Roth Accounts

Backdoor Roths and beyond: The four camps who can benefit Roth IRA conversions can unlock serious savings, especially if you find yourself in one of these scenarios. Roth IRAs and their tax-free perks are pretty great—so great that in some scenarios, it can make sense to convert pre-tax dollars from traditional retirement accounts into post-tax dollars in a Roth IRA. This is what’s known as a Roth conversion. You’re effectively taking those pre-tax funds and telling Uncle Sam you’d rather pay taxes on them now in exchange for the benefit of tax-free and penalty-free withdrawals in retirement. And if you need the money earlier, the IRS requires only that you wait five years before withdrawing each conversion to avoid a 10% penalty. So who do Roth conversions appeal to in particular? Four types of people: High earners and the “backdoor” Roth conversion Recent retirees and unwelcome RMDs Early retirees and the Roth conversion “ladder” People experiencing temporary income dips High earners and the “backdoor” Roth conversion Did you know the IRS restricts access to Roth IRAs based on income? Shut the front door! Yes, if your income exceeds these eligibility limits, you can’t contribute directly to a Roth IRA. But as the saying goes, when one door closes, another door opens. A “backdoor,” more specifically. So if you make too much money, fear not – you can contribute indirectly to a Roth IRA via a Roth conversion widely known as a “backdoor” Roth. This entails contributing post-tax dollars first to a traditional IRA, then converting those funds to a Roth IRA. If you’ve never contributed to a traditional IRA before, pulling off a backdoor Roth can be simple, especially if you use Betterment. Open both a traditional and Roth IRA with us, fund the traditional, then convert those funds to your Roth IRA once they’ve settled. Done! If you have any existing traditional IRA funds, however, things get a little more complicated due to something called the pro rata rule. In short, you need to move any pre-tax dollars out of your traditional IRA(s) into an employer-sponsored retirement account like a 401(k) before you can use the account as a backdoor. This gets even more complicated if you have both pre- and post-tax dollars mixed together in your traditional IRA(s). Before going down the road of a backdoor Roth conversion, or any Roth conversion really, we highly recommend seeking the advice of a financial advisor, as well as a tax advisor in certain cases. They can help assess both your current situation and future projections. Recent retirees and unwelcome RMDs The IRS doesn’t let you keep funds in your traditional retirement accounts indefinitely. They’re meant to be spent, after all. So starting at age 73, annual required minimum distributions (RMDs) from these accounts kick in. RMDs aren’t inherently a bad thing, but if your expenses can already be covered from other sources, RMDs will just raise your tax bill unnecessarily. You can get ahead of this and lower your future amount of RMDs by converting traditional account funds to a Roth IRA before you reach RMD age. That’s because Roth IRAs are exempt from RMDs. And as an added benefit, you’ll minimize taxes on Social Security benefits and Medicare premiums later on in retirement. Just make sure you convert those funds before you turn 73, because once RMDs kick in, those amounts can’t be converted. Early retirees and the Roth conversion “ladder” If you want to retire early, even by “just” a few years, you very well might encounter a problem: Most of your retirement savings are tied up in tax-advantaged 401(k)s and IRAs, which slap you with a 10% penalty if you withdraw the funds before the age of 59 ½. A few exceptions to this early withdrawal rule exist, the biggest for early retirees being that contributions to a Roth IRA (i.e., not the gains you may see on those contributions) can be withdrawn early without taxes or penalties, in this specific order: “Regular” contributions made directly to a Roth IRA. As an aside, you can always withdraw these funds tax-free and penalty-free without waiting five years. Once you’ve burned through regular contributions, the IRS allows you to withdraw contributions that were converted from traditional 401(k)s and traditional IRAs! You won’t pay any additional taxes on these withdrawn contributions because taxes have already been paid. But withdrawn conversions (item #2 above) typically are still subject to a 10% penalty if withdrawn before 5 years. Think of this rule as a speed bump in an otherwise swift shortcut. So what does all of this mean for early retirees? Starting five years before they plan on retiring, they can create a “ladder” looking something like the table below (note: dollar amounts are hypothetical). They convert funds each year, pay taxes on them at that time, then withdraw them five years later 10% penalty-free and sans any additional taxes. Time Amount converted Amount withdrawn Source of withdrawal 5 years pre-retirement $40,000 $0 N/A 4 years pre-retirement $40,000 $0 N/A 3 years pre-retirement $40,000 $0 N/A 2 years pre-retirement $40,000 $0 N/A 1 year pre-retirement $40,000 $0 N/A Retired early! 🎉 Year 1 of retirement $40,000 $40,000 5 years pre-retirement Year 2 of retirement $40,000 $40,000 4 years pre-retirement Year 3 of retirement $40,000 $40,000 3 years pre-retirement Year 4 of retirement $40,000 $40,000 2 years pre-retirement Year 5 of retirement $40,000 $40,000 1 year pre-retirement Etc. Etc. Etc. Etc. People experiencing temporary income dips Say you find yourself staring at a significantly smaller income for the year. Maybe you lost your job. Maybe you work on commission and had a down year. Or maybe you had a big tax writeoff. Whatever the reason, that dip in income means you’re currently in a lower tax bracket, and it may be wise to pay taxes on some of your pre-tax investments now at that lower rate compared to the higher rate when your income bounces back. Watch out for potential Roth conversion pitfalls Each of these scenarios requires careful tax planning, so again, we recommend working with a trusted financial advisor and/or tax advisor. They can help you avoid the most common Roth conversion mistakes and take full advantage of this post-tax money maneuver. Our CERTIFIED FINANCIAL PLANNER™ professionals are here to offer on-demand guidance.

What’s an IRA and how does it work? Learn more about this investment account with tax advantages that help you prepare for retirement. An Individual Retirement Account (IRA) is a type of investment account with tax advantages that helps you prepare for retirement. Depending on the type of IRA you invest in, you can make tax-free withdrawals when you retire, earn tax-free interest, or put off paying taxes until retirement. The sooner you start investing in an IRA, the more time you have to accrue interest before you reach retirement age. But an IRA isn’t the only kind of investment account for retirement planning. And there are multiple types of IRAs available. If you’re planning for retirement, it’s important to understand your options and learn how to maximize your tax benefits. If your employer offers a 401(k), it may be a better option than investing in an IRA. While anyone can open an IRA, employers typically match a portion of your contribution to a 401(k) account, helping your investment grow faster. In this article, we’ll walk you through: What makes an IRA different from a 401(k) The types of IRAs How to choose between a Roth IRA and a Traditional IRA Timing your IRA contributions IRA recharacterizations Roth IRA conversions Let’s start by looking at what makes an Individual Retirement Account different from a 401(k). How is an IRA different from a 401(k)? When it comes to retirement planning, the two most common investment accounts people talk about are IRAs and 401(k)s. 401(k)s offer similar tax advantages to IRAs, but not everyone has this option. Anyone can start an IRA, but a 401(k) is what’s known as an employer-sponsored retirement plan. It’s only available through an employer. Other differences between these two types of accounts are that: Employers often match a percentage of your contributions to a 401(k) 401(k) contributions come right out of your paycheck 401(k) contribution limits are significantly higher If your employer matches contributions to a 401(k), they’re basically giving you free money you wouldn’t otherwise receive. It’s typically wise to take advantage of this match before looking to an IRA. With an Individual Retirement Account, you determine exactly when and how to make contributions. You can put money into an IRA at any time over the course of the year, whereas a 401(k) almost always has to come from your paycheck. Note that annual IRA contributions can be made up until that year’s tax filing deadline, whereas the contribution deadline for 401(k)s is at the end of each calendar year. Learning how to time your IRA contributions can significantly increase your earnings over time. Every year, you’re only allowed to put a fixed amount of money into a retirement account, and the exact amount often changes year-to-year. For an IRA, the contribution limit for 2024 is $7,000 if you’re under 50, or $8,000 if you’re 50 or older. For a 401(k), the contribution limit for 2024 is $23,000 if you’re under 50, or $30,500 if you’re 50 or older. These contribution limits are separate, so it’s not uncommon for investors to have both a 401(k) and an IRA. What are the types of IRAs? The challenge for most people looking into IRAs is understanding which kind of IRA is most advantageous for them. For many, this boils down to Roth and/or Traditional. The advantages of each can shift over time as tax laws and your income level changes, so this is a common periodic question for even advanced investors. As a side note, there are other IRA options suited for the self-employed or small business owner, such as the SEP IRA, but we won’t go into those here. As mentioned in the section above, IRA contributions are not made directly from your paycheck. That means that the money you are contributing to an IRA has already been taxed. When you contribute to a Traditional IRA, your contribution may be tax-deductible. Whether you are eligible to take a full, partial, or any deduction at all depends on if you or your spouse is covered by an employer retirement plan (i.e. a 401(k)) and your income level (more on these limitations later). Once funds are in your Traditional IRA, you will not pay any income taxes on investment earnings until you begin to withdraw from the account. This means that you benefit from “tax-deferred” growth. If you were able to deduct your contributions, you will pay income tax on the contributions as well as earnings at the time of withdrawal. If you were not eligible to take a deduction on your contributions, then you generally will only pay taxes on the earnings at the time of withdrawal. This is done on a “pro-rata” basis. Comparatively, contributions to a Roth IRA are not tax deductible. When it comes time to withdraw from your Roth IRA, your withdrawals will generally be tax free—even the interest you’ve accumulated. How to choose between a Roth IRA and a Traditional IRA For most people, choosing an Individual Retirement Account is a matter of deciding between a Roth IRA and a Traditional IRA. Neither option is inherently better: it depends on your income and your tax bracket now and in retirement. Your income determines whether you can contribute to a Roth IRA, and also whether you are eligible to deduct contributions made to a Traditional IRA. However, the IRS doesn’t use your gross income; they look at your modified adjusted gross income, which can be different from taxable income. With Roth IRAs, your ability to contribute is phased out when your modified adjusted gross income (MAGI) reaches a certain level. If you’re eligible for both types of IRAs, the choice often comes down to what tax bracket you’re in now, and what tax bracket you think you’ll be in when you retire. If you think you’ll be in a lower tax bracket when you retire, postponing taxes with a Traditional IRA will likely result in you keeping more of your money. If you expect to be in a higher tax bracket when you retire, using a Roth IRA to pay taxes now may be the better choice. The best type of account for you may change over time, but making a choice now doesn’t lock you into one option forever. So as you start retirement planning, focus on where you are now and where you’d like to be then. It’s healthy to re-evaluate your position periodically, especially when you go through major financial transitions such as getting a new job, losing a job, receiving a promotion, or creating an additional revenue stream. Timing IRA contributions: why earlier is better Regardless of which type of IRA you select, it helps to understand how the timing of your contributions impacts your investment returns. It’s your choice to either make a maximum contribution early in the year, contribute over time, or wait until the deadline. By timing your contribution to be as early as possible, you can maximize your time in the market, which could help you gain more returns over time. Consider the difference between making a maximum contribution on January 1 and making it on December 1 each year. Then suppose, hypothetically, that your annual growth rate is 10%. Here’s what the difference could look like between an IRA with early contributions and an IRA with late contributions: This figure represents the scenarios mentioned above.‘Deposit Early’ indicates depositing $6,000 on January 1 of each calendar year, whereas ‘Deposit Late’ indicates depositing $6,000 on December 1 of the same calendar year, both every year for a ten-year period. Calculations assume a hypothetical growth rate of 10% annually. The hypothetical growth rate is not based on, and should not be interpreted to reflect, any Betterment portfolio, or any other investment or portfolio, and is purely an arbitrary number. Further, the results are solely based on the calculations mentioned in the preceding sentences. These figures do not take into account any dividend reinvestment, taxes, market changes, or any fees charged. The illustration does not reflect the chance for loss or gain, and actual returns can vary from those above. What’s an IRA recharacterization? You might contribute to an IRA before you have started filing your taxes and may not know exactly what your Modified Adjusted Gross Income will be for that year. Therefore, you may not know whether you will be eligible to contribute to a Roth IRA, or if you will be able to deduct your contributions to a Traditional IRA. In some cases, the IRS allows you to reclassify your IRA contributions. A recharacterization changes your contributions (plus the gains or minus the losses attributed to them) from a Traditional IRA to a Roth IRA, or, from a Roth IRA to a Traditional IRA. It’s most common to recharacterize a Roth IRA to a Traditional IRA. Generally, there are no taxes associated with a recharacterization if the amount you recharacterize includes gains or excludes dollars lost. Here are three instances where a recharacterization may be right for you: If you made a Roth contribution during the year but discovered later that your income was high enough to reduce the amount you were allowed to contribute—or prohibit you from contributing at all. If you contributed to a Traditional IRA because you thought your income would be above the allowed limits for a Roth IRA contribution, but your income ended up lower than you’d expected. If you contributed to a Roth IRA, but while preparing your tax return, you realize that you’d benefit more from the immediate tax deduction a Traditional IRA contribution would potentially provide. Additionally, we have listed a few methods that can be used to correct an over-contribution to an IRA in this FAQ resource. You cannot recharacterize an amount that’s more than your allowable maximum annual contribution. You have until each year’s tax filing deadline to recharacterize—unless you file for an extension or you file an amended tax return. What’s a Roth conversion? A Roth conversion is a one-way street. It’s a potentially taxable event where funds are transferred from a Traditional IRA to a Roth IRA. There is no such thing as a Roth to Traditional conversion. It is different from a recharacterization because you are not changing the type of IRA that you contributed to for that particular year. There is no cap on the amount that’s eligible to be converted, so the sky’s the limit for those that choose to convert. We go into Roth conversions in more detail in our Help Center.

Five common Roth conversion mistakes Learn more about Roth conversion benefits—for high earners and retirees especially—and common conversion mistakes to avoid. Converting pre-tax funds from your traditional retirement accounts into a post-tax Roth IRA (i.e., a Roth conversion) can make sense in certain scenarios. But before you move any money, we recommend connecting with a trusted financial advisor and, in some cases, a tax advisor. They can help you sidestep five common Roth conversion mistakes: Converting outside of your intended tax year You must complete a Roth conversion by a year’s end (December 31) in order for it to count toward that specific tax year’s income. Keep in mind this is different from the IRA contribution deadline for a specific tax year, which (somewhat confusingly) bleeds into the following calendar year. As we’ve mentioned before, Roth conversions require careful planning on your part (and, ideally, your tax advisor) to determine how much you should convert, if at all, and when. Converting too much Speaking of, the question of how much to convert is a crucial one. Blindly converting too much could push you into a higher tax bracket. A common strategy used to avoid this is called “bracket filling.” You determine your income and how much room you have until you hit the next tax bracket, then convert just enough to “fill up” your current bracket. Of course, it can be difficult to determine your exact income. You might not know whether you’ll get a raise, for example, or how many dividends you’ll earn in investment accounts. Because of this, we highly recommend you work with a tax advisor to figure out exactly how much room you have and how much to convert. You no longer have the luxury of undoing a Roth conversion thanks to the 2017 Tax Cuts and Jobs Act. As a side note, you can squeeze more converted shares into your current bracket if the market is down since each share is worth less in that moment. To be clear, we don’t recommend making a Roth conversion solely because the market is down, but if you were already considering one, this sort of market volatility could make the conversion more efficient. Withdrawing converted funds too early When making a Roth conversion, you need to be mindful of the five-year holding period before withdrawing those converted funds, which is different from the 5 year holding period for qualified distributions. And as we mentioned earlier, you’ll typically pay taxes on the amount you convert at the time of conversion, and future withdrawals in retirement can be tax and 10% penalty free. After making a Roth conversion, however, you must wait five tax years for your withdrawal of your taxable conversion amount to avoid the 10% penalty. Withdrawals of amounts previously converted are always tax-free. Notably, this countdown clock is based on tax years, so any conversion made during a calendar year is deemed to have taken place January 1 of that year. So even if you make a conversion in December, the clock for the five year rule starts from earlier that year in January. One more thing to keep in mind is that each Roth conversion you make is subject to its own five year period related to the 10% early withdrawal penalty. Paying taxes from your IRA Paying any taxes due from a conversion out of the IRA itself will make that conversion less effective. As an example, if you convert $10,000 and are in the 22% tax bracket, you’ll owe $2,200 in taxes. One option is to pay the taxes out of the IRA itself. However, this means you’ll have only $7,800 left to potentially grow and compound over time. If you’re under the age of 59 ½, the amount withheld for taxes will also be subject to a 10% early withdrawal penalty. Instead, consider paying taxes owed using excess cash or a non-retirement account you have. This will help keep the most money possible inside the Roth IRA to grow tax-free over time. Keeping the same investments Conversions can be a great tool, but don’t stop there. Once you convert, you should also consider adjusting your portfolio to take advantage of the different tax treatment of traditional and Roth accounts. Each account type is taxed differently, which means their investments grow differently, too. You can take advantage of this by strategically coordinating which investments you hold in which accounts. This strategy is called asset location and can be quite complex. Luckily, we automated it with our Tax Coordination feature.