When it comes to contributing to retirement, you might have various options available to you. One of those options could be a Roth IRA. These accounts have unique benefits that separate them from a more “traditional” retirement plan. One of the biggest differences is that Roth IRAs are funded with after-tax dollars. 

What does that mean? Contributions to traditional retirement plans use pre-tax dollars – in other words – those contributions are tax-deductible. This lowers your taxable income. However, any distributions from a traditional retirement plan will be taxed as income. 

For a basic illustration, assume you earn a gross income of $100,000 annually. You then contribute $10,000 in pre-tax dollars to your 401(k). Instead of the IRS taxing you on the full $100,000, you are only paying income taxes on $90,000 ($100k minus the contribution of $10k). 

Keep in mind that you are only deferring the tax bill. You will eventually pay income taxes on those contributions once you withdraw the funds. The hope is you will be in a lower tax bracket in retirement than you are currently, but no one knows if they will be or not.

With a Roth IRA, you reverse the tax impact: Not tax deductible, but distributions can be withdrawn tax-free. Using the same example above, if you could make a $10,000 Roth contribution, you would be paying taxes on the entire $100,000 of income. So, instead of paying taxes later, you pay them now. (Side note: you can’t really make a $10K Roth contribution, I was just trying to keep numbers consistent for the concept).

However there are income limits in place that can prohibit high earners from contributing to a Roth IRA. Boo!

How do we get around those limits? Let’s introduce the Backdoor Roth strategy.

Backdoor Roth

A common workaround is utilizing a backdoor Roth by way of a Traditional IRA. You contribute non-deductible dollars into the Traditional IRA and quickly convert it to a Roth IRA. Sounds easy enough, but there are quite a few drawbacks to this strategy:

• The backdoor Roth really only works if you have no other traditional IRAs due to the pro-rata rule.
• The funding limits are relatively low ($7,000, plus $1,000 if age 50+, for 2024).
• You must keep track of your non-deductible IRA contributions, which can be a pain when filing your taxes.

Don’t lose hope yet, as there are still other strategies that may be available to you!

Roth 401(k)

Over the past few years, it has become more common to have employers allow Roth contributions to a 401(k) plan. The good news here is that, unlike a Roth IRA, Roth 401(k) plans do not enforce any income caps. That’s right… no matter how much you earn, there are no restrictions from contributing Roth dollars to your 401(k). However, even though you can contribute to a Roth 401(k), it may not make sense to do so, depending on your overall household income and tax bracket. A financial planner or a tax advisor could help you determine an optimal contribution scenario here.

Mega Backdoor Roth

If your employer-sponsored 401(k) allows for after-tax, non-Roth contributions, you may benefit from the Mega Backdoor Roth. If you have access to after-tax contributions through your 401(k), here is how a mega backdoor Roth might work:

• Pump in the max pre-tax dollars into your 401(k) – $23,000, or $30,500 if 50+ in 2024
• Then, you opt-in to contribute after-tax (non-Roth) dollars up to the annual maximum (combined employee and employer). In 2024, this is $69,000 ($76,500 if 50+). If your employer offers matching or profit-sharing contributions, this will reduce how much is left for you to contribute. But this is a good problem to have.
• From there, you can elect an in-plan Roth 401(k) rollover/conversion (if applicable) or roll the after-tax contributions into a Roth IRA, paying tax on the earnings, if any.

Comparing the dollar amounts, the mega backdoor Roth can supercharge your overall retirement savings and grant you access to the tax-free Roth! 

There are many other factors to consider when deciding when a Roth strategy might make sense. Your current and expected tax brackets are essential to keep in mind, which may negate the long-term benefits of a Roth IRA.

If this all sounds confusing, don’t worry. Creative Money financial planners work with our clients on issues like these all of the time, and we can help you decide the best path based on your current financial situation so you make the right choice for your future. If you’re interested, you can schedule a consultation to find out more.

Brett Lathrup is a CFP® professional, and Certified College Financial Consultant (CCFC). When he is not helping clients, you can find Brett spending time in the great outdoors, being a pit boss on one of his many charcoal grills or smokers, or learning how to craft the perfect wood-fired pizza. Read more about Brett here.