Scottsdale Financial Advisor Explains: Tax-Free Retirement Growth – How Anyone Can Use a Roth IRA
The Roth IRA stands as one of the most powerful retirement planning tools available, yet many investors overlook it—either because they are unaware of this option or because their financial or tax advisors fail to explain its benefits. In some cases, high-income individuals may hear, "You can’t contribute to a Roth because you earn too much." Unfortunately, they often stop there, assuming a Roth IRA is off-limits. If this sounds familiar, you might be making a costly mistake. This article will help you understand how a Roth IRA can help you build a tax-free retirement income stream and shield you and your family from the likelihood of significantly higher future income tax rates as the U.S. debt grows.
If this approach resonates with you and you’re seeking guidance tailored to your goals, please reach out for a free consultation. I’d be glad to discuss how we might work together.
What Is a Roth IRA?
"IRA" stands for Individual Retirement Account. The original IRA, now referred to as a Traditional IRA, was established in 1974 under the Employee Retirement Income Security Act (ERISA). It was designed to help employees save for retirement when they didn't have access to a pension. Over time, eligibility for IRAs expanded, and new rules and provisions were introduced.
The Roth IRA was created under the Taxpayer Relief Act of 1997 and named after Senator William Roth, who spearheaded its legislation. The main distinction between Traditional and Roth IRAs lies in tax treatment. Contributions to a Traditional IRA are typically tax-deductible, reducing your taxable income in the year of the contribution. However, withdrawals during retirement are taxed as ordinary income. In contrast, contributions to a Roth IRA are made with after-tax dollars and are not tax-deductible, but qualified withdrawals in retirement are entirely tax-free.
Why Does This Matter?
As of 2024, the highest federal income tax bracket is 37%—relatively low by historical standards. But as the U.S. continues to run substantial budget deficits, the national debt keeps rising. Eventually, the government will face difficult choices: either default on its debt—which would devastate the nation's credit rating and result in higher interest rates—or raise income tax rates to cover interest payments. The latter seems most likely. While some suggest that a combination of cost-cutting and tax increases could help, realistically, neither political party is advocating for substantial budget cuts or a balanced budget.
In my professional opinion, significantly higher tax rates are a probable outcome within the next 10 to 20 years. For many of you, this could hit during peak earning years or in retirement. Higher income tax rates would impact everyone, and the Roth IRA, with its tax-free withdrawal feature, offers one of the few protections we have against such increases. For instance, during the 1940s to 1960s, the highest federal tax rate reached 94% to finance World War II, recover from the Great Depression, and cover other wartime expenses. When the government needs revenue, it has historically raised taxes.
How Do You Open a Roth IRA?
Most investment firms—whether they are do-it-yourself platforms or traditional financial advisors—can open one for you. It's as simple as opening a bank account.
What Can You Contribute to a Roth IRA and How Much Per Year?
You can only contribute "earned income" directly into a Roth IRA, although there are strategies involving other retirement account funds, which I'll discuss later. The IRS defines "earned income" on their website, which you can consult to see if your income qualifies.
Assuming your income qualifies, you can contribute $7,000 in 2024, or $8,000 if you’re age 50 or older. The IRS recently announced that they did not increase the contribution limits for 2025. Generally, IRA contribution limits are increased based on inflation in $500 increments. The IRS must have determined that a $500 increase wasn't warranted for 2025.
Time is important here because the more years you have to contribute and grow your Roth IRA, the more impactful this account becomes due to compounding growth. For example, someone who is age 30 and starts maxing out their Roth IRA every year until age 65 (retirement), assuming the IRA grows at 9% per year and that the Roth gets a $500 contribution limit increase every two years, the estimated account balance at the end of 35 years would be approximately $2.24 million. Applying the basic 4% retirement withdrawal rule to that, you have now created an $89,600 tax-free income stream.
Now, if we take a quick trip down memory lane, the top marginal tax rate between the 1940s and 1960s was over 90%. In the mid-1960s to 1980s, it was 70%, and before President Reagan began to dramatically cut tax rates, the highest tax rate was 70%, later reduced to 50%. So, for the sake of considering a potential higher future tax rate without providing too extreme an example, let's use 50% as our future highest federal tax rate once the U.S. debt issue truly gets out of hand.
An $89,600 net income stream—which is what the Roth would provide in the scenario mentioned earlier—would be equivalent to a $179,200 taxable income stream. This would require a traditional 401(k) or IRA balance of $4.48 million if we continue to use the 4% withdrawal rule. In order for someone investing in a 401(k) or Traditional IRA at that same annual amount to achieve a $4.48 million account balance in that same timeframe, they would need to earn an 11.93% annual rate of return.
Therefore, by utilizing the Roth and assuming tax rates go up to median-high historical levels, you’re enhancing your portfolio's after-tax value by 2.93% per year, which is significant. If tax rates end up going higher than 50%, then your after-tax returns are enhanced even more. Hopefully, this drives the point home: utilizing a Roth IRA ultimately provides you with a strong hedge against higher future tax rates, protecting you and your family's retirement nest egg.
Are There Limitations to Who Can Invest in a Roth IRA?
Technically, there are limitations, but like most things in the tax code, there are workarounds. For married couples filing jointly, if your modified adjusted gross income (MAGI) is less than $230,000 in 2024, you can make a full contribution to a Roth IRA. If your MAGI is between $230,000 and $240,000, then you can only make a partial contribution, and if you're over $240,000, then you're not allowed to make a contribution at all. For single filers and married filing separately, you have different limits, so please ensure you know what those are. You can read more about them on the IRS website. These limits can change annually, so stay up to date. If you get large raises or bonuses through your work, you may find yourself ineligible to contribute directly.
Now, as I mentioned, there are workarounds. A direct Roth IRA contribution is when you get paid, and you deposit money into your Roth IRA directly—simple. However, as mentioned earlier, direct contributions have MAGI limits and rules. There's something called a "Backdoor Roth" strategy, and this does not have an income limit. As the name implies, it's a backdoor way to contribute to a Roth IRA.
Understanding the Backdoor Roth IRA
Step 1: Open a Traditional IRA.
Step 2: Open a Roth IRA.
Step 3: Contribute to your Traditional IRA but don't claim a deduction for the contribution.
Step 4: Perform a "conversion" from your Traditional IRA to your Roth IRA.
And there you have it—you just executed a backdoor Roth IRA contribution. You might be wondering, "Don't I have to pay income tax on the conversion to the Roth?" The answer is generally no, provided you've made non-deductible (after-tax) contributions to your Traditional IRA and have no other pre-tax IRA balances. This is because you paid tax on the income that you received once you got paid, and you didn't claim a tax deduction for contributing to your Traditional IRA. Now, you can convert the Traditional IRA to your Roth IRA tax-free, and you've successfully bypassed the income limitations since you didn't directly contribute to a Roth IRA. You did a "conversion" from one IRA to another, and there are no income limitations on doing that.
What Is a Mega Backdoor Roth?
Simply put, this is a similar strategy to the backdoor Roth IRA but using your 401(k) plan. Since the contribution limits in 401(k)s are much higher than IRAs, the backdoor amount is greater—hence the "mega" name. The steps are a bit different because of the different terminology used in a 401(k), and not all 401(k) plans allow this, so you'll want to check with your company to make sure. Your 401(k) plan typically has three buckets: "Pre-Tax," "Roth," and "After-Tax." The "After-Tax" bucket is seldom used because most people don't talk about it, and it doesn't provide an immediate tax benefit, so it's ignored. But it's instrumental for mega backdoor Roths.
In 2024, the total amount of money that can go into your 401(k) plan is $69,000, or $76,500 if you're age 50 or older. You can "elect" to defer part of your income—up to $22,500 or $30,000 (50 or older)—and your employer can provide a match. Let's say you're age 50 and decide to defer $30,000 of your income into the "Pre-Tax" bucket of your 401(k); this will help save you money on taxes today since that $30,000 of income isn't getting taxed. But if you want to put a lot into Roth accounts—which is why many are reading this article—you can instead elect to defer $30,000 of your income to the "Roth" bucket of your 401(k), or a combination of both. How much you do, and why, should be a conversation you have with your financial planner.
Now, let's say your salary is $300,000 and your employer provides a 5% match—that means they will put $15,000 in your 401(k) account for you as their matching benefit. So far, you've added $45,000 to your 401(k) plan this year.
Remember, you can put up to $76,500 per year in your 401(k) if you're age 50 or older. Therefore, there is another $31,500 that you can contribute to your 401(k) plan for the year. But how? This is where the after-tax bucket comes in handy.
You can contribute up to $31,500 (to reach the $76,500 limit) in the after-tax bucket. Since this bucket is "after-tax"—meaning you already paid tax on the income and you're not claiming a deduction for contributing to it—you can process a rollover from the after-tax bucket into your Roth IRA or perform an in-plan Roth conversion. And just like that, in one year, you were able to move an additional $31,500 into your Roth IRA. The individual in this scenario making $300,000, whether single or married, is a great example because they're most likely ineligible to contribute to a Roth IRA directly. But by following this strategy, they could still do so at a much faster pace than someone who makes normal direct contributions. There are lots of moving parts here, and your company 401(k) plan has to allow for it.
Beware of the Pro-Rata Rule & 5 Year Rule
When doing backdoor Roths, please be mindful of the pro-rata rule. Basically, this means if you already have a pre-tax IRA (Traditional IRA, SEP-IRA, SIMPLE IRA, etc.), you can't just open a new IRA and put money in there to immediately convert into a Roth without considering your existing pre-tax IRA balances. The IRS considers all your pre-tax IRA assets in aggregate.
For example, if you have other pre-tax IRA accounts already, such as a rollover IRA from an old 401(k) plan, then you have to determine the taxable portion of your conversion:
Calculate the ratio of your pre-tax IRA balance to your total IRA balance.
Multiply the conversion amount by this ratio to determine what amount of the conversion is taxable.
Simply put, if you open a new IRA and deposit $7,000 into it for the purpose of doing a Roth conversion, but you have $500,000 in other pre-tax IRA accounts, then you need to find how much of the $7,000 conversion would be taxable. The math is straightforward: multiply $7,000 by (500,000 / 507,000), which comes out to about $6,904. Therefore, almost the entire conversion is taxable at your income tax rate. The IRS doesn't want people sidestepping the pre-existing pre-tax IRA account; they want you to convert those funds to Roth first so they can get the tax revenue on it. Lastly, it's crucial to understand the 5-year rule associated with Roth IRAs. For your withdrawals to be completely tax-free, two conditions must be met: your Roth IRA must have been open for at least five years, and you must be at least 59½ years old (or qualify for an exception like disability or a first-time home purchase). While you can withdraw your original contributions at any time tax- and penalty-free, withdrawing earnings before meeting these conditions may result in income taxes and a 10% early withdrawal penalty.
Conclusion
I hope you found this article helpful. The risk of personal income tax rates going higher is immense. We've seen administration after administration, regardless of political party, continue to run high budget deficits, leading to record levels of national debt. At some point, the dam will break, and people who have all their wealth tied up in taxable income streams are going to be severely hurt. If you're like many people who are busy high-income professionals focused on greatness in your field and see the value in having a financial professional advise, guide, and oversee your portfolio and wealth accumulation, then please reach out to my office. I would be happy to meet you and be a valuable partner in your wealth journey for the many years and decades to come.
About the Author
Zak Gardezy is a Certified Financial Planner professional and is regarded as one of Scottsdale, Arizona's top financial advisors. Having been a partner on a Forbes Best-In-State Wealth Management team for multiple years and being recognized two years in a row as a Pacesetter at Morgan Stanley—a distinction given to the firm's top young advisors—Zak eventually determined that his clients would be best managed and guided at a boutique, fee-only wealth management firm dedicated to building deep, long-lasting client relationships.
Zak launched Wealthstone Private Wealth Management in Scottsdale, Arizona, with the vision to provide a truly personalized experience for clients, where he has the time to get to know every single client, their families, and their financial dreams, guiding them through every step of the process using the industry’s latest and best technology. Zak creates comprehensive financial plans and partners with client CPAs, attorneys, and other professionals to ensure his clients are always making the right financial decisions.
Additionally, Zak is a highly knowledgeable portfolio manager. He designs and manages custom stock and bond portfolios and partners with the world’s leading private equity and alternative asset management firms to provide his clients access to exclusive investments in the private markets, such as venture capital, private equity, real estate, and hedge funds.
Zak is also the host of Money Minutes, a weekly market update YouTube series covering the latest market headlines and his outlook for the days ahead. Also on YouTube, Zak releases regular educational content in the series Wealthstone Learn, educating clients on topics such as taxes, retirement planning, equity compensation, estate planning, and more. Additionally, Zak has provided financial education at the headquarters of companies, ranging from local small business to large publicly traded companies. He's also provided in-depth presentations to investors leveraging his political science and finance background, such as, “How Will The 2024 US Election Impact Your Wealth?”. Lastly, Zak regularly publishes relevant financial planning and investment articles on LinkedIn and Medium.
Zak has been entrusted with managing the wealth of numerous high-income, high-net-worth, and ultra-high-net-worth families in Arizona, and he is accepting new clients.
Outside of finance, Zak is an avid traveler, golfer, gym-goer, and an espresso aficionado. His love of espresso has reached a level of obsession that may be on par with his love of finance. Zak has studied and learned from some of the top baristas and espresso experts and crafted his own way of making the "perfect latte."
To request a meeting with Zak, you can contact him directly at: zak@wealthstonepwm.com
