Creating and maintaining an investment portfolio that provides the best risk/return profile is the obsession of many investors. More return with less risk is obviously the goal. The stakes are high, which is why professionals and academics alike get into heated debates about competing models. A model that produces return results superior to others by mere fractions of a percentage point without more risk is considered a resounding success. That’s all good for investors, but sometimes it just isn’t the most important issue. That’s where Roth IRA strategies come into play. In this blog, we’ll explain how Roth IRA strategies, including Roth Simple IRAs can benefit investors.
In the real world (as opposed to a deliberately simplified financial model), the tax drag caused by investing decisions can have a much greater effect on the investor’s after-tax investment return. After-tax return is the money left over after taxes are paid that can actually be spent, and different types of investment accounts offer different tax treatments for different assets. For instance, capital gains earned within a traditional IRA (where distributions are taxed at the investor’s marginal income tax rate) may face twice the tax drag once distributed from the IRA when compared to a taxable account (where long-term capital gains receive a preferential rate). Traditional IRAs do provide for tax deferral (no taxes due along the way on income or gains earned) and many times the dollars inside our IRAs came from tax-deductible contributions either to the IRA or the 401k while we accumulating those dollars, so there are benefits for consideration in asset location and utilization for these pre-tax and tax deferral strategies within our overall plan to maximize our after-tax returns. All too often investment managers ignore the practical realities involved in maximizing the after-tax investment return through an asset location strategy.
When an investment manager can create a higher after-tax return for investors by minimizing tax drag, that’s referred to as “tax alpha” (where alpha means more return without more risk). Roth IRA strategies, when done right, are the holy grail of investment accounts if the goal is to increase tax alpha. If handled properly, Roth IRA conversions may never face any taxes. In the years since 1998, when the Roth IRA was launched, Congress has steadily liberalized the constraints that prevent many affluent investors from making Roth IRA strategies a large percentage of their portfolio.
This steady change in the tax rules has meant that investment managers can create more tax alpha for their clients if they are aware of all the techniques at their disposal. Sometimes this requires close coordination with a client’s tax advisor. Still, these generally aren’t considered risky maneuvers and a good tax advisor usually gets pretty excited to see that their client is working with an investment manager who isn’t making the tax bill even higher than it should be.
The most basic technique for increasing the amount of assets in a Roth IRA strategy is for the investor to make contributions each year. The investor, or their spouse, must have compensation for the year, so investors in retirement are usually out of luck. As of 2023, the contribution limit is up to $6500, with folks 50 and over able to add an additional $1000 as a “catch-up” contribution. This contribution limit is increased to $7000 for 2024, with the “catch-up” contribution for folks 50 and over remaining at the additional $1000.
Many employer-sponsored 401ks now also offer the ability to make Roth contributions, where the deferral limits for employees are $22,500 for 2023 and $23,000 for 2024, with the “catch-up” amounts for folks 50 and over being $7500. It’s worth noting that there may be ways for you to make contributions above these levels on an after-tax basis depending on your specific plan and how much your employer contributes to your plan in the form of matching. These details are a touch more complicated as the IRS has limits on how much can be contributed in total to an individual’s 401k. We’ve touched on this in a previous post and won’t walk through the full details here since we are focusing on IRAs.
The biggest change to help affluent investors was when the income limits for Roth “conversions” went away. When Roth IRAs were first introduced, Congress wanted to make sure that folks at higher income levels couldn’t benefit from this new type of investment strategy, so income limits were added. Lawmakers looking to plug budget gaps realized that a Roth IRA conversion requires the investor to pay taxes on the balance of the assets (minus any non-deductible contributions known as “basis”).
One big administrative trap remains, however, and we’ve seen it catch investors, investment advisors, and even CPAs who didn’t understand the rules. It’s simple: the IRS considers all of your IRAs to be just one IRA. So, if one IRA is full of post-tax/non-deductible contributions, you can’t just convert that one IRA to a Roth IRA strategy to minimize your tax burden.
Here is an example:
Some naïve tax filers will try to convert IRA #1 to a Roth IRA strategy, thinking that they will only pay tax on the $10K in earnings. The $20K converts tax-free, right? Wrong! The IRS says that the tax filer has only one IRA, worth $100K, with $20K in non-deductible contribution basis that isn’t taxed upon distribution or conversion. Any contribution is a pro-rata mix of the total of all IRA assets. So a $30K conversion pulls $6K from the basis and $24K from other sources that are taxable. When the tax filers try to only pay taxes on $10K instead of $24K, then penalties likely result.
When considering whether or not to convert an IRA to a Roth IRA strategy, it’s important to decide if the intention is to eventually convert all of the IRA. The future benefit of tax-free returns is impossible to estimate with certainty, whereas the bill for converting is pretty easy to calculate. But there is one extra technique available once all of the IRA is converted, and that is the so-called “back door Roth IRA”.
So the basic flow of funds and paperwork is this:
First, cash from your bank account goes into your IRA as a non-deductible contribution. This requires that you file Form 8606 to document that there is basis. It results in the IRA custodian sending you and the IRA a Form 5498 to document that you made a contribution (but beware, you probably won’t get this until June of the next year).
Then the cash in the IRA gets moved into the Roth as a conversion. This needs to be documented on your Form 1099 when you file for that tax year. The conversion from the IRA results in your custodian sending you a Form 1099-R to show that the funds left the IRA (you will get this in January of the next year). It also results in your custodian sending you yet another Form 5498, but this time from the Roth IRA strategy that received the funds.
At the end of this you essentially put cash from your bank account into your Roth IRA, but beware of the paper trail and notated steps along the way. The June time frame to get some of the forms causes many filers to make mistakes. But it stems from the fact that custodians wait until after April 15 of the following year to begin producing tax forms to document any money that was put into an IRA. Informing your tax advisor of the steps you went through is crucial, as they may not be able to see the trail just by providing them the 1099-R provided by the custodian.
You may also have the ability to utilize Roth conversion strategies within your employer-sponsored 401k as well! These considerations and steps are a bit different than described above but follow a similar process. (Important to note that Roth contributions and conversions are not available in all employer-sponsored plans, and the process for requesting Roth conversions for each plan will likely also be different if available). Certain rules within the plan around how/when conversions can occur (automatic, once a quarter, etc.), what you must do to initiate the conversion, and a key driver around making after-tax contributions are all important and something we’ll cover in a separate post.
At BIP Wealth we always encourage our clients to get the best tax advice they can find from a qualified tax advisor. We don’t give tax advice per se, and when we have an idea that could increase your tax alpha we like to coordinate with you and your tax advisor. And sometimes the benefits you reap are even more significant than the investment returns. Contact us to learn more about how a Roth IRA strategy could benefit you in the long term.
This communication contains general investing information that is not suitable for everyone and is subject to change without notice. Past performance is no guarantee of future results and there is no guarantee that any views and opinions expressed will come to pass. The information contained herein should not be construed as personalized investment advice, tax advice, or financial planning advice, and should not be considered a solicitation to buy or sell any security. Investing in the stock market and the bond market involves gains and losses and may not be suitable for all investors. Indices are not available for direct investment.
How are Roth IRA contributions handled for tax purposes?
Roth IRA contributions are made with after-tax dollars, so they’re not tax-deductible.
How are Roth conversions handled for tax purposes?
Roth conversions are considered a taxable event, as they are taxed like a distribution from your traditional IRA but do not impose any penalty for occurring prior to 59 ½ . The taxable portion on any Roth conversion would be any portion not previously taxed (previously deducted contributions and any earnings on deductible or non-deductible contributions), so after-tax (non-deductible) basis would not be included.
What is basis of Roth IRA conversions?
The basis of a Roth IRA conversion is the amount of the conversion that is not subject to tax, typically representing after-tax/non-deductible contributions made to a traditional IRA before converting to a Roth IRA strategy. Non-deductible contributions are tracked using form 8606 and an important step in the process.
What does Roth stand for?
“Roth” doesn’t stand for a series of words; it’s named after Senator William Roth of Delaware, who introduced the Roth IRA legislation.
It’s one thing to have a vision for your wealth. But, in our complex financial landscape, where things can change in a heartbeat, it’s just as important to have a plan in place that takes a comprehensive approach. This is where the concept of holistic financial planning comes into play. Beyond taking a traditional view of finances—one that focuses solely on single aspects like investments, savings, or retirement—holistic planning has a more human approach and embraces a person’s lifestyle, priorities, and goals. It weaves together every financial thread of their life—from tax planning to investments to insurance needs—ultimately aligning each aspect with their unique financial circumstances. Because of this, holistic planning can not only enhance financial decision-making but can also help to foster peace of mind in the long term, knowing that every part of your financial life is working in harmony to potentially achieve long-term goals.
So, why might holistic wealth management be important to your success? In this blog, we’ll break down the top five reasons to implement a holistic financial strategy in navigating toward a secure, prosperous financial future.
For many, financial planning means more than just short-term stock returns. Perhaps you’re hoping to buy your dream home or car. Maybe you want to fund your child’s college education. You may even want to start a small business. Whatever the case may be, holistic planning can help you align with those goals in a more efficient way.
Now, what happens if your goals change? As you get older or the financial markets evolve, can holistic planning adapt to your new situation? Yes. Holistic wealth management from a firm like BIP Wealth can provide clients with a plan that is prescribed to be resilient to sudden changes such as dips in the stock market or higher taxes. Through these personalized plans, clients have the opportunity to establish a more resilient portfolio and lifestyle that can adapt to their evolving needs.
As life and the financial markets change with time, so should your wealth planning. A key value of holistic planning is its versatility, allowing both advisors and clients to make constant changes to target specific goals if needed. This flexibility is especially important for analyzing the global markets. The below graphic takes a look at the percentage of annual returns across a number of the world’s key markets, solidifying the need for a broadly diversified portfolio that can adapt to changing conditions.Source: Dimensional
Through a holistic financial plan, you may be able to achieve higher or more consistent returns as you focus on diversifying your portfolio to be more flexible. A study from Dimensional, a financial investment firm, found that from 1990-2020, investors looking to yield higher returns from global equities as well as global intermediate government and credit bonds would have performed better with holistic planning in most instances.
While thinking about your dream retirement or financial future can be an exciting time, it is also important to keep in mind the many risks that are associated with investing. Say you have a large chunk of your money invested in a single stock. At any given moment, that stock’s value could plummet, taking your hard-earned capital with it. That’s why a core element of a holistic planning philosophy should hold a somewhat pessimistic projection of the future. By actively thinking about how to properly react to inevitable market fluctuations, tax increases, or unexpected life shifts such as job loss, relocation, or injury, you can potentially limit your overall risk and set your portfolio up for a more robust future.
While it can be tempting to pursue high-risk, high-reward investments with quick payouts, holistic planning takes into account several other factors, especially when focusing on a sustainable, long-term gain, including one’s desire for a comfortable retirement or generational wealth transfer. Think of this like sitting in rush hour traffic, for example. You may quickly switch to a lane that is going faster only to find yourself at a standstill soon after. Although you might have temporarily moved ahead of some cars, they may end up beating you in the long run.
Holistic wealth management can include comprehensive plans that are built around passive income sources that drive a client’s retirement years or figure out the best way for them to enjoy their current lifestyle without having to continue their working days. By considering a client’s complete financial situation, holistic wealth management may help them accomplish more than just simple returns. Over the course of years, this system may help turn that dream retirement into an actual reality.
Finally, a component of a comprehensive holistic plan may aim to manage, control, and reduce your tax liabilities wherever possible. This is very important for estate planning and generational wealth transfers, as figuring out areas to reduce your tax burden can make a major difference over the years.
Our holistic planning formula blends Nobel Prize-winning empirical research with savvy integrations of alternative investments. Through our carefully-personalized plans, we’ve helped our clients unlock financial opportunities in both private and public markets that have historically been reserved for the ultra-wealthy.
At BIP Wealth, you’ll have access to a team of experts who will be with you and your family at every step of your financial journey. If you’re looking for a unique approach to holistic wealth planning, you can browse our offerings—from private equities, private credit offerings, public market investment plans, and covered call strategies.
What is holistic wealth planning?
Holistic wealth planning does not focus solely on singular investments, instead determining a person’s current financial situation, lifestyle, and ultimate goals to create a long-term plan for retirement, estate planning, investments, and more.
Why is holistic planning important?
From potentially limiting financial risk to better aligning with personal goals, holistic planning is important for those who are looking for more than just short-term investment returns.
