Are There Roth Options for High-Income Earners?
I see a lot of articles and videos about the benefits of Roth IRAs. They have become popular in recent years. Due to the promotion of these types of accounts, many people understand the benefits of a Roth IRA. However, high-income earners often don't understand their options because there are participation limitations for high-income earners. So, what are your options?
Here is a refresher on some of the benefits of a Roth IRA. First, Roth IRAs allow you to make after-tax contributions. In other words, you earn $10 and contribute $1 from those earning into a Roth IRA. You are taxed on the whole $10 even though you put $1 into a Roth account. Roth funds will not be taxed if withdrawn according to IRS rules. These rules apply not only to the contributions but also to the growth.
In other words, when you contribute to a Roth IRA, it does not reduce your taxable income. Of course, this assumes you take the money out of the account after age 59 ½ and after the account has been active for five years. In addition to this, you don't have to take mandatory distributions (RMDs). So, individuals who expect to pay more in taxes later on can pay taxes now and contribute to a Roth IRA. So, if your account doubles through the interest and investment earnings, you don't have to pay taxes on those gains. However, keep in mind that investment earnings are dependent on the performance of the underlying investments in the Roth account.
Many people would love to not worry about paying taxes on their retirement account later on in life. But, there are limitations on who can participate in a Roth IRA. The rule is that an individual's maximum contribution is up to $6,000 if under 50 or $7,000 if you are 50+ (for 2021). The issue, however, is that the IRS phases out the maximum amount an individual can contribute based on their Modified Adjusted Gross Income (or AGI). So, for example, if a couple is married filing jointly, they cannot contribute to a Roth IRA if their AGI is equal to or greater than $208,000.
These limitations can be an issue for high-income earners. If a family earns a high income and cannot contribute to a Roth IRA, what can they do? One option is to go the route of a backdoor Roth IRA. A backdoor Roth IRA is not a type of account; it's converting a Traditional IRA or Traditional 401(k) into a Roth account. It sounds simple, but there is more to it than just waving a wand or signing a paper and moving the money to a Roth account. A backdoor Roth is not a way to dodge taxes. You are still going to need to pay taxes on that money. I recommend you work with your CPA to figure out the tax implications if you go this route.
Another way to participate in a Roth account is to contribute to your 401(k) as a Roth contribution. Most 401(k)s these days have a Roth contribution option. Unlike a Roth IRA, a Roth 401(k) does not have an income limit requiring participants to phase out of eligibility. However, like a Roth IRA, there are maximum contribution limits. The contributions of a Roth 401(k) are another highlight of why Roth 401(k)s can be such a great strategy.
While Roth IRAs have a max contribution limit of $6,000 for those under 50 and $7,000 total for those 50+, Roth 401(k)s have a higher limit. For 2021, the 401(k) contribution limit is $19,500 for those under 50 and a total of $26,000 for those 50+. These maximums don't include the possible employer match. Remember, an employee's contributions can be Roth, but employer matches are like a traditional contribution (taxed once you start withdrawing an income).
So many high-income earners know they cannot contribute to a Roth IRA, but many don't know their other Roth options. This article does not go through all the pros and cons of Roth IRAs vs. Roth 401(k)s. It is also not tax or legal advice. But, hopefully, it has been eye-opening and will get you started on researching what the best options are for you.