Do Roth IRAs Work as They Should? Not Exactly

The Roth individual retirement account (IRA) was introduced in 1997 as a tax-advantaged way to help low- and middle-income Americans save more for retirement. And while Roths largely do achieve that aim, they’ve also disproportionately helped high-income individuals who use loopholes to invest and make vastly better tax-free returns than the average Roth investor.  

By design, Roth IRAs have strict income and contribution limits to prevent high net-worth investors from reaping especially favorable tax breaks. However, many high-income investors have found ways around regulations that allow them to leverage these tax benefits. Comparing Roth IRA returns across income levels, a group of researchers found that although Roth IRAs were “intended to help hard-working, middle-class Americans,” they “greatly benefited high-income individuals and amplified wealth inequality.”

The Advantages of a Roth IRA

Just because Roth IRAs have proven to be more beneficial for high-income investors doesn’t mean they can’t work for you. In fact, Roth IRAs are the most advantageous retirement account from a tax standpoint, because your investments grow tax-free, according to Sarah York, an Enrolled Agent with the IRS and tax expert for Keeper Tax.

“That means no income or capital gains tax when you make qualified withdrawals,” York told The Balance in an email.

York explained that this tax-free treatment is possible because Roth contributions are made using after-tax income. Unlike traditional IRA accounts, you can’t deduct Roth contributions on your tax return. However, if you expect your income to go up in the future, the long-term tax savings on Roth earnings can outweigh the upfront taxes you pay on the income you contribute now. 

Roth IRAs can be a great way to save for retirement, but there may be lessons to learn from strategies adopted by wealthier investors on how to maximize benefits.

How Roth IRAs Help Widen the Wealth Gap

Roth IRAs were created to help level the playing field for investors with lower incomes. Unfortunately, it’s the wealthiest investors who have been reaping the highest returns, on average. 

The study above found that there was great disparity in IRA investment returns according to account holder income, based on data provided by the IRS. In 2018, individuals with an annual income between $10,000 and $100,000 saw 2%-3% returns per year across all IRA types, while those who earned more than $100,000 had average returns above 8%. Individuals who earned more than $1 million gained almost 10% per year. 

However, the study also determined that these numbers are heavily skewed by Roth IRA returns in particular. In fact, between 2004 and 2018, high-income individuals earned 523% more than low-income individuals in their Roth IRAs. This is largely due to the investment and tax savings opportunities that are only available to the rich.

How the Rich Use Roth IRAs Differently

Even though Roth IRAs have income limits on annual contributions, and public investment options are available to everyone, high-income earners still manage to earn greatly superior returns. 

One major example is Peter Thiel, an entrepreneur and investor who co-founded Paypal. According to a report by ProPublica, Thiel used his Roth IRA to turn less than $2,000 as of 1999 into $5 billion. If he waits until his 60th birthday in April 2027 to withdraw those funds, he won’t have to pay a penny in taxes on the money. So how is it possible for Thiel and other wealthy investors to leverage Roth IRAs in this way?

Backdoor Roth IRA 

The IRS limits who can make regular Roth IRA contributions based on their modified adjusted gross income (MAGI). In 2023, a single taxpayer with a MAGI of $153,000 or more, for example, can’t contribute at all.

“However, there is a trick that allows savers to get money into a Roth IRA regardless of their income,” said Matt Hylland, a financial planner at Arnold and Mote Wealth Management in Hiawatha, Iowa, in an email. This strategy is commonly known as a “backdoor Roth IRA.”

Officially known as a Roth IRA conversion, this loophole lets investors skirt the income restrictions for Roth IRAs. You can contribute pre-tax funds to a traditional IRA, then convert that account into a Roth IRA without adhering to the MAGI limits. Income taxes are due on the converted amount that year, but those funds then grow tax-free.   

A “mega backdoor Roth IRA” is a similar strategy where you make after-tax contributions to your 401(k) plan (if the employer allows it) and transfer that money to a Roth account.

Investing Strategy

High-income earners also often have access to investment products that common investors don’t. These may include hedge funds, private equity, pre-IPO stock, certain real estate investments and more, which have high initial investment requirements and often require investors to be accredited.

The SEC’s definition of accredited investors includes those with at least $1 million in net worth or individual income of at least $200,000 in the past two years, with a reasonable expectation of similar income levels in the current year.

Thiel, for example, is said to have built his billions by contributing private, high-growth assets into his Roth IRA at a very low cost. That includes PayPal shares once worth about a penny each, which then skyrocketed in value (one share is worth close to $70 as of December 2022).

Passing on Roth IRAs to Heirs

Roth IRAs also allow investors to pass on generational wealth with few tax consequences. “If you have a goal to leave money for heirs, a Roth IRA is usually the best option,” Hylland said. “The IRS requires that the money be withdrawn over 10 years, but those withdrawals do not create taxable income like withdrawals from traditional IRAs do,” he said.

Why Wealth Gap in Retirement Savings Matters

All of these factors have contributed to a major gap in retirement savings among people of different income levels. However, not only do the wealthy make higher returns through a tax-advantaged vehicle never intended for them, but the situation is exacerbated by the fact that most Americans don’t save nearly enough for retirement. 

The situation is even more dire for some due to gender and racial wealth gaps.

Racial Wealth Gap

According to the Survey of Consumer Finances (SCF) conducted by the Federal Reserve, White families had a median retirement balance of $80,000 in 2019 (not including pensions). The median balance for Black families, on the other hand, was $35,000. For Hispanic families, it was $31,000.

Reasons for this racial wealth gap in retirement savings include higher unemployment rates and  lower access to work-based retirement plans for workers of color. According to an analysis of SCF data by researchers, only 37% of black households and 26% of Latino households were likely to have a 401(k) in 2021, compared to 50% of White households.

Gender Wealth Gap

The 2018 SIPP Survey by the Census Bureau found that women are less likely than men to have retirement savings. Fifty percent of women aged 55 to 66 had no personal retirement savings, compared to 47% of men in the same age group. Women lagged men at the other end of the spectrum as well. Fewer women (22%) had $100,000 or more in personal retirement savings compared to 30% of the men.

Saving for retirement is imperative for women, as they make less money on average than men but need to make those dollars stretch for longer due to greater life expectancy.

What You Can Do To Make the Most of Your Roth IRA

Despite the advantage that high-income earners may have, a Roth IRA is still a great tool for middle- and low-income investors who play it smart. But that means making retirement savings a priority, a goal many Americans are behind on. 

Below are a few strategies that low- and middle-income earners can employ to maximize their retirement savings in a Roth IRA.

Start ASAP

When it comes to investment returns, time is key. 

Let’s assume you’re 25 years old and can contribute $6,000 toward your Roth IRA every year. Also, let’s assume there’s no change in Roth IRA rules or your income and a constant 8% annual return. By the time you’re 60, you’d have contributed $210,000 but your Roth IRA balance would be $1.034 million.

Now if you started at 35 years of age, keeping all else equal, by the time you’re 60 you contributions would have amounted to $150,000, but your Roth IRA balance would be only $438,635.64.

In fact, for every 10 years you delay saving for retirement, you’ll need to save three times as much each month to catch up.

Prioritize High-Growth Investments

While the IRS places some restrictions on investments that can be held in Roth IRAs, most brokerages offer a wide variety of investment options to choose from.

According to Hylland, the best investments for Roth IRAs to maximize the tax savings are generally those that have the highest potential return. That can include actively managed funds, dividend-paying stocks, real estate, and even cryptocurrencies.

Choose an Appropriate Asset Allocation

Keep in mind that investments with a high earning potential also require taking on more risk. So you should be sure any investments in your Roth IRA match your risk tolerance and retirement goals.

“Wealthy investors like Peter Thiel have made headlines by purchasing very speculative investments in their Roth IRAs and watching their initial investments grow into millions or billions of dollars,” Hylland said. But he offers words of caution to “everyone except the ultra-wealthy” that maintaining a balanced asset allocation is necessary “to ensure the safety of your retirement nest egg.” 

After all, big gains are great. But you don’t want to jeopardize years of diligent saving by losing the money in your Roth from risky investments that never pay off.

The Bottom Line

Tactics such as Roth IRA conversions, stuffing accounts with exclusive, high-growth investments, and passing wealth on to heirs tax-free allow high-income earners to leverage Roth IRAs for their gain. But that doesn’t mean people with lower incomes should not invest or should invest less. Roth IRAs are still a great way to maximize your retirement savings thanks to their beneficial tax rules. So if you qualify, seriously consider contributing to one.

Frequently Asked Questions (FAQs)

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