Adobe Stock
I was having breakfast with a longtime friend and client this weekend and he asked me, “Do I need to start putting money into my Roth IRA?”
While this is a simple question that I get asked regularly, the answer can be complicated. The IRS rules for Individual Retirement Accounts, both Traditional and Roth, have more moving parts than a marching band. So, I answered with a question: “Are you contributing the maximum to your 401(k) at work?”
He told me he was not and that gave me an easy out as his financial planner and I told him, “When you get to maximum contribution to your 401(k) and still want to save more then let’s talk.”
Wes Shannon
Here are the parts that support the short answer:
- The maximum amount that can be contributed to a 401(k) this year is $22,500 plus an additional “catch-up” of $7,500 for people age 50 and over. For this friend who is 57, the maximum is $30,000 per year. Most 401(k) plans today offer a Roth option (my friend’s plan does) so the opportunity of putting away $30,000 in a Roth 401(k) is much better than the individual Roth IRA maximum of $7500 for his age. ($6,500 normal contribution plus $1,000 catch-up contribution)
- In addition to having a higher contribution limit, the 401(k) has employer matching. Even if the employer doesn’t match in the 401(k) it is a better way to save since it is taken directly from your paycheck. It is the best way to accomplish the goal of “Pay yourself first.” When you know that your savings goal is done first, you experience the freedom of spending the rest of the paycheck with the knowledge that you did save.
- Another advantage to the 401(k) Roth is that most plans will allow you access via a loan to the money. An individual Roth or Traditional IRA does not allow borrowing from the account, nor may it be used for collateral on a loan. The 401(k) Roth with loan provisions allow for a loan of 50% of the balance not to exceed $50,000. The interest on the loan is credited back to your account so it is basically borrowing from yourself. During down market years like 2022 the interest earned on the loan balance could be the best performing investment in the 401(k) at the time.
- Another reason for taking the “easy-out” for my answer is that Roth IRAs, unlike Traditional IRAs, are subject to an income limit. (Traditional IRAs only have an income limit if you have a work sponsored retirement plan.) And the income limit is based upon “Modified Adjusted Gross Income. Here is the beginning of the moving parts I mentioned above.
“Modified Adjusted Gross Income” is calculated by the IRS like this:
- Take your Adjusted Gross Income (line 11 on the 2022 1040 tax return)
- Add back to this number the following:
- Deductions you took for an IRA contribution and taxable Social Security Payments
- Deductions you took for Student Loan interest
- Tuition and fees deductions
- Half of Self-employment tax
- Excluded Foreign Income
- Interest from EE savings bonds used to pay education expenses
- Losses from a Partnership
- Passive Income or loss
- Rental losses
- The exclusion for Adoption expenses
- The sum of 1 and 2 above equals “Modified Adjusted Gross Income” which gets back close to gross income
So, after figuring out your “Modified Adjusted Gross Income,” if it is more than $153,000 for an unmarried tax filer, or $228,000 for a married filing jointly tax filer you cannot contribute to a Roth IRA. If a person is contributing 10% to a 401(k) and that is meeting the maximum contribution of $30,000 then they are making at least $300,000 and they would most likely put their “Modified Adjusted Gross Income” over the limit for a Roth IRA Contribution.
I hope this explains why the answer to the original question is, “When you get to maximum contribution to your 401(k) and still want to save more then let’s talk.”
Wes Shannon is a Wes is a Certified Financial Planning Professional for Brazos Wealth Advisors.