Tax Free Income for All!

I’ve been asked many questions and shared a lot of thoughtful strategies with many individuals and families in my career. As I share my story with you about the path to a work optional lifestyle and financial independence, we will be taking detours to explore some of those topics that could move the needle forward for you in your endeavor to be work optional or financially independent.

Taxes are an important consideration when it comes to properly preparing your investment assets to become a printing press for income. Managing taxes on income is an event that can take place during both the accumulation (growth) and distribution (turning into income) of your assets. For example, did you know you could direct after tax dollars (money you have already paid taxes on) into a bucket that will allow for tax free growth as well as the potential for tax free income? This is essentially giving you the option in your work optional and financial independent years to have a bucket of assets that is no longer subject to taxes!

Let’s explore the bucket that will help you get to tax freedom income. This bucket is called a Roth IRA. This is different from a traditional IRA. A traditional IRA is typically funded with pretax dollars. (Please note, I said typically. Please bear that in mind as you read on.) Since a traditional IRA is funded with pretax dollars, meaning you did not pay any taxes on the money going in, you will have to pay taxes on the money going out as you make future withdrawals. The Roth IRA is the complete opposite. You will have already paid taxes on the money going in, but guess what, since you have already paid your taxes on that money, the money comes out tax free!

Of course, for both type of IRAs, there is no tax on the growth of the money while in the IRAs. So, a simple way of looking at it is as follows: 

• Pay no taxes now and pay taxes later = Traditional IRA
• Pay taxes now and pay no taxes later = Roth IRA

Which is better for you? It all depends on your current taxable situation, what your income could look like later in life, your time horizon when you need the money from the IRAs, etc. Consulting with your retirement income specialist is key to unlocking options that are best for you.

There are several ways to fund a Roth IRA. However, here is the hitch…. You can only make a full Roth IRA contribution if you make less than $198,000 (married filing jointly for 2021). The contribution amount decreases and is eliminated at $208,000 (married filing for 2021). The Roth contribution limit for 2021 is $6,000 and an additional $1,000 can be added if you are 50 or over. Making annual contributions to this type of account can add up over time, especially with long term growth!

Now, what happens if you make too much money to allow for a full contribution? Does that mean you can no longer contribute to a Roth? Remember I indicated earlier in the article that most traditional IRAs are funded with pretax dollars. If you happen to make too much money, you can always fund a traditional IRA with after tax dollars. There is no income limit to fund a traditional IRA with after tax dollars. This is called a nondeductible IRA contribution. Once the nondeductible contribution is placed into the IRA, the funds can then be converted into a Roth IRA. Viola! This is known as the back door Roth IRA. 

There are other ways to put funds into a Roth IRA as well if you make too much money. Perhaps your employer offers a Roth 401K option. By the way, this option usually works well for most people, regardless of income.

Utilizing a Roth IRA is an excellent way to cement a work optional lifestyle and maintain financial independence in the future. Tax rates, and rising tax rates at that, can derail a long-term plan and it is prudent to have the option to access income that is free of taxes!

As mentioned before, work with your retirement income professional to determine which option is best for you and what is the best way to achieve tax free growth and income during those years when you will need it.

Roth 401(k) plans are long-term retirement savings vehicles. Contributions to a Roth 401(k) are never tax deductible, but if certain conditions are met, distributions will be completely income tax free. Unlike Roth IRAs, Roth 401(k) participants are subject to required minimum distributions at age 72 (70 ½ if you reach 70 ½ before January 1, 2020).

Contributions to a Roth IRA are never tax deductible, but if certain conditions are met, distributions will be completely income tax free. Unless certain criteria are met, Roth IRA owners must be 59½ or older and have held the IRA for five years before tax-free withdrawals are permitted. Additionally, each converted amount may be subject to its own five-year holding period. Converting a traditional IRA into a Roth IRA has tax implications. Investors should consult a tax advisor before deciding to do a conversion. While we are familiar with the tax provisions of the issues presented herein, as Financial Advisors of RJFS, we are not qualified to render advice on tax or legal matters. You should discuss tax or legal matters with the appropriate professional.