Can a Roth IRA Account Lower Your Lifetime Tax Bill?

As a child, I was given the opportunity to work on a friend’s family farm and learn a couple of important lessons about money.

On my first day on the job, my childhood best friend (Peter) and I were hired at his family farm in Stanchfield, MN, to bale hay for a whopping $4.25 / hour. It was a blistering August day. Within 45 minutes, my young city boy’s hands started to blister. My nose ran like a faucet; everything itched because I was allergic to hay! To top it off, I tripped on the wagon and fell into a fresh pile of manure! I didn’t get in a full hour before needing to quit and hose off. Farmer Wally was kind enough to give me $5.00 for my efforts.

Lesson #1: Many people work hard for their money

After working so hard for that $5.00, I realized I didn’t want to let hard-earned money go to waste. If you feel the same way, continue reading to see how you might be able to keep more of your hard-earned money from taxes.

Lesson #2: I think successful farmers and investors think alike

They are both conscious of the taxes they pay on their earnings or yield. Why? Because they want to keep as much of their harvest as possible (after all taxes have been paid).

Wally and his son Bradley, who took over the farm, were smart in controlling their costs and taxes. If the operation had a good financial harvest one year, they would prepay for seed and supplies for the upcoming year to lower their tax bill. They could delay purchases until the following year if it was a down year.

They were prudent with controlling their tax bill to “harvest” as much as possible. The goal was to provide for their families after all taxes had been paid.

Are you on track to harvest as much as possible, after taxes are paid, from your investment and retirement accounts? Or are you letting the IRS take more than their fair share of your harvest?

This blog post explores how getting money into a Roth account could help secure your future and potentially increase your “after-tax” harvest. You will learn about:

  1. Taxation differences between Roth and tax-deferred accounts
  2. How could adding more to your Roth strategy lower your lifetime tax bill?
  3. Contribution Limits & Roth IRA Income Restrictions

Taxation differences between Roth and Tax-Deferred Accounts

You can pay three types of taxes when looking at tax-deferred and Roth accounts:

  1. Tax on contributions
  2. Taxes on earnings and gains
  3. Taxes on withdrawals.

Let’s look at how these accounts are taxed differently.

Tax-Deferred Retirement Accounts

The most common tax-deferred retirement accounts are individual retirement accounts, 401(k)s, and 403(b)s. Typically, your income or earnings are deposited in a tax-deferred account. There is no tax on your contribution because you defer income tax to a later date.

What about earnings in the account? All your earnings (capital gains, dividends, and interest) are tax-deferred, which means you don’t have to pay any taxes until you take distributions (or when you’re forced to take money out in your 70s).

When it’s time to take money out and reap your harvest (typically after age 59 1/2 without a penalty), it’s time to “pay the man his money.” Since your account contributions and earnings have not been taxed, Uncle Sam collects income taxes on your distributions. Using a farming analogy, you’re being taxed on your entire tax-deferred harvest.

Paying more tax at harvest time (when you take your money out) isn’t necessarily bad. It could be helpful if you project to be in a lower tax bracket in the future or if you believe that tax rates will go down. However, if you were going to be in a higher tax bracket in retirement for any reason (earnings, inherited money, large nest egg, tax rates increase), having money in a Roth account might be an option to lower your lifetime tax bill.

Roth Accounts

Different types of Roth accounts include a Roth IRA, a Roth 401(k), and a Roth 403(b). These accounts are all similar for taxation.

Roth contributions are not tax-deductible. Your income is taxed before you make contributions. The great part about Roth accounts is that earnings and qualifying withdrawals are entirely tax-free!

When you reap the harvest, there is no tax on qualifying withdrawals*. Tax-free withdrawals can help lower your tax bill and increase your harvest when you anticipate a higher tax rate in retirement.

* Some IRA contributions may not be deductible

** Taxes and penalties may apply for early withdrawals

Penalties can also apply if account holders do not take required minimum distributions or for early withdrawals

***Roth IRA Guidelines

Should you add more to a Roth strategy?

The IRS gives investors different options for accumulating wealth. Those options have different tax treatments.

To recap what you’ve already read in this post:

  • Roth accounts can receive a tax-free harvest but are hit with that tax up-front.
  • Tax-deferred accounts don’t get taxed upfront but are taxed on the harvest.

Determining if you should add more to a Roth strategy depends on your situation and requires you, or a qualified advisor, to analyze 1) when you should pay taxes and 2) make projections about returns and tax rates.

For example, assume you are a farmer with access to a particular type of seed that would provide a 100 times return on your investment!

Also, assume you had $10,000 cash in your account for purchasing this seed. You expect the return on your seed investment to be 1000%. Like any smart farmer or investor, your goal is to harvest as much as possible after taxes.

You’re given two options for paying taxes. You can either:

  1. Use the $10,000 to buy $9,000 of seed and pay $1,000 of your taxes up-front at the store. The benefit of this strategy is that your harvest is tax-free.OR
  2. You use the $10,000 to buy more seed up front, produce a larger yield, and defer the tax until harvest time. You get more seed in the ground up front. The trade-off is that your harvest’s expected income tax rate is 20%.

Would you pay the tax up-front or get more seed in the ground and pay more tax on the entire harvest?

Let’s look and see what happens in both of these hypothetical scenarios:

One of my favorite ways we help our clients at One Life Financial Group is to run a deep-dive tax minimization analysis. This analysis includes a Roth conversion analysis alongside dozens of other tax planning strategies to see if the client might be able to keep more of their hard-earned money instead of giving it to Uncle Sam.

While scenarios that add more to a Roth strategy (for those who qualify) don’t help everyone, it’s not uncommon to run an analysis for a client and discover they could potentially increase their after-tax harvest, as seen in the hypothetical illustration below.

Are you worried you might be paying too much in taxes or leaving money on the table?

Click here to take our free “Tax Minimization Assessment.”

Before you get too excited and try to add money to a Roth account, you should review the contribution limits and income restrictions to see if you qualify for contributions to a Roth account (below).

Also, work with your financial advisor and run any strategies by your accountant before pulling the trigger. Adding more to a Roth account does not always result in more of a tax-free harvest at retirement.

Contribution Limits & Roth IRA Income Restrictions

Retirement plans have different contribution limits, which can be seen below.

There are no income limits for contributing to a 401(k) or a 403(b), but the contribution limit for 2023 is $22,500 for a 401(k) or a 403(b). And there is also a catch-up contribution. So if you have made it to age 50 this year, or if you make it there by December 31st, you can contribute an additional $7,500 (for a total of $30,000).

Roth IRA Income Limits

As you can also see in the chart, investors are phased out from making Roth IRA contributions if they make too much money.

If you’re single and filing taxes, the phase-out is between $129,000 and $144,000 of modified adjusted gross income (MAGI).

That means if your income is below $129,000 per year, you can make a total contribution of $6,500. If you’re age 50 or above by the end of the year, you can contribute an additional thousand dollars per person. If you make over $144,000, you are not allowed to fund a Roth IRA contribution as a single filer.

You can make a partial contribution if your income is between $129,000 and $144,000. So if you’re right in the middle of that income bracket, you can contribute half of the $6,500 ($3,250). If you’re three-fourths of the way through that bracket, you can contribute 25% of $6,500; it’s a pro-rata calculation.

If you are married, the income phase-out is $204,000 to $214,000. The contribution limit is $6,500 per person, and a thousand dollars catch up. So if there are two of you over age 50, you could contribute $7,500 each for a total of $15,000.

There is one catch. For the Roth IRA, if you’re over 50, you must have at least $7,500 of income to contribute $7,050. If you’re below 50, you must have $6,500 of income to contribute $6,500 to a Roth. If you’re married and your spouse is not working, your spouse can contribute to a Roth IRA as long as the two of you have a total of $13,000. If you’re under 50, you could both max out the contribution.

If you make too much money to contribute to a Roth IRA, you might be interested in reading my blog post on three practical strategies you could use to get money into a Roth IRA.

Wondering how to create a tax-efficient withdrawal strategy in retirement? Contact us for a complimentary, 90-minute no-obligation consultation! You can also take our Tax Minimization Assessment to explore opportunities to  lower your tax bill and keep more of your hard-earned money by clicking the link below. All you need to do is answer 10-12 questions about your situation. Your results are instantaneous.

Disclaimer: Consult with a qualified financial advisor and a tax professional before making any changes or decisions regarding your retirement, investment, and tax minimization strategies.