By Doug Ewing
- 2023 could be a really good year to fund a Roth account because of low tax rates and changes to how the standard deduction, tax brackets, and retirement account contribution limits are adjusted for inflation.
- There are potential drawbacks to funding a Roth account over a traditional pre-tax IRA or qualified retirement account; contributions to Roth accounts are made on an after-tax basis, so it’s important to consider what tax rate you’re paying on this contribution now. The lower the tax rate, the more attractive the Roth contribution becomes relative to a pre-tax contribution.
- Increasing your Roth contribution will reduce your tax refund, but it could be a good strategy, as you’ll be using that money to pay taxes on your Roth contribution, essentially buying the federal government out of any future growth in the Roth account. Plus, you’ll be increasing your tax diversification for retirement.
- Contributing to a designated Roth account is also a good option, in general, for younger workers and those who don’t reach the 22% or higher tax brackets.
2023 could be a really good year to fund a Roth account. Why? Because of low current tax rates and changes to how the standard deduction, tax brackets, and retirement account contribution limits are adjusted for inflation. The high inflation of 2022 means that in 2023, the standard deduction will be higher, and federal income tax brackets will be expanded. As a result, some people could be looking at a lower federal income tax bill this year. This can make contributing to a Roth account more efficient.
What’s the best way to get money into a Roth account?
One option is to contribute to a Roth IRA. Roth IRA contributions are made on an after-tax basis, but qualified distributions from a Roth IRA in retirement are generally tax free. There are, however, a couple of potential issues that can make it difficult to build significant Roth IRA balances through Roth IRA contributions.
For one, many taxpayers are not allowed to make Roth IRA contributions. For 2022, Roth IRA contribution eligibility begins to phase out for single filers at just $129,000 of modified adjusted gross income, and married filers phase out beginning at $204,000. So many high earners simply can’t fund a Roth IRA through annual contributions.
Even for people who can make a Roth IRA contribution, another potential issue is the contribution limits. They’re good, but not great. For 2022, eligible taxpayers can make a Roth IRA contribution of up to $6,000 ($7,000 if age 50 or older). But what if you want to get more money into a Roth IRA? Is there a better way? The answer may be yes.
Additional ways to fund a Roth IRA
For workers with access to a 401(k) or other qualified retirement plan, a designated Roth account can be a fantastic opportunity to create a larger Roth account balance for retirement. One reason is that unlike Roth IRAs, there are no income restrictions when contributing to a designated Roth account. Even high earners can choose to fund a designated Roth account. The other big advantage is that the contribution limits are significantly higher than for a Roth IRA. For 2023, a worker can contribute as much as $22,500 to a designated Roth account. Workers aged 50 or older can contribute as much as $30,000. Remember that the contribution limits include both traditional and Roth contributions. If you max out the Roth contribution, you won’t be able to also make traditional pre-tax contributions.
Potential drawbacks to funding a Roth account over a Traditional pretax IRA
Of course, there are potential drawbacks to funding a Roth account over a traditional pre-tax IRA or qualified retirement account. Contributions to Roth accounts are made on an after-tax basis. So one very important question is, what tax rate are you paying on this contribution now? The lower the tax rate, the more attractive the Roth contribution becomes relative to a pre-tax contribution. This brings us to our current tax environment.
Benefits of the current tax environment
Under the Tax Cuts and Jobs Act (TCJA), which went into effect in 2018, taxpayers currently enjoy a generous standard deduction, followed by relatively low 10 and 12% brackets. The TCJA also mandated more taxpayer-friendly inflation indexing of both the standard deduction and brackets. As a result, 2023 will see the standard deduction increase from $12,950 to $13,850 for single filers, from $25,900 to $27,700 for married filing jointly, and from $19,400 to $20,800 for a head of household. The 10 and 12% brackets were also expanded to capture more income. This can result in a lower federal income tax bill.
Let’s consider a married couple with $150,000 of total income in both 2022 and 2023. Let’s further assume that this is after $10,000 in pre-tax contributions to a traditional 401(k) plan. Their federal income tax liability for 2023 would actually drop by $619 as a result of the inflation adjustments. If that couple didn’t adjust their tax withholding, they might see that money come back to them in the form of a tax refund.
Strategies for tax refunds
Everyone loves tax refunds, but what usually happens to that money? Do we save it for retirement, or do we spend it? Let’s be honest, most people just spend that money. And that could be a wasted opportunity. Here’s an alternative strategy:
Based on their income, our couple is in the 22% tax bracket. That means that they could change their 401(k) contributions by allocating $2,800 of their $10,000 401(k) contribution to a designated Roth account for 2023 and pay the exact same amount in taxes. We simply divide their tax savings for 2023 ($619) by their tax bracket (22%) to come up with the Roth allocation ($2,814). In this case, their refund should be the same for 2023 as it was for 2022, but the couple benefits by adding $2800 of potentially tax-free Roth money (plus future growth) to their retirement portfolio.
Of course, our example assumes that this couple experiences no wage growth from 2022 to 2023, which might not be totally realistic. But it does draw attention to an opportunity that will still apply to many people—income tax refunds. You can make a case that anyone who regularly gets a tax refund should consider increasing their allocation to a designated Roth account. It is often noted, correctly, that a tax refund is simply the repayment of your interest free loan to the government. Increasing your Roth contribution will certainly reduce that refund, but you’ll be using that money to pay taxes on your Roth contribution, essentially buying the federal government out of any future growth in the Roth account. Plus, you’ll be increasing your tax diversification for retirement.
Designated Roth Accounts for young or lower-income workers
Finally, contributing to a designated Roth account is also a good option for younger workers and those who don’t reach the 22% or higher tax brackets. For 2023, a single filer can have total income as high as $58,575 and not hit the 22% bracket. For married couples filing jointly, it’s $117,150. For head of household, it’s $80,650. For taxpayers who are below these thresholds, their effective (or average) tax rate won’t exceed 8.6%. Being able to settle up with Uncle Sam at 8.6% or less, and then enjoy years of tax-free compounding growth is a pretty good deal.
Designated Roth accounts aren’t a new idea. They’ve been around since 2006. But when you consider that the Tax Cuts and Jobs Act is scheduled to expire at the end of 2025, the next three years could provide taxpayers with a compelling opportunity to build up potentially tax-free Roth retirement account balances. Without action by Congress, 2026 could usher in significantly higher tax rates. Helping clients leverage the opportunity to take advantage of designated Roth accounts now and create a tax diversified retirement portfolio for the future is a great way to add value to your relationships.
Originally published by Nationwide on 26 January 2023.
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Federal income tax laws are complex and subject to change. The information is based on current interpretations of the law and is not guaranteed. Nationwide and its representatives do not give legal or tax advice. Please consult an attorney or tax advisor for answers to specific questions.