax-free after age 59½ and 5+ years since you opened the IRA account.

2. Earned income is required: You can contribute if you had earned income. Think of this as income subject to payroll taxes: social security (FICA) and Medicare taxes, or more accurately, what the IRS defines as taxable compensation.

3. Spousal IRA: You can contribute to a Roth IRA even if you did not have taxable compensation as long as your spouse did.

4. No age limit for Roth IRA contributions (and traditional IRAs, as of 2020).

  • Got kids? Custodial Roth IRA: Assuming they had earned income from babysitting, yard work, coding software, etc. — taxable compensation, they can contribute to their Custodial Roth, as can others, such as a grandparent, as part of the $15K annual gift exclusion when done properly.
  • Their Roth IRA stock-trading gains might not impact their financial aid while at college, as they would within their taxable Robinhood account.
  • Got a business? Business owners can expense properly-earned income of their minor children, and even avoid FICA/payroll taxes. You really want to read this one carefully and get your own adult supervision before moving forward. I recommend starting here:

5. Income Limit on Roth Contributions: Unfortunately, above these income levels for 2021, the allowable Roth IRA contribution is reduced to $0.

  • Single: $129K-$144K
  • Married: $204K-214K

Are you close? AGI-reducers include contributions to employer 401(k) & health savings accounts. But qualified tuition expenses and IRA contributions will not reduce your income for Roth qualification.

The formula to determine if you can contribute to a Roth IRA is a small modification of your Adjusted Gross Income (AGI). Modified AGI for Roth IRA Purposes

Higher Income? The ‘backdoor Roth’ is worth a look.

6. STEP 1: Nondeductible IRA contributions have no income limitation. Use earned income to make a nondeductible IRA contribution ($6K-$7K) into an empty traditional IRA.

  • It’s reported on IRS Form 8606.

7. STEP 2: The backdoor Roth is a conversion (of #6): if you start with an empty traditional IRA account and did STEP 1 (#6), nondeductible IRA contribution, and you have no other IRA accounts, then you simply convert that IRA into a Roth IRA. The money moves over with no tax hit (with no earnings).

  • The combination of #6 and #7 is how you can annually fund your Roth IRA when your income is too high for a direct contribution.
  • This is an option to consider if your income might be above the limit and you do not want to wait for the final income calculations before funding the Roth IRA.
  • The conversion is also reported on IRS Form 8606.
  • This is a Roth conversion. It is NOT a Roth contribution.

8. BUT if you have IRAs in addition to #6, you do NOT have this 2-step option of the tax-free backdoor Roth.

  • When you make a conversion the IRS treats all IRA accounts together, pro-rata: as if they are all one account with pretax and post-tax contributions. You cannot simply identify the IRA that, as in #6 above as the “one” to convert.
  • SOLUTION A: are you under-contributing to a 401(k) or is your spouse? Bump up your pretax 401(k) contributions and offset them with Roth conversions of those your pretax IRA accounts. This should generate neutralizing tax impacts.
  • SOLUTION B: First rollover your IRAs into a 401(k) plan. Check with your 401(k) plan administrator to see if you are allowed.
  • SOLUTION C: establish a solo-401(k) if you own your own business with no other employees. You can even do this for 2020 and make pretax profit-sharing contributions if you have not yet filed business taxes.
  • SOLUTION D: set-up a 401(k) at your company. A retirement plan is required in California by 6/30/2021 if you have 50+ employees, or by 6/30/2022 if 5+ employees.
  • Be mindful of the IRA One-Rollover-Per-Year Rule. Fortunately, this rule does not apply to Roth IRA Conversions, which are rollovers.
  • Entrepreneurs: boosting your pretax contributions can help you qualify for the QBI deduction, especially in light of Biden’s proposal of a phase-out above $400K.

9. Roth Conversion Withdrawals: penalty-free at age 59½ or if it’s been 5 years since the conversion or if an exception applies.

  • If under age 59½ and it’s been less than 5 years since the conversion, there is a 10% penalty for early withdrawal of your conversion amount (+2.5% in CA)
  • Exceptions include $10K for the first-time homebuyer, $5K for birth/adoption, qualified higher education expenses, etc. see more

10. The mega backdoor Roth comes into play when you have the ability to contribute more to a 401(k) plan, such as a solo-401(k) where the annual 401(k) contribution max is $64,500 in 2021.

  • If your 401(k) plan allows distributions anytime, you top up your solo-401(k) contributions, then distribute, or rollover, into your Roth IRA account.
  • NOTE: If your plan allows after-tax contributions, then there is no tax implication.
  • NOTE: If your plan only allows pretax contributions then, top-up to your max, which reduces taxable income in that tax year, then distribute (convert) into your Roth IRA, thereby reversing the tax effect in the year of the conversion.

  • Schedule C filers can still open a solo-401(k) for 2020 employer contributions. 

We’ve been getting them opened next-day for our clients this tax season. This is new for 2020.

  • Entrepreneurs: be mindful of the effects on your QBI deduction, especially in light of Biden’s proposal of a phase-out above $400K.

In Summary:

Roth contribution vs. conversion, and vs. earnings:

Withdrawals of Roth contributions have no strings attached but withdrawals of Roth conversions and Roth earnings follow different rules, with earnings — that part has never been taxed — you need to be age 59½ for the full tax break and the Roth IRA account needs to have been opened for five years.

Key ingredients for moving taxable savings into your Roth IRA:

☑️ unprotected savings + ☑️ earned income + ☑️ a desire to reduce taxation

  1. You have savings, unprotected, in a taxable account, with at least a portion of it earmarked for long-term investing.
  2. You have earned income.
  3. You then identify — or can get set up to have — underutilized IRA/401(k) contributions.
  4. For the Mega backdoor options, your 401(k) plan must accommodate in-plan distributions to your Roth IRA — which are while you still work there. The extra mega contribution can be after-tax (non-deductible) before being converted into the Roth IRA or, if pre-tax, you offset the tax effect when you roll over the pretax 401(k) distributions into the Roth IRA.

Get help; cross-check each step with a professional

If you learn something from this top-10 list and decide it is worth pursuing–or you conclude that something should be avoided–I strongly encourage you to do so only under the guidance of a CPA and a qualified financial advisor who are familiar with your complete tax profile and the nuances of Roth/IRA rules.

Please share your questions and comments below. I’m happy to make edits and revisions. I didn’t say it was easy to invest like Peter Thiel or, for that matter, Mitt Romney who should have well over $100M in his traditional IRA by now.

I will pick up on the self-directed IRA in a future article…

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