Do you earn too much to make a Roth IRA contribution? Are you bogged down by the Roth IRA limit for your income?
The Roth IRA is a powerful retirement savings vehicle. Unfortunately, the IRS prohibits large number of individuals and married couples from making Roth IRA contributions because (in the eyes of the federal government at least) they earn too much income.
If this describes your situation, you have been barred from making Roth IRA contributions (and probably Roth IRA conversions as well) for more than a decade. And while the Roth IRA income limits are still in effect, the restriction on your ability to make a Roth IRA contribution is not.
The Roth IRA Income Limits
Under the current Roth IRA rules, you’re prohibited from contributing a single penny to your Roth IRA if:
- You’re married, file a joint return, and earn more than $183,000
- You’re married, file separately, and earn more than $100,000
- You’re single, head of household, or married filing separately (and did not live with your spouse), and earn more than $125,000
If you fall into any of these categories, you’re out of luck, right?
Wrong. You were out of luck until two years ago when a backdoor method became available which allows you to make an indirect Roth IRA contribution.
Elimination Of The Income Limit On Roth IRA Conversions
In 2010, Congress eliminated the $100,000 income limit on Roth IRA conversions.
Prior to lifting this limit, anyone earning more than $100,000 could not convert a 401k, Traditional IRA, or other retirement account in order to take advantage of the many benefits of a Roth IRA.
For example, if you earn $200,000 per year and have a 401k with a $500,000 balance, you can convert all or part of your 401k to a Roth IRA (assuming you pay the conversion taxes). But prior to 2010, federal law prohibited you from performing this conversion because your $200,000 income exceeded the $100,000 income limit for making a Roth IRA conversion.
Now that the conversion limit is gone, not only can anyone perform a Roth IRA conversion regardless of income, but the new rule creates an opportunity for anyone to make an indirect Roth IRA contribution regardless of income. Just bear with me, and you’ll find out how.
Non-Deductible Traditional IRA Contributions
According to the IRS, anyone (regardless of income) can make non-deductible contributions to a Traditional IRA. This is nothing new. Typically, people take advantage of a Traditional IRA because the contributions are tax deductible, but if your income exceeds the IRS contribution limits, you’re prohibited from making deductible contributions to your Traditional IRA. The IRS seems to love prohibiting things, doesn’t it?
If you’re among the group of Americans who earn too much to make deductible IRA contributions, the door is still open for you to make non-deductible IRA contributions.
And this is where the elimination of the income limit on Roth IRA conversions creates a golden opportunity…
You can make non-deductible contributions to your Traditional IRA, then convert your Traditional IRA to a Roth IRA tax-free (since you only pay income taxes on contributions which were previously deductible during a conversion). This allows anyone regardless of income to make annual Roth IRA contributions, because even if your income exceeds the limit for making a direct Roth IRA contribution, you can always make non-deductible Traditional IRA contributions and then convert them – since the income limit on performing Roth IRA conversions no longer exists.
For example, let’s say you earn too much to make a Roth IRA contribution this year, but if you were eligible, the maximum contribution limit for your age is $5,000.
Under the current rules, you can make a $5,000 non-deductible contribution to a Traditional IRA. Since you made those contributions with after-tax dollars, you can convert them to a Roth IRA tax-free – unlike deductible contributions which trigger an income tax liability upon conversion.
Convert Your Traditional IRA To A Roth IRA
While this is a perfectly legal method for anyone to make a backdoor Roth IRA contribution, it’s not always simple.
It is if you don’t already have a Traditional IRA. But if you’ve made tax deductible contributions to a Traditional IRA in the past, it can get a bit more complicated. Why? Because the IRS won’t let you convert your non-deductible contributions only. You can’t segregate between your tax deductible and non-deductible contributions during the conversion process.
This means that any conversion you perform will involve both deductible contributions (fully taxable upon conversion) and non-deductible contributions (tax-free upon conversion). So while you’re still able to make non-deductible Traditonal IRA contributions and then perform a Roth IRA conversion, your conversion won’t be completely tax-free.
For instance, let’s say you earn $300,000, you’re in the 35% tax bracket, and you have a Traditional IRA worth $200,000 (composed of $100,000 in deductible contributions and $100,000 in non-deductible contributions). You decide to convert $100,000 of your Traditional IRA to a Roth IRA.
Unfortunately, you can’t convert only the $100,000 in non-deductible contributions and leave the tax deductible contributions in your Traditional IRA. Instead, the IRS views your Traditional IRA in terms of 50% deductible contributions and 50% non-deductible contributions.
So when you go to convert $100,000, 50% of your conversion will be non-deductible (tax-free contributions) and 50% will be deductible (fully taxable) contributions. In this case, that means 50% of your conversion is subject to income tax upon conversion, so you’ll owe $17,500 in taxes (35% of $50,000).
If the Roth IRA income limits imposed by the IRS prohibit you from making a Roth IRA contribution, you can still fully fund your Roth IRA by taking advantage of the recent rule changes governing Roth IRA conversions. Just make sure you understand the tax implications before you act. In fact, whenever you perform any kind of retirement account conversions, it’s always a good idea to seek the advice of a certified financial professional.
Britt Gillette is the creator of Your Roth IRA, an online resource for helping you understand and manage your Roth IRA.