Advanced Roth Strategies—Part I of II
Good to Know
This article is intended to create or deepen a financial advisor’s awareness of the creative use of Roth IRAs or Designated Roth Accounts in special circumstances such as:
- Business Owners with Net Operating Losses and
- High-Income Clients that are ineligible for a Roth IRA contribution.
Caveat—this article is meant to raise awareness only and should not be used to provide financial advice. The strategies summarized below are complex and should be considered only through consultation with a credentialed tax professional experienced in these techniques.
Business Owners & Net Operating Losses
What is the most challenging part of a Roth Conversion for many clients? Frequently, it’s the tax cost! Here’s what happens—all previously deferred income and gains from, for example, a Traditional IRA must be included in your client’s total gross income in the year of the conversion. Remember that income tax rates of up to 37% may apply.
Next, we’ll consider a business owner with a net operating loss. But first, here’s a bit of context.
- The owners of “flow-through” business entities with net operating losses (NOLs) may be able to use those losses—within limits—to shelter the income from a Roth conversion.
- A “flow-through” business pays no entity-level income tax—profits and losses “flow through” to the owner personally and are reported on the owner’s personal income tax return.
- Examples of “flow-through” businesses include Sole Proprietorships, Partnerships, LLCs,1 and S Corporations.
- A business operating loss occurs when expenses are greater than revenue.
Example
Assume your client is the sole owner of an LLC. The LLC generated a net operating loss of $600,000 for the current year. Your client files as married filing jointly and has a deductible traditional IRA worth $500,000. Assuming your client otherwise qualifies, they could convert the entire deductible Traditional IRA into a Roth IRA at zero income tax cost. The NOL shelters the conversion income.
High Income Clients with 401(k) Plans
Eligibility to make Roth IRA contributions phases out higher income levels. But, notwithstanding their high income, what would your high-income client say to contributing almost 8 times the Roth IRA contribution limit in 2023?
Here’s how that could work.
- Your client must be a participant in an employer-sponsored retirement plan— such as a 401(k) plan—that allows participants to make after-tax contributions.
- The 401(k) plan should allow in-service distributions or a rollover to the 401(k) plan’s Designated Roth Account.
- There’s an annually indexed limit to the maximum that may be contributed by employer and employee combined. That limit is $66,000 (plus $7,500 if the participant is age 50 or more) for 2023.
Example
Assume your client participates in a 401(k) plan (the plan) that allows after-tax contributions but does not offer a Designated Roth Account option. However, the plan allows in-service distributions.
Depending upon how much the employer contributes (or matches) to the plan, your client could contribute $43,500 or more in after-tax dollars into the plan in 2023. Your client could then take an in-service distribution and roll the entire after-tax contribution amount into a Roth IRA.
Stay tuned for our next blog as we dig even deeper into creative uses for Roth IRAs and Designated Roth Accounts.
1 Owners of an LLC may generally elect to have the LLC taxed as a “flow-through” entity or C Corporation. Net operating losses of a C Corporation do not flow through to shareholders’ personal income tax returns.
Disclaimer
The information presented herein is provided purely for educational purposes and to raise awareness of these issues; it is not meant to provide and should not be used to provide legal, identity theft protection, investment, income tax, risk management, retirement, estate, or financial planning advice of any kind. An experienced and credentialed expert should be consulted before making decisions relating to the topics covered herein. There are variations, alternatives, and exceptions to this material that could not be covered within the scope of this blog.
