Do you plan to earn a lot of money in the future? Use a Roth IRA before that happens.

SIt’s best to save and invest for retirement from multiple angles, using all the resources at your disposal. One resource that everyone should take advantage of is an IRA. There are two types of IRAs: Roth and traditional. Unlike a 401(k), an IRA is not tied to your employer and must be opened by yourself, like a regular bank account.

The main difference between Roth and traditional IRAs — and what should ultimately decide which you contribute — is when you get your tax relief.

With Roth and traditional IRAs, you can contribute after-tax money, but you may be able to deduct your traditional IRA contributions, depending on your filing status, income, and whether or not you have a workplace retirement plan. Since you get initial tax relief with a traditional IRA, you’ll have to pay taxes on retirement withdrawals, which you have to start taking at age 72 due to the minimum required distributions (RMD).

With a Roth IRA, you cannot deduct your contributions, but you can take tax-free withdrawals retired. If your current tax bracket is likely to be lower than your retirement tax bracket, it makes sense to opt for a Roth IRA and pay taxes now while your rate is lower.

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You may one day be ineligible for a Roth IRA

Unfortunately, one of the drawbacks of Roth IRAs is their income cap. Here’s how much you can contribute to a Roth IRA:

Filing status Annual revenue Amount you can contribute (age 50 or older)
Married filing jointly

Less than $204,000

$6,000 (or $7,000)

Married filing jointly

$204,000 to $213,999

Reduced amount

Married filing jointly

$214,000 or more

$0

Groom filing separately

Less than $10,000

Reduced amount

Groom filing separately

$10,000 or more

$0

Only

Less than $129,000

$6,000 (or $7,000)

Only

$129,000 to $143,999

Reduced amount

Only

$144,000 or more

$0

Data source: IRS

As you are progress in your career, you may one day find yourself over the income limit and ineligible to contribute to a Roth IRA. Before that happens, you should take advantage of the tax advantage offered by Roth IRAs. Having the ability to grow your money and accumulate tax-free withdrawals in retirement can easily save you thousands of dollars in taxes down the road.

The maximum amount you can contribute to a Roth IRA for the 2022 tax year is $6,000 ($7,000 if you’re 50 or older).

If you were to contribute $6,000 per year ($500 per month) for 20 years, with an average annual return of 10%, your account would exceed $343,500. If this were a non-Roth IRA account, you would have to pay taxes on nearly $223,000 in capital gains. However, since it is held in a Roth IRA, the entire $343,500 would be tax-free to withdraw upon retirement.

What to do after exceeding the limit

If you go over the eligibility income limit, you can still contribute to a Roth IRA, you just have to go a different route. This is known as a Roth IRA backdoor. To create one, you will first need to contribute to a traditional IRA (which has no income limit) and then convert the traditional IRA to a Roth IRA. The process may vary by plan provider, but you can usually do it online or by contacting the provider and having them do the conversion for you.

When you convert, any money you convert that was previously deducted from your taxes will generate taxable income. For example, if you contribute $5,000 to a traditional IRA, deduct $3,000, and then convert the entire $5,000 to a backdoor Roth IRA, $3,000 would become taxable income.

If you could deduct all of your traditional IRA contributions and then convert them to a backdoor Roth IRA, the resulting taxable income negates the deduction, leaving you with no tax impact.

If you’re eligible to contribute to a Roth IRA, you don’t have to go through the hassle of the Roth IRA backdoor, but if you’re not eligible, the conversion process may very well be worth it. There are few gifts from Uncle Sam as impactful as the ability to grow your money and grow it with tax-free retirement withdrawals.

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