eric, Author at Strata Capital

One of the primary reasons people establish a financial plan is to make sure their hard work pays off. The fact is, you can make good money and save your whole life, but that doesn’t ensure you’ll have enough assets to maintain your lifestyle in retirement or that you won’t waste some of your hard-earned cash on taxes you could have avoided. That’s why strategic retirement income planning is so important—it helps you position your assets to accomplish your goals in the most tax- and time-efficient way possible. After all, what good is all that return if you don’t get to keep it?

One of the most important things to consider is where to invest your money for retirement. A Roth IRA (individual retirement account) allows you to invest post-tax dollars that grow over time—then when you retire, you get to reap the benefits of your investments and their gains, knowing those taxes have already been paid. With a traditional IRA, you invest pre-tax dollars (a strategy that’s advantageous for individuals who want to deduct these contributions) and pay income taxes later when you withdraw the money.

Roth IRAs are great for individuals who want to avoid paying additional taxes in retirement, but there are limits to who can invest in a Roth and how much they can contribute. In this blog, we’ll talk about some of those limitations and alternative ways to minimize your tax burden in retirement.

What are some restrictions for people who want to fund a Roth?

For the year 2023, the maximum amount an individual can contribute to a Roth IRA is $6,500 (or $7,500 if you’re 50 or older). If your income exceeds a certain amount, you’re disqualified from making contributions to a Roth at all. These income limits are based on an individual’s modified adjusted gross income (MAGI), which is your adjusted gross income with deductions and other tax-exempt income added back in.

Here’s how those limitations break down:

Roth IRA Contribution Limits (Tax year 2023)

Roth IRA contribution limits 2023

1. You may contribute simultaneously to a Traditional IRA and a Roth IRA (subject to eligibility) as long as the total contributed to all (Traditional and/or Roth) IRAs totals no more than $6,000 ($7,000 for those age 50 and over) for tax year 2022 and no more than $6,500 ($7,500 for those age 50 and over) for tax year 2023.

Individuals can contribute the full $6,000 if their MAGI is less than $125,000. But if your MAGI is between $125,000 and $139,999, that contribution limit decreases incrementally as your MAGI increases. If your modified adjusted gross income is $140,000 or more, you are no longer eligible to contribute to a Roth IRA.

Married couples filing jointly with a MAGI of $198,000 or less are eligible for the full contribution amount ($6,000 per person, $7,000 for individuals 50 or older). If their income is between $198,000 and $207,999, their contribution limit decreases (again, incrementally as their MAGI increases), and once a couple’s modified adjusted gross income reaches $208,000 or more, both individuals become ineligible to contribute to a Roth IRA.

It can be frustrating if you’re a high earner who wants to create tax-free gains later, but luckily, there are some ways around these limits.

What can I do if my income exceeds the contribution limits?

The first option is through your employer—if you have access to a Roth 401(k), you can contribute up to $19,500 (for the 2021 tax year) to that Roth 401(k) regardless of your income level. Individuals 50 or older can contribute up to $26,000 to their employer-sponsored plan.

The second option is to convert money from a traditional IRA or 401(k) into a Roth account. This strategy only recently became feasible. Before 2010, individuals with a modified adjusted growth income of $100,000 or more could not perform a Roth conversion. At that time, the income limit for Roth contributions was $105,000 for individuals and $166,000 for married couples filing jointly —so individuals earning $105k or more had no method of investing in a Roth (unless their employer offered a Roth 401(k)). Since that $100k limit was removed in 2010, individuals can now convert money into a Roth from another account.

In the industry, this is referred to as a “backdoor Roth” because of the roundabout way it allows individuals to leverage this type of account. So while you may hear the term “backdoor Roth,” it’s important to note that this doesn’t refer to a type of retirement account—it’s simply a strategy for contributing to a Roth.

How does this Roth IRA strategy differ from a regular Roth conversion?

Normally, when investing in a traditional IRA, you would deduct those IRA contributions from your taxes in order to lower your income bracket for that year. Then, if you did a Roth conversion, you would have to pay the income taxes on the contributions when you transferred the money from the IRA to a Roth.

But if a backdoor Roth is done correctly, you should have a zero-dollar tax liability. The key is to not deduct the IRA contribution from your modified adjusted gross income—this qualifies the money as a post-tax contribution. That frees you from being taxed on those contributions when you convert them to a Roth.

What about money in my 401(k)? Can I use that for this Roth IRA strategy?

You can also fund a Roth with post-tax contributions from your 401(k)—this includes any money that was contributed without a MAGI deduction. Just like IRA contributions made without a deduction, nondeductible 401(k) contributions qualify as post-tax dollars. You can then take the total of your post-tax contributions and transfer them to a Roth IRA. Something to note, though, is that only the after-tax contributions themselves (not the gains from the 401(k)) can be rolled over to a Roth. You can, however, transfer the gains to a traditional IRA.

That means if you make a $10,000 post-tax contribution to your 401(k) and it grows to $15,000, only $10,000 can be transferred into a Roth. Five thousand dollars (your gains) could be transferred into a traditional IRA or left in the 401(k).

What are some of the pros and cons of leveraging this strategy?

Pros:

The backdoor Roth strategy allows you to turn post-tax dollars (which would normally be subject to capital gains tax if you invested them elsewhere) into Roth IRA dollars, which gain value tax-free.
It can be difficult for high-income earners to grow their assets tax-efficiently, and backdoor Roths provide an option for tax-free gains.
Lots of people have post-tax contributions in their 401(k)s, typically because they’ve over-contributed some years. Backdoor Roths allow you to take advantage of those post-tax contributions and have them grow tax-free (rather than paying income taxes on the distributions if you leave them in a 401(k)).

Cons:

To set up an effective backdoor Roth IRA, you must forgo the tax benefits of deductible IRA contributions.
If you have existing IRAs that were funded with pre-tax dollars as well as post-tax dollars, any Roth conversion you make is subject to the IRS Pro-Rata Rule, which could mean you pay taxes on part of the conversion. (More on this below.)

Who can leverage these strategies?

Technically, anyone with earned income can use a backdoor Roth strategy. But it’s only necessary if your modified adjusted gross income (as an individual) exceeds the $125,000 limit for contributing to a Roth IRA.

What are some things to consider before leveraging this Roth IRA strategy?

One thing to note is that if you have both post-tax and pre-tax money in your IRAs, something called the Pro-Rata Rules determines how much of your conversion is taxable. The Pro-Rata Rule involves a bit of math—here’s how it breaks down:

Let’s say you have $75,000 in pre-tax IRA dollars (which are deductible) and you want to make a $6,000 nondeductible contribution to an IRA. Even though you contributed $6,000 of nondeductible dollars, the Pro-Rata Rule takes into account additional factors to determine your taxable rate for a subsequent Roth conversion. The equation looks something like this:

Current IRA Balance = $75,000
Nondeductible contribution to traditional IRA = $6,000
Current IRA balance + contribution = $81,000
You can’t convert your nondeductible contribution to a Roth as a separate transaction, so your nondeductible balance divided by your total IRA balance determines the percentage of your conversion that is not taxable:
- $6,000/$81,000 = .074 or a 7.4% ratio
Your nondeductible contribution is then multiplied by that ratio to determine your nontaxable balance. o $6,000 x 7.4% = $444 (not taxed)
Then, whatever amount is left from your nondeductible dollars is taxed during the conversion. In this case, that would look like this:
- $6,000 – $444 = $5,556 (taxed conversion dollars)

Because of the Pro-Rata Rule, you won’t experience the same zero-dollar tax liability that you would if you had only nondeductible contributions in the account. If you’re considering a backdoor Roth strategy, you’ll want to talk with your advisor to determine if the transaction would minimize your tax burden or not.

What advice would you give a client who’s interested in this type of Roth IRA strategy?

It’s incredibly important to make sure your financial advisor (or whoever manages your investments) and your accountant (or tax advisor) are on the same page. If they don’t collaborate or communicate, your accountant might implement a strategy that your advisor could inadvertently undermine with their own strategies. That’s why it’s important to consult your financial advisor and your accountant to ensure your strategies are cohesive, support your overall goals, and minimize your tax burden.

What’s Next?

If you have more questions about minimizing your tax burden while you prepare for retirement, we’d love to help! We know it can get a little complicated, so we’re happy to discuss your options with you. Just shoot us an email or give us a call!

*Contributions to a Roth IRA may generally be withdrawn at any time without tax consequences. Earnings may generally be withdrawn tax-free if the account is held at least 5 years and withdrawals are made after the account owner reaches age 59 ½. If earnings withdrawals are made before the 5-year period or age 59 ½, income taxes are due, and a 10% federal tax penalty may apply.

[1] https://www.bankrate.com/finance/taxes/

Our society has become increasingly aware of how our individual actions influence the world around us. Now more than ever, Americans are making an effort to “go green,” speak out for the underrepresented, and make the world a better place to live. With that, consumers and investors have become increasingly adamant about contributing to worthy causes—not only do buyers want to shop local and support the small business owner, but they want to invest in companies that reflect their personal values.

In short, people want to put their money where their mouth is.

When it comes to investment strategies, the term “ESG investing” has gained a lot of traction. Most people define ESG investments as ones that improve the environment or benefit society in a positive way, but the true definition is a little more complex.

In this blog, our team at Strata Capital will tell you everything you need to know about this financial buzzword and how it applies to your plan.

What exactly is ESG investing?

ESG stands for environmental, social, and governance, and it refers to a ranking system that uses these three categories to classify companies as sustainable investment opportunities. (The term “sustainable” is used broadly here to refer not only to environmental longevity, but a positive impact in each category.) The rank (or score) a company receives helps investors determine whether the company is worthy to be included in a portfolio of sustainable investments.

A company’s environmental ranking considers how the company contributes to the conservation of the natural world.
A company’s social score reflects the treatment of people inside and outside the company.
Governance considers a company’s operations from an ethical perspective.

Here are some of the specific factors that determine a company’s ESG score:

ENVIRONMENTAL	SOCIAL	GOVERNANCE
Energy Sources	Company-Employee Relationship	Executive Pay
Waste Management	Sexual Harassment Policies	Political Contributions
Pollution Control	Fair Employee Pay	Honest Accounting Practices
Climate Change	Employee Diversity	Board Member Diversity
Raw Material Sourcing	Offering Similar Benefits Among Peers	Company Corruption
Carbon Emissions	Human Rights Issues	Executive’s Acting as Fiduciaries
Green Energy Initiatives	Does the Company’s Mission Benefit Society	Lawsuits
Deforestation	Positive Relationship with Community	Lobbying

In general, the higher the ESG score, the more sustainable the company (and therefore the investment).

Is ESG different than SRI (socially responsible investing)?

Yes and no—ESG is the grading system used to measure companies in these categories, while SRI refers to the act of using an ESG-based grading system to choose companies or funds to include in portfolios. So if you’re investing in companies that have a high ESG score, you’re probably partaking in what you would consider socially responsible investing.

That said, socially responsible investing is a general term that encompasses environmentally sustainable investing, impact investing, or ethical investing. SRI investing can differ depending on the investor’s definition of what is “socially responsible.”

Some investors (or wealth managers helping choose investment accounts) use an exclusionaryonly approach. This strategy, rather than seeking value-driven investments, simply avoids investments that don’t align with an investor’s values—like companies that produce tobacco, alcohol, or firearms.

So while you might define socially responsible investing as avoiding tobacco investments, others might take a more comprehensive approach.

How is a company’s ESG score determined?

Each company is compared to others in its industry, so there’s no numerical threshold for what qualifies a company as an ESG investment. Companies are generally considered part of a sustainable investment strategy when they have a higher ESG score than their peers in the three qualifying categories. Depending on who is ranking the company, the precise score or ranking can vary, and most analysts use a percentile system rather than a specific score.

Who determines a company’s ESG score?

ESG scores aren’t regulated by one particular authority, so there are lots of companies that use their own grading systems to measure a company’s ESG qualification. MSCI is one of the largest independent providers of ESG ratings, and they create sub-categories within the three main categories (environmental, social and governance) that each carry their own weight to determine a company’s final percentile ranking.

How can I find out a company’s ESG score?

Unfortunately, it’s not always easy to find a company’s ESG score, since much of the research and data is sold to institutional firms, rather than distributed for public consumption. There are a few websites like Sustainalytics where you can search for companies’ scores, but they typically don’t disclose why the score is high or low or where the company ranks in individual categories. However, most publicly traded companies have an ESG section on their website where consumers can investigate their ranking.

Should I consider ESG scores when shaping my investment strategy?

There are pros and cons to focusing solely on companies with high ESG scores. The main benefit, of course, is that you’re supporting companies with values similar to yours (assuming you agree with the standards of the ESG scoring system). And because this is increasingly important to many investors, it can also benefit your portfolio from an economic standpoint. Investments into ESG funds have increased dramatically in recent years, which has caused them to outperform lower-scoring companies—which in turn makes them a more viable investment.

But just because a company has a low ESG score, that doesn’t mean it’s a bad company or a bad investment. By excluding low-scoring companies, you could miss opportunities to invest in lucrative companies that could benefit your portfolio.

If it’s important to you to invest sustainably, the most important thing to understand is your definition of “sustainable” and how it compares to an ESG score. Your values may not align with an analyst’s definition of sustainable, so if you’re relying heavily on an ESG score to influence your decisions, make sure you do as much research as possible.

What’s next?

At the end of the day, different investments suit different people, and part of our job is helping clients determine which strategies best align with their values and goals. If you’re interested in maximizing your portfolio for socially responsible investing, we’d love to help. We’ve learned a thing or two about ESG investing (and by that, we mean quite a lot), and we’re here to help in any way we can. To talk with one of our advisors, just give Carmine a call!

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