For those unfamiliar, a Roth IRA is a retirement investment account where you invest after-tax dollars that grow tax-free. Unlike a 401k or Traditional IRA, you can withdraw your investment at any time without paying a penalty or taxes. For example, if you contribute $15,000 over 4 years and you made $4,000 in that time, you can withdraw your contribution of $15,000 any time you want. However if you want to withdraw your $4,000 earnings, you will pay a 10% penalty for withdrawing it before age 59.5. In my opinion, a Roth IRA is a great alternative to the emergency savings account.
The Mega Backdoor Conversion
While it sounds great, Roth IRA’s have low contribution limits of $6000 per year ($7000 if you are over 50). They also have income limits. If your 2021 modified adjusted gross income is $140,000 or more (filing single), you are not eligible to contribute to a Roth IRA. If filing as a married couple, the modified adjusted gross income limit is raised to $208,000. The Roth IRA Mega Backdoor Conversion is one way you can avoid this rule. If you contribute before-tax dollars to a Traditional IRA, which has the same contribution limits as a Roth IRA, you can immediately do a Roth IRA conversion by rolling over that money from a Traditional IRA to a Roth IRA. Since you are moving before-tax income to an after-tax account, you will pay income taxes when you do this conversion. You can also do this in your 401k with a Roth 401k. Not all, but most employers allow you to contribute after-tax dollars to your 401k. This increases what you can contribute to your 401k and your Roth IRA. If you do it right, converting your after-tax 401k contributions immediately will allow you to avoid taxes and fill up your Roth IRA account so that it can compound and grow tax free.
Why Congress wants to Change the Roth IRA
While more than 98% of Roth IRA accounts have less than $1 million, there are some people who have billions in their account. How is this possible with such small annual contribution limits? When you invest in the stock market or crypto, you have to pay taxes on your earnings. With Roth IRA’s, you don’t. You can have self-directed Roth IRA accounts where you can choose to invest in the stock market, real estate, or private companies. Those with millions or billions of dollars in their Roth IRA’s have been buying up shares in PayPal, Facebook, and other companies pre-IPO when the price of company ownership was extremely low, earning them millions if not billions of dollars that they don’t have to pay taxes on. They are even investing in their own businesses, which allows them to avoid paying taxes on that business when it grows and makes more money.
Using a Roth IRA calculator on Bankrate.com, I was able to come up with some numbers. If you start contributing $500 per month ($6000 per year) to your Roth IRA at age 18 and continue to max out your Roth IRA annually through age 65, you can expect to have about $2 Million in your Roth IRA account when you retire. This assumes an expected rate of return of 7% annually. If you use the Roth IRA like how the government expects you to use it, you should never go too much past $2 million at best. Congress noticed that people are getting smart and legally avoiding taxes on their businesses using a Roth IRA account. That is why Congress wants to change the laws around Roth IRA. Their suggestions involve limiting how much you can make by adding taxes on certain Roth IRA balances. They are also looking into making it illegal to invest in private companies through self-directed IRA’s. Will this affect you? Probably not if you are one of the 98% who have their Roth IRA managed by a company like Betterment or Wealthfront. Interested in opening a Roth IRA, join Betterment or Wealthfront here to get your first $5000 managed for free. Not familiar with these companies? Read my reviews on Betterment and Wealthfront.
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