How High Earners Create Tax-Free Roths

Roth accounts offer tax-free growth and tax-free withdrawals. But these benefits can be hard to come by, especially for high earners.

Should you consider a tax-free Roth or are you better off sticking to your current strategy? We’re discussing what you need to know below.

Roth Versus Traditional

When saving and investing for retirement, you’re typically presented with two options: contributing to a traditional account or to a Roth account. Traditional accounts offer a tax deduction. Roth accounts don't.

Many people stick with a traditional account (e.g. 401(k) or IRA) for the initial tax savings. High earners are especially attracted by the tax savings but might forget that this is step one of two. While traditional accounts offer a tax deduction today (step one) all withdrawals – those stemming from your initial contribution and any growth – will be taxed tomorrow (step two).

Roth accounts forgo a tax deduction today in exchange for tax-free growth and tax-free retirement income tomorrow.

Building Balance Is Key

We encourage clients to seek a balance between traditional accounts and Roth accounts. The right balance can protect you against future tax rates.

But balance can be hard to come by. First, you're limited to a $6,000 or $7,000 yearly contribution. Second, if your income is more than $150,000 to $200,000⁽¹⁾ you're not allowed to contribute directly to a Roth account. (With some maneuvering, you can pursue a "backdoor Roth contribution", but the right pieces must be in place before proceeding.) For the high earner, your yearly allowable Roth contribution essentially falls to $0.

Fortunately, all these restrictions apply to contributions to Roth accounts, NOT to conversions into Roth accounts. Anyone can make a switch from a traditional account to a Roth account at any time, even the highest earners. Making this switch with existing funds – moving funds from a traditional IRA or 401(k) into a Roth account – is called a Roth conversion.

Personalized and pre-planned over your lifetime, Roth conversions are a great way to build a Roth account, especially for the high earner.

The Cost of Balance: A Tax Bill

When done right, a Roth conversion is a strategic choice to pay an inevitable tax bill at a known and favorable rate.

Why would you choose to pay a tax bill today if it is not due?

Keep in mind that income taxes are embedded within your traditional retirement accounts (IRAs and 401(k)s). Your name might be on the account, but the government also owns a slice. These taxes exist as a silent liability. You (or your beneficiaries) will someday pay this tax bill.⁽²⁾ Even your death does not eliminate the government's claim on your retirement savings. In this case, a tax bill avoided today will come due tomorrow.

When your tax bill comes due what will tax rates look like? Where do you think tax rates be 5 years from now? How about in 50 years?

Consider the history of U.S. income tax rates, illustrated below, starting in 1913.

Where will tax rates go from here? No one truly knows.

If you expect future rates to be higher than today, it may make sense to pay some of your bill today at a lower rate. Even for those in today's top tax bracket, this may be true. Tomorrow's top tax bracket may be higher still.

Guiding Principle: Instead of reflecting on your tax bill each year after it comes due, plan your bill in advance and over many years and decades.

When To Pursue A Roth Conversion:

We hope to pursue a Roth conversion anytime "space" is left within a favorable tax bracket. To help explain, let's look at the mechanics of a Roth conversion.

A Roth conversion creates additional income on your tax return; it increases your taxable income just as if you had earned more income by working more. You can think of any income you generate – regardless of if it is generated by earning more money or by converting more dollars to Roth – as water added to a bucket. As more water is added you reach higher rates of taxation on your income. Each level is called a tax bracket. In the illustration below, enough income was generated to fill the bucket to the very top of the 15% tax bracket. This income is all taxed at 15%.

A great time to do a Roth Conversion is during a relatively lower-income year. Your tax bucket may look like the image below. Note the white space below the top of the 15% bracket. This is space left within the theoretical 15% tax bracket. This gap represents a great opportunity!

Tax brackets exist as a 'use it or lose it' opportunity. If you don't fill up the tax bracket space with income in the current year, that bracket space is lost forever.

After a well-executed Roth conversion your tax bucket may again look like this:

Note how you've captured the entire available 15% tax bracket "space" by creating income with a Roth conversion, but without moving into the higher 30% tax bracket.

From a tax planning perspective, your tax bill remains relatively consistent to last year. Said another way, you were able to harvest the unused tax bracket "space" that would have otherwise gone unused.

Had you performed the same Roth conversion during a relatively normal income year, your conversion would have crossed the line and been taxed at the higher theoretical 30% bracket. You would be paying twice the tax rate as usual on your income (30% versus 15%).

Benefits of Roth Conversions

More Potential income

While a Roth conversion increases today's income and tax bill, in return, your tax bill is paid forever. You've paid an inevitable tax bill at a known and favorable rate. If invested well, your Roth conversion amount should grow and withdrawals should remain fully tax-free.

Building a combination of tax-favored accounts – traditional and Roth – from which to draw income can help you avoid being pushed into higher tax brackets, now or in the future.

Lower required distributions, Higher Social Security Benefits, Lower Medicare Premiums

Many retirees are pushed into higher tax brackets, often unintentionally due to required distributions from traditional IRAs and 401(k)s.

Traditional IRAs and 401(k)s require you to withdraw a minimum amount each year once you reach age 72 (previously age 70.5). In addition, these required distributions are included as income on your tax return. Include too much income and more of your Social Security benefit becomes taxable, resulting in a lower total Social Security benefit. Finally, additional income could cause your Medicare premiums to increase (Read more of our thoughts on Medicare "IRMAA" premium increases here).⁽³⁾

Roth IRAs do not force you to distribute a minimum amount each year, no matter your age. Roth conversions serve to lower future required distributions from traditional IRAs or 401(k)s, help avoid additional Social Security taxation, and help avoid higher Medicare premiums.

Better Estate Transfer

Roth accounts are great accounts to inherit. Just like traditional IRAs and 401(k), they can be assigned a directed beneficiary and pass outside of probate. Plus, you can withdraw from a Roth at any time without paying income taxes.

Roth IRAs are also free from the complication of taxable required distributions.⁽⁴⁾

We even consider Roth conversions when your beneficiary is expected to be in a lower tax bracket than you. Although they might pay fewer taxes by inheriting a traditional IRA or 401(k), they also inherit the complication of taxable required distributions. We think there is value in simplicity. Consider paying some of your embedded tax bill as a gift to your beneficiary in the form of a Roth conversion.

Potentially Less estate taxes

If estate or death taxes are a concern, a Roth conversion can decrease your taxable estate by strategically prepaying some of the tax bill embedded in a traditional IRA and 401(k). In certain cases, estates can be reduced to a point where the 40% bite of estate taxes no longer applies.

Other Opportunities

Once you've mastered the balance between traditional and Roth accounts, there are plenty of other financial opportunities to capture.

Additional Tax Diversification

If you’re able to save even more, or if you have accumulated savings that you want to use for future goals, consider building a third category of assets called "taxable" accounts. Although not as well-known as retirement accounts like 401(k)s and IRAs, a "taxable" account can serve the same purpose of saving for retirement while also building protection against future tax rates.

Building A Charitable Foundation

Are you charitably inclined? Roth conversions are a great tool to combine with charitable giving.

Do you realize that giving cash with your checkbook is one of the most expensive ways to give to charity? In addition, gifts are commonly not deducted from income (even though they are tax-deductible)⁽⁵⁾.

By using a tool called a charitable giving account you can seek a tax deduction this year, but give those same dollars to charity over the rest of your life (or pass them to your children to give to charity). With a charitable giving account, you wouldn't change who you give to, but you could potentially get a greater benefit for your existing or planned gifts. We describe this as holding a 'coupon' for charitable gifts. In the end, more dollars should be available for charity.

While Roth conversions increase your income, a charitable giving account can decrease your income. When pursued together, these two actions can offset each other.

Imagine creating tax-free growth and tax-free withdrawals, plus pre-funding your charitable intentions, all at a 0% tax rate!

View a summary of a charitable giving account – how it works, what it costs, and if it is right for you – at Fidelitycharitable.org.

How Can We Help?

Growing an account tax-free, then withdrawing income tax-free in retirement is an appealing option. And it’s good to know that while you may have chosen to open a traditional account years ago that you have the option to convert it at any time. Before making any moves to your retirement savings, make sure to speak with a trusted professional first. Together, you can go over these important considerations in regard to your unique financial situation.

At any time, we stand ready to help you navigate these hurdles and speed you on your way. That’s what we’re here for!

Call us now or schedule some time with us at www.openwindowFS.com/connection.

1 – In 2022 your Modified Adjusted Gross Income (MAGI) must be under $144,000 to contribute to a Roth IRA. If you're married and file jointly, your MAGI must be under $214,000.

2 – One way to avoid this embedded tax bill is to give these same funds directly to charity using a directed beneficiary designation and/or a Qualified Charitable Distribution.

3 – If you're age 65 or older and you choose to pursue a Roth conversion, be careful of incurring a Medicare IRMAA ‘penalty’. There is always a two-year lag: 2020 actions affect 2022. 2021 actions affect 2023. Read more on Medicare IRMAA here.

4 – Although the original account owner does not have forced or required distributions on a Roth IRA at any age, a beneficiary of a Roth IRA will have required distributions if held in an Inherited Roth IRA. The rules are even more complicated for Roth 401(k) owners - both the original owner and their beneficiary face required distributions. Thankfully, since these distributions are made from a Roth account, they are not taxable.

5 – Taxfoundation.org estimated that 13.7% of taxpayers will itemize in 2019, meaning 86% will not itemize their deductions. We believe that the trend of non-itemizing has likely increased since 2019.