Top 8 Roth Hacks to Maximize Their Potential
Roth accounts are an incredibly useful way to combine investing with tax efficiency.
However, there are scores of IRS rules, laws, and regulations that can make navigating the use of these accounts a bit of a headache.
The good news is these rules also occasionally leave loopholes or other opportunities to take their effectiveness to another level.
Here are eight crafty Roth hacks to help you maximize their potential
1) Roth Conversion Ladder
The required age for making qualified distributions from an IRA is age 59.5.
However, there are a couple of ways to crack into these accounts early. The first is by using a Roth Conversion Ladder.
Roth conversion ladders are not terribly complicated, but they do require some advanced planning.
To begin, you need to start this process at least five years ahead of when you actually want to start taking distributions from your Roth IRA to account for the five-year rule.
The five-year rule basically requires your conversion to sit in your Roth account for at least five years before you can withdraw it.
So, five years before your first withdrawal, you’ll just convert the amount you think you’ll need from a Traditional IRA, let it sit for five years, and then the converted amount is available to you penalty and tax-free.
And all before you turn 59.5.
Remember that the five-year clock for conversions expires at age 59.5 so it may not make a ton of sense to pursue this strategy if you’re already in your late 50s.
2) Rule 72T or SEPP
Another way to access your IRA early is through a Series of Equal Period Payments, also known as a 72T distribution.
A 72T distribution must be calculated one of three ways: through an amortization method, an annuity method, or the minimum distribution method.
Once you choose which method you want to use, you’ll have to stick with it for five years or until you turn 59.5, whichever occurs later.
So, if you start a 72T at age 52, you’ll have to keep it up through age 59.5.
If you start at age 57, you’ll have to keep it up through age 62.
SEPPs can be challenging to manage. I always recommend talking to a tax professional if you decide to go this route because getting it wrong can be a painful mi$take.
3) Spousal IRA
You’re probably aware that a person must have earned income in order to contribute to a Roth IRA.
There is a notable exception, however.
Non-working spouses whose husband or wife has earned income can contribute to an IRA on the basis of their working spouse.
It’s called a spousal IRA and as far as I know, it’s the only way to get unearned income into an IRA.
If the working spouse has the same or more earned income than the cumulative total of each person’s annual contribution amount, both can contribute.
So, for 2023, if the working spouse earns over $13,000 in modified adjusted gross income, both spouses could contribute the maximum annual contribution of $6,500 to their IRAs.
4) Custodial Roth IRA
Even though the IRS requires us to have earned income in order to contribute to an IRA, they don’t put any restrictions on contributions based on age.
That means even your minor children can contribute to an IRA if they have earned income.
And, if you know much about Roth IRAs, you probably know the longer you can have money in the account the greater its potential for growth.
So, if your kid is keen on saving some money in a Roth, as their parent you can reach out to just about any brokerage and set up a custodial Roth on their behalf.
You’ll have control over the account until they reach the age of majority, at which point they’ll take over.
Keep in mind the income your kid receives should also be reported to the IRS.
So, if they’re making money through freelance work like mowing lawns and babysitting, they’ll need to report that income or just skip the Roth until they have a W2 job.
5) Convert 529 Leftovers to Roth
This is a new option that will be available beginning in 2024.
Basically, you are allowed to roll 529 assets into a Roth IRA for a named beneficiary in an account that you own.
The intention is to give parents with leftovers another option to put that money to good use without paying a penalty for an unqualified distribution.
The recipient of this generous Roth contribution will need to have earned income in the year of the distribution and it will reduce their annual contribution limit in the same amount as the rollover.
6) Backdoor Roth IRA
Another limitation on contributions to Roth is your annual income. If you make too much money, you won’t be allowed to contribute to a Roth IRA.
The good news is you can use a Backdoor Roth IRA to fund one instead.
Just contribute to a traditional IRA on an after-tax basis, then convert the contributions to a Roth and, voilà, Roth contribution.
This is legal and people have been doing it for well over a decade now.
If you decide to use a Backdoor Roth IRA contribution, be sure to research the pro-rata rule which basically says you’ll be taxed on a pro-rata or proportional basis on your conversion for any amounts you have in tax-deferred IRAs.
7) Mega Backdoor Roth
While IRAs have annual contribution limits of $7,000 and $8,000 in 2024, 401(k)s boast much more space.
In fact, you can contribute up to $69,000 into a 401(k) in 2024, and if you’re over 50 that amount goes up to $76,500.
Like the backdoor Roth IRA, you’ll make contributions on an after-tax basis to your 401(k) and then convert those contributions to Roth and Voilà, Roth contribution.
If your plan allows you can roll this into a Roth IRA using an in-service rollover if you wish.
All 401(k) plans are different, so you should take a look at your plan document or contact the plan custodian if you have questions about what the plan will or won’t allow.
8) Remove Your Contributions
Last and least, you can remove Roth contributions from your Roth accounts at any time tax and penalty-free.
I’ll admit this is a feature, but it’s one we should all be reluctant to use.
Once you make a withdrawal from an IRA, you can’t make up for it with a larger contribution later. Once it’s gone, it’s gone for good and you’ve forever surrendered all the earnings that contributions would have gained in the future.
Raiding your Roth should be a last resort. Build up an adequate emergency fund instead.
Conclusion
Roth IRAs are useful for sure, but knowing how to use these Roth hacks could allow you to take yours to the next level.
Keep these hacks in mind for years of happy, tax-free investing.
