By Lucas Felbel, CFP®, CIMA ® Director, Dynamic Asset Management
When managing clients’ investments, strategic wealth advisors know that timing is important. What’s more, consideration of all aspects of a client’s financial household must be executed to provide optimal outcomes. Many investors are unaware of the interconnectedness between investment optimization, tax strategies, retirement and estate planning, risk management, household budgeting and debt management, and more. This underscores the importance for investors to work with a trusted financial professional who sees the intricate web of complexities and can help navigate for better results, for life.
Roth IRAs are a crucial component to wealth management strategies designed to enhance tax-efficiency, increase flexibility when taking distributions in retirement and provide the greatest opportunities to optimize wealth-creation for current and next generations in families.
With a new year upon us, the timing of Roth IRA contributions and other important considerations around Roth IRAs shouldn’t be overlooked by advisors looking to amplify the benefits for their clients. Making contributions at the beginning of the year — instead of the end — can have significant financial benefits, especially for clients with a consistent salary and predictable income levels. Here’s why this strategy and other important Roth IRA variables should be considered by advisors to help maximize wealth-building potential:
Time Value of Money (TVM): The Power of Early Contributions
The time value of money (TVM) principle underscores the importance of investing sooner rather than later to maximize one’s participation in the market. Early-year contributions to a Roth IRA benefit from an additional 11 to 12 months of compounding each year compared to end-of-year contributions. Over time, this seemingly small adjustment can create significant growth in a client’s portfolio.
Consider this example:
- Scenario 1: $7,000 annual contributions made at the end of each year for 20 years, starting with a $0 balance and assuming a 7% annual rate of return, result in an ending value of $286,968.45.
- Scenario 2: The same contributions made at the beginning of each year instead result in an ending value of $307,056.24.
The difference? An additional $20,000 in value over two decades simply by changing the timing of contributions. That’s the power of TVM and compounding —the “eighth wonder of the world,” consistently espoused for decades by Warren Buffett and coined by Albert Einstein who said, “Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.”
This fundamental principle extends beyond Roth IRAs. Advisors should encourage early contributions to other accounts such as taxable investment accounts, Traditional IRAs, employer-sponsored retirement plans and Health Savings Accounts (HSAs). This strategy offers greater opportunities to enhance long-term investment outcomes. It’s most effective when the investor’s entire financial situation is thoroughly evaluated, and the advisor determines it aligns with the client’s best interests.
Client Income Considerations: Navigating MAGI Thresholds
Despite the benefits of early contributions, income variability, potential interactions with ongoing tax strategies and other factors can complicate matters. This provides an opportunity for advisors to demonstrate their value to clients who don’t have the time or expertise to interpret IRS codes and guidelines. Roth IRA contributions are subject to IRS Modified Adjusted Gross Income (MAGI) limits based on tax filing status, which investors must consider when determining Roth IRA contribution eligibility. Some key guidelines for income and tax considerations are as follows:
- Consistent income: For clients with predictable annual salaries and expected MAGI levels below the thresholds, early-year contributions are ideal if possible. MAGI thresholds are readily accessible on the IRS website.
- Variable income: For clients with income variability, it may be prudent to wait until year-end when their income picture is clear to determine the best path for Roth IRA contributions, direct or indirect (the “backdoor” method).
- Tax-filing status: Advisors must be aware that tax-filing status can dramatically impact eligibility. For instance, Married Filing Separately filers have an extremely low MAGI threshold of $0–$10,000 for direct Roth IRA contributions. Penalties for ineligible contributions are 6% per year until remedied.
Advisors who proactively assess clients’ expected income and filing status can ensure IRS compliance and avoid time-consuming, complex fixes for overcontributing. In addition, they avoid needless penalties and tax bills for ineligible contributions while optimizing contribution timing, keeping holistic financial planning goals on track.
The ‘Backdoor’ Roth IRA: Advanced Considerations
For higher-earning clients exceeding MAGI thresholds, and others ineligible for direct Roth IRA contributions, converting non-deductible IRA contributions tax-free to a Roth IRA, or the “backdoor” Roth IRA strategy can be an effective workaround to achieve tax-free investment growth. This strategy consists of a few basic steps: 1) A non-deductible Traditional IRA contribution 2) an intention to make (and the presence of) a non-deductible Traditional IRA contribution in a Traditional IRA for a period and 3) the tax-free conversion of non-deductible Traditional IRA funds to a Roth IRA for tax-free investment and growth.
However, it requires careful execution and strong communication between advisors and clients to avoid costly mistakes. A few best practices for this Roth IRA strategy:
- Income Forecasting & Review of Accounts: Evaluate income levels projected for the year to determine what retirement savings strategies should be executed to maximize tax-efficiency. Advisors and clients should be keenly aware of all pre-tax 401k and IRAs that are attributed to the client and begin consolidating to simplify and maximize Roth IRA and other opportunities.
- File IRS Form 8606: This form is essential for logging the basis of Traditional IRA contributions as non-deductible to the IRS. Failure to file can lead to penalties and unnecessary taxes.
- Understanding the IRA Aggregation Rule:
- The rule aggregates all IRA accounts’ pre-tax AND after-tax (non-deductible) contributions when calculating taxable income during Roth conversion execution.
- For example: A client has $93,000 pre-tax funds in a Traditional IRA. Their income is above the direct Roth IRA contributions MAGI threshold this year and want to use the “backdoor” Roth IRA method. The advisor and client execute a $7,000 non-deductible IRA contribution to their IRA with intentions of converting it to after-tax Roth IRA dollars. The client now has $100,000 in their Traditional IRA, consisting of $93,000 deductible (pre-tax) contributions and $7,000 non-deductible (after-tax) contributions. The advisor performs a $7,000 Roth IRA conversion thinking they are only converting the $7,000 non-deductible contribution and avoiding any tax liability. However, the client will be taxed on 93% of the $7,000 converted at their marginal income tax bracket, creating about $6,500 of taxable income for that year (0.93 x $7,000 = $6,510). Not being aware of the IRA Aggregation Rule can have severe consequences beyond tax implications to a client’s overall household.
- SEP and SIMPLE IRAs are included in this rule, but inherited IRAs are exempt.
- Roll Pre-Tax IRAs into 401(k)s: To avoid aggregation complications and incurring income taxes on Roth conversions as illustrated above, the advisor should work with clients to roll all pre-tax IRA balances into an active 401(k) or eligible employer-sponsored qualified retirement savings plan. Since these plans are exempt from IRA Aggregation Rule consideration, this strategy now allows for tax-free Roth IRA conversions of non-deductible Traditional IRA contributions.
- Intentional Documentation: In the event of an IRS audit, efforts should be taken ahead of time to avoid explicit mention of the “backdoor” Roth IRA strategy in written form. The use of this language in notes can potentially be interpreted by examiners as attempts to circumvent processes despite tax laws being correctly followed.
Action Steps for Advisors
To implement these Roth IRA best practices effectively:
- Review income projections early: Schedule annual income reviews with clients early in the year to determine Roth IRA eligibility and plan contributions.
- Educate clients on compounding benefits: Use tangible examples like the $20,000 compounding advantage over 20 years to illustrate the power of early contributions.
- Stay current on relevant tax code: Clients look to their advisors as a primary knowledge resource. It’s our responsibility to them to be lifelong, curious learners to make the best recommendations possible through our own development and partnering with specialized professionals like CPAs who are also tax strategists.
Investors often struggle to navigate the complexities and pitfalls of Roth IRA strategies as well as the nuances of retirement planning in relation to tax laws and how these pieces interact with other aspects of their financial household.
A trusted financial professional must work to ensure a clear understanding of these intricate rules and their interplay with all aspects of a client’s comprehensive financial plan. Effective guidance can help investors maximize opportunities for improved lifelong financial outcomes and to achieve these outcomes through intentional and efficient strategy, instead of by accident or luck.
Invest with intention.
For more information, contact Dynamic’s Investment Management team at (877) 257-3840, ext. 4 or investmentmanagement@dynamicadvisorsolutions.com.
As Director, Asset Management, Lucas Felbel, CFP®, CIMA® leads the implementation, monitoring and evaluation of trading activities at Dynamic Advisor Solutions.
Disclosures
For advisor use only. This commentary is provided for informational and educational purposes only. The information, analysis and opinions expressed herein reflect our judgment and opinions as of the date of writing and are subject to change at any time without notice. This is not intended to be used as a general guide to investing, or as a source of any specific recommendation, and it makes no implied or expressed recommendations concerning the manner in which clients’ accounts should or would be handled, as appropriate strategies depend on the client’s specific objectives.
This commentary is not intended to constitute legal, tax, securities or investment advice or a recommended course of action in any given situation. Investors should not assume that investments in any security, asset class, sector, market, or strategy discussed herein will be profitable and no representations are made that clients will be able to achieve a certain level of performance, or avoid loss.
All investments carry a certain risk and there is no assurance that an investment will provide positive performance over any period of time. Information obtained from third party resources are believed to be reliable but not guaranteed as to its accuracy or reliability. These materials do not purport to contain all the relevant information that investors may wish to consider in making investment decisions and is not intended to be a substitute for exercising independent judgment. Any statements regarding future events constitute only subjective views or beliefs, are not guarantees or projections of performance, should not be relied on, are subject to change due to a variety of factors, including fluctuating market conditions, and involve inherent risks and uncertainties, both general and specific, many of which cannot be predicted or quantified and are beyond our control. Future results could differ materially and no assurance is given that these statements or assumptions are now or will prove to be accurate or complete in any way.
Past performance is not a guarantee or a reliable indicator of future results. Investing in the markets is subject to certain risks including market, interest rate, issuer, credit and inflation risk; investments may be worth more or less than the original cost when redeemed.
To the extent that this material concerns tax matters, it is not intended to be used by a taxpayer as tax advice. Each taxpayer should seek independent advice from a tax professional based on his or her individual circumstances.
Investment advisory services are offered through Dynamic Advisor Solutions, LLC, dba Dynamic Wealth Advisors, an SEC registered investment advisor.
