Eligibility for Roth Contributions is Different From Roth Conversions

A common mistake investors make is to continue to contribute to their Roth IRA even though they are no longer eligible. Most people will start a Roth IRA when there income is lower and mistakenly think that they can continue to make annual contributions; but unfortunately, the IRS limits Roth contributions at higher income levels. Luckily, there are ways to continue to build these accounts, regardless of income. Here is what you need to consider if you want to increase your investments to Roth accounts.

First off, what is a Roth?

A Roth account is a great way to save on your tax bill to Uncle Sam. Roth accounts are unique in that they are only taxed once. When you contribute to the account you are adding after-tax dollars, the money then grows tax-free, and it is not taxed when it is withdrawn. (Earnings may be taxed and or penalized if they are taken prior to 59 ½ or within 5 years of the first contribution to the account.)

Why should I invest in a Roth?

A Roth account is particularly valuable when contributions are made when your tax bracket is relatively low, and you have a long time for the money to grow. For example, let’s say you start to contribute to a Roth IRA at age 20 and contribute $5,000 a year until age 30. Even if you do not contribute to it at all after age 30, your balance, assuming a rate of return of 8%, at age 65 would be roughly $1,070,900. You only paid taxes on the $50,000 of contributions and will never pay taxes on over $1M worth of growth. That is the power of tax-free compounding.

Who can contribute?

Generally, you can contribute to a Roth IRA if you have taxable compensation, are less than 70 ½ years of age, and your Modified Adjusted Gross Income is less than:

  • $191,000 for married filing jointly
  • $129,000 for single, head of household, or married filing separately and you did not live with your spouse at any time during the year, and
  • $10,000 for married filing separately and you lived with your spouse at any time during the year.

The maximum contribution is the lessor of $5,500 ($6,500 if you are age 50 or older), or your taxable compensation.

If you have income over these amounts, you are disqualified from adding to your Roth account. (In addition, you will also be over the limit for a deductible traditional IRA.)

If my income disqualifies me from contributing to my Roth IRA, do I have any other options?

Yes. You have three options a Roth conversion, Roth 401K, or backdoor Roth conversion.

Roth Conversion

Even though you are unable to contribute to a Roth, there are no income limits to Roth conversions, so you may decide to convert your traditional IRAs to Roth IRAs and take advantage of your investment growing tax-free with no future required minimum distributions. A conversion would make sense if you expect your tax rate to be higher in the future and are willing to pay the taxes on the conversion with funds outside of the IRA account.

Roth 401K

Another way to build some tax-free investment growth via a Roth is to sign up for your Roth 401K if your workplace offers the option. Unlike the Roth IRA, the Roth 401K has no income limitations for eligibility. Since we prefer income that will be taxed at relatively low rates to fund a Roth, it may make sense to contribute after-tax payroll deductions to the Roth 401K up to point where your taxable income puts you in the top of the 25% income tax bracket, after which point, any additional contributions could be made to the traditional 401K, so as to keep you in the 25% marginal tax bracket. This not only helps diversify the taxability of your investments but also provides added flexibility for your withdraws in retirement.

Note that you will likely want to roll over the Roth 401K at retirement and or prior to age 70, as the Roth 401K does require that you take annual RMDs (Required Minimum Distributions) during your lifetime, whereas the Roth IRA does not.

Back door Roth conversion

Another way to add funds to your Roth IRA is through a “backdoor” Roth conversion. Here is how it works. You make a non-deductible contribution (after-tax dollars) to a traditional IRA and then, convert the IRA to a Roth IRA. If done correctly, this conversion will result in minimal taxation.

Ex: Tony and Tina make over $225K a year. They are in their 40s and want to build some tax-free funds into a Roth for their retirement. They each make a $5,500 contribution to a traditional IRA in January which has a zero balance, as they have already converted all of their traditional IRA accounts. Six months later, they convert the funds to their Roth account. The tax impact of the conversion will be based on the difference in the value of the account at conversion and the original $5,500 contribution.

When would you not want to do a backdoor conversion?

  • If you have substantial traditional IRA assets which have been deductible, the back door conversion becomes tougher as the pro rata rule comes into play. The pro rata rule aggregates all of the existing IRA balances and taxes the conversion based on the ratio of deductible funds to the total. For example, say that Lars has $94,500 in several traditional IRAs in which he contributed deductible pre-tax money. He makes a contribution of $5,500 to a non-deductible IRA this year and then converts the $5,500 account using the backdoor strategy. If he did not have any existing IRAs, the conversion would likely not be a huge taxable event (depending on the account value when he converted that year). However, since the total IRAs are now $100,000 and his conversion amount is $5,500, 94.5% of his IRAs are deductible, so $5,198 of his conversion would be taxable.
  • If you are going to need the funds within 5 years, this strategy will not be optimal, because a backdoor Roth is considered a conversion and not a contribution. Converted funds will incur a 10 percent penalty if withdrawn within five years unless you are age 59 ½ or older.
  • As always with a Roth, if you are in a higher tax bracket now then you expect to be in retirement, you may want to keep the money in the traditional IRA.

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