3 Ways To Get More Out Of Your Roth IRA

Updated: Apr 13



Roth IRAs provide tax-free income in retirement. In general, the more money an investor can get inside a Roth IRA, the better.


In order to contribute to a Roth IRA and subsequently receive tax-free income, there are some basic eligibility guidelines investors must follow. However, this information is plastered all over the internet and is not what this post covers.


Below are three strategies financial advisors and the general investing public may not be aware of or have the expertise to implement. Each strategy on its own will help boost the overall after-tax return of a Roth IRA, maximizing its earning potential, and ultimately, how much tax-free income an investor enjoys in retirement.



CHOOSE ROTH INVESTMENTS CAREFULLY


Most investors have more than one investment account. What we normally see with our clients is something like this; a 401(k) plan at work, a rollover IRA, a taxable account, and usually a Roth IRA.


Instead of buying the same portfolio over and over again in each account which is what most people do, determine which investments have the highest expected returns and aim to fill the Roth IRA with the most aggressive investments. This portfolio strategy is referred to as Asset Location.


Other methods for asset location involve analyzing dividend yields as well as whether or not international investments based in non-U.S. currencies are hedged to the U.S. dollar or not. There is some subjectivity to this, and no solution is perfect over long periods of time.


In this current market environment, our approach's strongest consideration uses historical benchmark data as the basis for determining the best candidates to place in a Roth IRA.


Depending on which historical time frame one chooses as well as which benchmark is selected, one might come up with different numbers than what I'm presenting. However, I believe in examining the entire historical data sets from as far back as possible from the most commonly used benchmarks.


Based on that context, here are our top asset classes I recommend you place in a Roth IRA.


Source: Dimensional Matrix Book 2020 & Returns Web

You might wonder why international stocks didn't make the cut. When I first did the research, I was just as surprised as you might be reading this. But, let's look at the numbers.


Source: Dimensional Matrix Book 2020 & Returns Web

Independent research supports the value of asset location. Both Vanguard & Morningstar have quantified the extra return an investor likely receives from asset location. Their findings suggest an extra 0.23% to 0.32% extra overall after-tax return by practicing asset location*.




ROTH CONVERSIONS


This strategy involves transferring money from a retirement account with distributions taxed at ordinary income rates to a Roth IRA that distributes retirement income tax-free. Typically, an investor converts money from a 401(k) or IRA to their Roth IRA to accomplish this goal.


Conversions shouldn't be confused with contributions. Conversions aren't limited to the $6,000 annual limit ($7,000 if you're over age 50) that contributions are. In theory, an investor could convert 100% of their 401(k) or IRA to a Roth IRA if they wanted to. However, they probably wouldn't want to do so all at once because in most cases, conversions are taxable events that increase taxable income in the year of conversion.


Think of taxes on Roth conversions as a trade-off between paying taxes now versus paying taxes later. The decision to convert 401(k) or IRA dollars to Roth IRA dollars is based on considerations that are both quantitative as well as assumptive.


The general idea behind Roth conversions is that even though there is a tax cost now, there is greater tax benefit waiting for the investor down the road. Some of the analyses we've done at my firm even suggest positive net after-tax outcomes for investors who are currently in high tax brackets, which results in a high "cost" to convert but still results in an overall benefit.


Mechanically, the way Roth conversions work is for every dollar that's converted, that dollar is added to taxable income. For example, if someone in the 24% marginal federal tax bracket converted $10,000, an additional $2,400 would be added to their taxes in the year of conversion. Don't forget to add in your state tax rate too, unless of course, you live in a tax-free state.


The investor squares up with this tax bill the following year, i.e., a conversion in 2021 would be incorporated within the 2021 return and any tax due would be paid at the time of the return is filed in 2022.


Philosophically, financial advisors promote Roth conversions based on the idea that tax rates are low right now, but will increase in the future. Therefore, investors should take advantage of our current tax environment.


There is some validity to this argument. We already know that unless Congress acts, the Tax Cuts and Jobs Act of 2017 will expire on December 31st, 2025, resulting in a reversion to pre-2017 tax rates. Some of the Tax Cuts and Jobs Act taxes are already sunsetting, but for our purposes, we care about marginal income tax brackets.


For most of us, this means that if we're currently in the 22% marginal bracket, we'll find ourselves in the 24% marginal bracket in 2026. Folks currently in the 24% marginal bracket will revert to the 28% bracket. These are just two common brackets. Here is what all the current brackets look like.



A potential issue with assuming tax rates will increase down the road is that our known tax future only extends a few more years. What if you're in your 50's and not planning on Roth distributions for another two or three decades? How is it possible to say whether or not now is a good time to convert without the knowledge of what the tax environment will be like when Roth distributions actually occur?


The answer is you can't know.


A bit of strategic timing can help with the conversion decision. Many of our clients retire in their early to mid-'60s but don't begin Social Security distributions (almost always taxable for our clients) until age 70. This window is an ideal time to convert because they're not paying taxes on employment income anymore and it's likely they're only paying long-term capital gains rates at 0% or 15%.


This low tax rate window allows us to "fill up" a tax bracket with conversions.


Here's a graph conceptualizing the window when it might make sense to execute Roth conversions in those early retirement years. In this hypothetical example, we're showing the effect of conversions on ordinary income brackets by adding enough taxable income to fill up the 12% bracket before spilling over into the 22% bracket.


Source: Right Capital Tax Analysis Module

In most of the cases we've looked at, Roth conversions during this window provide a higher after-tax retirement income outcome than not converting.




ROTH IRA ADVISORY FEES


The concept is relatively simple. The more money an investor can keep inside a Roth IRA growing for them, the more tax-free retirement income they should expect down the road.


At my firm, we have a mechanism for clients to pay our Roth IRA advisory fee from another account. Typically, a taxable account we also manage serves as the paying account for the fees associated with the Roth IRA. This is permissible under IRS Letter Ruling 201104061.


It used to be common to pay IRA and Roth IRA fees from outside of the accounts to potentially qualify for a tax deduction (on the fees themselves) under IRS Section 212 covering miscellaneous deductions. However, the Tax Cuts and Jobs Act of 2017 nuked this deduction.


These days, it's still beneficial for clients to pay their Roth IRA fees from a taxable investment account because the more money that's compounding in the Roth IRA, the bigger the balance will be down the road.


Unfortunately, we can't say the same thing about paying IRA fees from an outside source. It's much more complicated under the new tax rules due to various factors such as time as well as the notion that paying an advisory fee with pre-tax cash inside an IRA is still a compelling strategy.




WHAT YOU SHOULD DO


Each of the three strategies above can increase the value of a Roth IRA. However, if you're a DIY investor, I wouldn't recommend any of these strategies without professional guidance.


If you already work with a financial advisor and they're not discussing or currently implementing these strategies, you should ask. If your advisor can't or won't implement these strategies for you, then I encourage you to reach out to us to evaluate your situation. We just might be able to do a better job in your Roth IRA by taking some extra time and being smart about it.


If you're curious or have questions, reach out using the Contact button at the top of your screen to initiate a conversion.





* Alpha, Beta, and Now...Gamma, Blanchett & Kaplan, Morningstar Investment Management, Morningstar, August 2013 and Putting A Value On Your Value Proposition, Kinniry, Jaconetti, DiJoseph, Zilbering, & Bennyhoff, Vanguard Research, Sep 2016.