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.
Paul @ The Frugal Toad says
This article would be great for the Roth IRA movement!
are you sure?
Jai Catalano says
I already have a Roth IRA. Go Roth!!!
Superb Jai! Go Roth!
Very useful guest post SB. Roth conversions can be very confusing, the post helps clear some of it.
Glad that the post is of help. Frankly I haven’t done any conversion yet.
Bichon Frise says
The rub is you are paying 28% or 35% (+ state income tax) tax rate. Hopefully high income earners are maxing out their 401(k) and have ample taxable accounts before making this move.
Julie @ Freedom 48 says
Good job in making some sense out of it all…
DO you mean I generally do not make sense? 🙂 great you got the sense.
Money Infant says
I think if you have the free cash to pay the taxes on the conversion you make out much better. It is generally not recommended to pay the taxes out of the IRA. One other potential benefit to converting is that there is no required minimum distribution on a Roth and it can be passed to your heirs tax free so it can be useful in avoiding estate taxes.
You sure know the tax system very well Steve. What the tax stricture back in Thailand?
Money Infant says
Honestly I don’t know much SB. I have no Thailand based income so pay no taxes here. The little I do know is that tax rates on personal income are lower than in the US, the tax on dividends is similar, but there is no tax on capital gains. There is also no property tax in Thailand. No help to me though as foreigners cannot legally own land. We are looking into some small investments here, so I can probably give you a better idea next year 🙂
I believe your wife is a native. She must have good idea about taxes there. Nonetheless, no capital gains tax, makes Bangkok an investors’ heaven!! So you have become a full time blogger now?
Money Infant says
My wife has very little idea about taxes or finances in general 🙂
Yes indeed it does, that is why we are going to test the waters. And yes I have become a full time blogger, hopefully I can live up to the demands.
Oh you are hard working I know. The day I saw you on FMF blogroll 🙂
I do not live in US so I don’t have to worry about IRS and Roth:). At least till my blog starts making some money.
I know what you meant by that. Even though you don’t pay taxes if you make less than 600 still you need to report that income.
Well Heeled Blog says
Great summary. I hope that in a few years I’ll make enough to need to do a conversion to Roth. 😉
Why not in this year. you have a good blog, you can increase your income anytime.
I’m a big Roth lover… we make sure we put $10,000 each and every year. For those who suggest people will be in a lower tax bracket at retirement so pay taxes now instead of then (1) are aiming too low and (2) base their prediction on no data – maybe the lowest rate will be higher than the higher rates…. Also, we max out a 401(k) every year, so we essentially “hedge” against tax movements. You give me a product with relatively low fees and tax advantages and I’ll fill the crap out of it!
Nick that means you are saving $45k a year in retirement saving! How old are you? And did you calculate how much saving you’ll have in retirement by 65? If you are plannign for early retirement then this money is not accessible, you know that right?
Thanks for all the kind comments!
@Money Infant – It’s true that Roth IRAs are not subject to the Required Minium Distribution like a 401k or Traditional IRA. But it’s not necessarily true that your heirs can inherit your Roth IRA tax free. An inheritied Roth IRA is not subject to the inheritance tax if the sole heir is the deceased owner’s spouse. Otherwise, an inherited Roth IRA is subject to the inheritance tax (although the original owner’s tax-free contributions are NOT taxable).
Thanks Britt for coming out and responding to comments. Appreciate the good gesture!
@SB – my wife is a SAHM so it’s only $27,000. We do it for a few reasons but mostly because we don’t know how long we’ll be able to contribute, so we do it while we’re young and earning good money) and for asset protection. I also view retirement savings in two ways: early retirement and “at 60” accounts. We also save outside of retirement in mutual funds, ETFs, a few single stocks and real estate. (it sounds like we’re making millions based on all of this but we’re not, haha. We’re just pretty cheap and keep our standard of living down). Those “early retirement” savings give us the option to retire when there is enough to get us “to 60” (well 59.5) when we can access the retirement accounts without penalty (assuming there is enough in those accounts). I’m 33 and she is 35.
Are you on target for saving towards home upgrade, car upgrade, child education etc? if you are then its perfectly well distribution.
Yep – my wife and I are pretty extreme when it comes to all of this for sure. We save a huge chunk of each paycheck and live off the rest, which allows us to have everything we “need” now, plus a few “wants.” So we contribute to retirement and college accounts and have an emergency fund and down payment on a house (we rent where we live currently). We’re definitely not “one percenters,” haha, but I’m fortunate to have a good job and we wanted to make sure we focused on living a nice simple life now, while setting ourselves up for the long term as aggressively as we can while we had the higher income. I think the whole 2008 debacle was what set that off. But we do most of it on auto-invest, so while it’s a large percentage of our money, it’s not a big part of our life. We just live on and budget from what’s left after the auto-investing. Crazy? Probably. But reading blogs like yours helps keep us motivated!!!
Great post. This is my game plan as of right now.
Wife – Max 401k
Me – Max 401k
Fund Roth IRA conversion (10K)
Remaining funds go into a taxable account
This will set us up to have pretty substantial sum of money to retire on.
that will give you huge money in retirement.
Housewife Empire says
I was planning on opening a Roth this month, then I found something on the IRS website saying I couldn’t contribute at all, regardless of my income (I’m well under $100,000), since I’m Married Filing Separately. I was disappointed. Now I’m going to speak to someone to see if there’s any way around this. Thanks! Great post.
Sorry I wish I could help, married filing separately with more than 10k in AGI is not eligible for Roth contribution.
Bichon Frise says
You can contribute to a non-deductible IRA and re-characterize as per this blog post. Also, if your income is less than $10,000, the gov’t phases in (or out, however you like to look at it) Roth IRA contributions. Or you can file jointly.
A question – In your example, you took a $200000 IRA with 50% deductible contributions and if you converted 50% to Roth, the IRA would consider 50% as taxable and 50% as non-taxable. Are the ratios proportionate to the contributions ?
For example, I have a $25000 IRA (rolled over from a 401k). So, if I contribute $5000 to an IRA now (am not eligible for deductions, so it will all be post-tax money) and then try to convert it (the new $5000 IRA) to a Roth, will the taxable:non-taxable ratio be 1:5 ? ie. will only $1000 of that $5000 be taxable ?
As I understand it, only 1/6th ($5,000/$30,000) will be tax-free. If you convert $5,000 to a Roth IRA, $833.33 will be tax-free, while $4,166.67 is subject to income taxes at your current income tax rate.
Bichon Frise says
I have the same understanding as Britt. You’ll have to add up the total of all your accounts as of Dec 31 for the tax year (that includes earnings on the non-deductible contribution) and pro-rate your non-deductible contribution.
There are a few ways out of this without paying taxes on the entire amount. If your employer allows contributions from IRA’s, you could always rollover the pre-tax amount into your current 401k and that will allow you to make the non-deductible IRA contributions and then convert the whole amount. This is probably the best option, assuming you can stomach your 401k investment options. The other options are the once a lifetime HSA contribution from IRA and a qualified charitable contribution. These are not the best options, in my opinion, unless you have a small amount, but why not just pay the taxes if your pre-tax amount is “small”?
It is typically advised not to be in this situation, so if you can contribute via a spouse in the future or exercise an option above, that would be much better. Although, there are worse problems in life than being forced to contribute to a non-deductible IRA.
I appreciate the responses. I’ll have to figure out if my current 401(k) plan allows that (my 401k has a brokerage trading option, so I can invest in pretty much anything). Correct me if I’m wrong, but the entire $25000 (in the rollover IRA) would be ‘pre-tax’ money since it came from a 401(k).
I’ve only recently started trading in this IRA account (it was in cash for a while) and wanted to figure out this conversion before it gets too big (high hopes 🙂 ). I want to convert the entire $25K IRA to Roth as well, but plan on doing it in stages to minimize taxes.
Lue Lanford says
Thought-provoking discussion ! I am thankful for the facts . Does anyone know where my company could possibly get a template graycookmovement FMS Score Sheet form to complete ?