Do Roth IRAs Work as They Should? Not Exactly

Research shows the wealthy earn more from Roths, but others can still benefit

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The Roth 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.”

Note

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,” she 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 future, the long-term tax savings on Roth earnings can outweigh the upfront taxes you pay on 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 2022, a single taxpayer with a MAGI of $144,000 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.

Note

The Build Back Better Act (H.R. 5376) includes provisions that could make Roth IRA conversions less advantageous. After being passed by the House, as of May 2022, the bill is stalled in the Senate.

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.

Note

Wealthier investors then “stuff” their most exclusive and highest-returning assets in tax-advantaged Roth IRAs.

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 over $90 as of May 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. 

Note

According to the U.S. Census Bureau’s Survey of Income and Program Participation (SIPP), 49% of adults ages 55 to 66 had no personal retirement savings in 2017.

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 40% of black households and 32% of Latino households were likely to have a 401(k) or an IRA in 2019, compared to 63% 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.

Note

Marriage and having children also adversely impact women’s ability to save for retirement more than men, the Census Bureau found.

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.

Note

You can visualize various investment scenarios using The Balance’s compound interest calculator.

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.

Note

Most mainstream brokerages do not allow direct cryptocurrency investments for Roth IRAs. You can either opt for indirect cryptocurrency exposure through funds or stocks of companies related to cryptocurrencies, or consider a self-directed Roth IRA that invests in 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, strongly consider contributing to one.

Frequently Asked Questions (FAQs)

What is a backdoor Roth IRA?

A backdoor Roth IRA is officially known as a Roth IRA conversion. Your modified adjusted gross income (MAGI) level determines if, and how much you can contribute to a Roth IRA. A backdoor Roth IRA allows investors with traditional IRAs to convert to a Roth without adhering to those income limits.

How much can I contribute to a Roth IRA?

For 2022, the maximum amount you can contribute to a Roth IRA is $6,000. People aged 50 and older can contribute up to $7,000. In addition to these general limits, your contributions may be capped according to your filing status and income. For example, single taxpayers with a modified adjusted gross income of less than $129,000 may contribute the full amount in 2022. However, those with a MAGI of $129,000 to $143,999 may contribute a reduced amount, while those with a MAGI of $144,000 or more cannot contribute at all.

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Sources
The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts within our articles. Read our editorial process to learn more about how we fact-check and keep our content accurate, reliable, and trustworthy.
  1. Lorenzo Bretscher, Riccardo Sabbatucci, and Andrea Tamoni. “The Unintended Consequences of Roth IRAs,” Page 1. Swedish House of Finance Research Paper No. 22-04, via SSRN.

  2. Lorenzo Bretscher, Riccardo Sabbatucci, and Andrea Tamoni. “The Unintended Consequences of Roth IRAs,” Page 13, 18 and 24. Swedish House of Finance Research Paper No. 22-04, via SSRN.

  3. ProPublica. “Lord of the Roths: How Tech Mogul Peter Thiel Turned a Retirement Account for the Middle Class Into a $5 Billion Tax-Free Piggy Bank.

  4. IRS. “Amount of Roth IRA Contributions That You Can Make for 2022.”

  5. Congress.gov. “H.R.5376 - Build Back Better Act.”

  6. Securities and Exchange Commission. “Accredited Investor.

  7. Daniel J. Hemel and Steve Rosenthal. “Mega-IRAs, Mega-401(k)s, and Other Mega-Retirement Accounts: Statement for the Record,” Page 7.

  8. Yahoo Finance. “PayPal Holdings, Inc. (PYPL).

  9. U.S. Census Bureau. “Women More Likely Than Men To Have No Retirement Savings.”

  10. Federal Reserve. “Survey of Consumer Finances, 1989 - 2019.”

  11. Department of Labor. “U.S. DOL ERISA Advisory Council Hearing – Gaps in Retirement Savings Based on Race, Ethnicity and Gender,’” Page 3 and Page 7.

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