26th Mar 2021 by Ashley Scher

The Power of the Roth


Roth Individual Retirement Accounts ‘Roth IRAs’ are often an integral part of a retirement planning strategy. However, despite being quite common, many people are unaware of just how powerful these accounts can be.

Roth Individual Retirement Accounts ‘Roth IRAs’ are often an integral part of a retirement planning strategy. However, despite being quite common, many people are unaware of just how powerful these accounts can be. Whilst we are not tax advisors (and we would recommend that you discuss your options with your tax advisor), it is helpful from an investment perspective to see what might be available in order to maximise savings for retirement.

The Roth IRA was established in 1997 by the Taxpayer Relief Act and was aptly named after the main sponsor of the bill, Senator William Roth of Delaware. Unlike Traditional IRAs , where investors (sometimes) receive a tax deduction on contributions and enjoy tax-deferred growth until they begin taking income distributions in retirement, at which time they pay ordinary income taxes on all pre-tax funds, with Roth IRAs, investors do not receive any immediate deduction on contributions. However, as long as they satisfy the holding period requirements, investors pay no tax on distributions in retirement.

Who Can Contribute?

Income limits determine who is eligible to contribute directly to a Roth IRA. In 2021, the thresholds are phased out as outlined below *:

The maximum total annual contribution for all IRAs (Traditional or Roth) combined is:
•    $6,000 if you're under age 50
•    $7,000 if you're age 50 or older

*If you reside outside the US and utilise the Foreign Earned Income Exclusion, talk to your wealth advisor or tax preparer as there are special considerations that could affect your ability to contribute directly to a Roth IRA. 

Roth Conversions

Roth IRAs offer a unique planning opportunity through a strategy called a Roth conversion.  A Roth conversion allows an investor to shift funds from a Traditional IRA to a Roth.  This works as follows:

-    An investor can elect to complete a full or partial conversion to move funds from the Traditional IRA into a Roth. 
-    Tax is due (at the investor’s effective tax rate) on the conversion amount less any after-tax contributions that have been made.  The tax can be taken from the gross conversion amount, or the investor can elect to pay it from an outside source (such as cash savings or other brokerage assets).  Given the Roth grows tax-free, it is generally advisable to pay from an outside source to maximize the compounded tax-free growth inside the account .  

Backdoor Roth IRAs

There are also options for investors whose income exceeds the threshold to contribute directly to a Roth, using the Roth conversion offers a way to shift non-deductible contributions from a tax-deferred Traditional IRA to a Roth each year.  This is referred to colloquially as a “backdoor” Roth.  This strategy provides accessibility for high earners, who may be restricted from contributing directly to Roth IRAs due to the income limits. We believe this can be a powerful tool overtime to help investors grow a tax-free asset base for retirement.

But what if you have a large Traditional IRA, perhaps from a rollover from another qualified retirement plan, such as a 401(k)…does a Roth conversion still make sense?  It is a complicated question because one has to consider current vs. future tax rates, asset growth rate over time, and the likely timeline for taking distributions in retirement.  However, in our opinion the power of the tax-free compounding of the Roth IRA can be formidable and can often be enough to outweigh even a hefty up-front tax bill.  Talk to your advisor, who can help you analyse if a Roth conversion is right for you. 

[1] https://www.congress.gov/105/plaws/publ34/PLAW-105publ34.pdf

[2] IRAs originally came to be through the passage of the Employee Retirement Income Security Act of 1974 (ERISA).

[3] https://www.irs.gov/retirement-plans/amount-of-roth-ira-contributions-that-you-can-make-for-2021

[4] For US citizens residing outside the US, a mandatory 10% withholding is automatically assessed at the time of the conversion, but using a process called an indirect rollover allows the investor to top-up any withheld tax.


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