It's always exciting when you're anticipating a salary increase, whether by a raise or a new job opportunity. However, one potential challenge that could come from it is becoming ineligible to contribute to a Roth IRA.
Roth IRAs are retirement accounts that allow you to contribute after-tax money and then take tax-free withdrawals in retirement. The latter is what makes them appealing. Growing your investments for years without taxes waiting for you in retirement can save you thousands.
Unfortunately, the IRS limits who can contribute to a Roth IRA by income. For 2024, the most you can make and contribute to a Roth IRA is $161,000 if you're single and $240,000 if you're married and filing jointly. If you anticipate crossing those thresholds in 2024 (or in the foreseeable future), you could benefit from using a Roth IRA before it's too late.
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A relatively low investment today could be worth a lot later
A good thing about Roth IRAs is that your investments in the account continue to grow and compound regardless of your eligibility to continue contributing to them.
As an example of how powerful that can be, let's imagine someone's Roth IRA is at $50,000 when they become ineligible to contribute. Without contributing another penny, the account could grow to over $336,000, averaging 10% annual returns over 20 years.
Depending on how much they contributed to get the IRA to $50,000, that could easily be close to $300,000 in capital gains. For single filers making over $47,025 or married couples filing jointly making over $94,050, the capital gains tax on $300,000 is anywhere from $45,000 to $60,000, given the 15% and 20% capital gains tax rates. In a Roth IRA, you get to keep all of that money.
Even making a one-time contribution of $6,500 (the 2023 tax year maximum allowed) could grow and compound to a nice amount by the time you hit retirement. Averaging 10% annual returns over 20 years would bring its value to over $43,700.
A retirement account that's made for flexibility
The Roth IRA's best benefit is the tax-free withdrawals it allows in retirement, but aside from that, it's also an excellent retirement account in general. Unlike a 401(k), where investment options are provided, a Roth IRA allows you to choose your own investments. This greatly benefits people who want to tailor their investments to match their risk tolerance, retirement goals, and time horizon.
For example, an Amazon employee who wanted to buy Apple shares in their 401(k) probably couldn't do so unless it was through a mutual or index fund. In a Roth IRA account, they could buy Apple shares just as easily as they would any stock through their regular brokerage account. The same goes for industry-specific exchange-traded funds (ETFs) and other investments likely not offered by a 401(k) plan provider.
Another route high earners can take for a Roth IRA
Crossing over the Roth IRA income threshold isn't the end of the world. You can still use a Roth IRA account; you'll just have to take a different route via a backdoor Roth IRA. It's not an official retirement account you can open like a regular Roth IRA or traditional IRA. Instead, it's a sidestep to the income limit.
The first step to opening a backdoor Roth IRA is contributing to a traditional IRA, which has no income limits. If you already have a traditional IRA, perfect; simply contribute to it. If you don't have a traditional IRA, you can open one fairly easily through the financial institution of your choice.
Once you've contributed to a traditional IRA, the next step is to contact your IRA provider and start a conversion. IRA conversions don't have income limits, so everyone is eligible. The exact conversion process can vary by IRA provider, so consult yours for guidance.
It's essential to note the tax implications of an IRA conversion. If you get to deduct your contributions made to a traditional IRA and then convert them to a Roth IRA, you will probably have to include the full conversion amount as taxable income. However, the deduction for the traditional IRA contribution and the income from the conversion will cancel each other out.
A backdoor Roth IRA may not make sense for everyone, but it's a great option for people with time on their side who've crossed the income limit but still wish to enjoy the benefits of a Roth IRA.
