Do you earn too much to make a Roth IRA contribution?
Under IRS rules, you’re prohibited from making a Roth IRA contribution if your modified adjustable gross income is more than:
- $183,000 if you’re married filing jointly, or
- $125,000 if you’re filing as a single person or head of household
If you fall into this category, you can’t make a Roth IRA contribution, right? Wrong.
While you can’t make a direct contribution to your Roth IRA, that doesn’t mean you should write off the idea of funding your Roth IRA this year.
You can still make an indirect contribution to your Roth IRA regardless of how much money you earn, and whether it’s a direct or indirect contribution, what’s most important is getting that money into your Roth IRA where it can grow tax-free and where you can withdraw it tax-free in your retirement years.
So how do you make an indirect Roth IRA contribution? It all starts with a 2010 congressional rule change.
Note: Check here for the latest Roth IRA Rules and Contribution Limits for 2012.
Roth IRA Conversion Limit Rule Change
The key to making an indirect Roth IRA contribution is a 2010 rule change in which Congress eliminated the income limit for performing a Roth IRA conversion.
Prior to 2010, if you had adjustable gross income in excess of $100,000, the IRS prohibited you from converting a Traditional IRA or an old 401k to a Roth IRA.
But now that the income limit has been lifted, anyone (regardless of income) can perform a Roth IRA conversion.
At this point, you’re probably asking yourself, “So what? The income limits on contributions are still in effect, and I earn too much!”
That’s a good question, and the answer is that the elimination of the income limit on Roth IRA conversions paves the way for you to make a Roth IRA contribution – regardless of income.
Fund Your Roth IRA Regardless of Income
How? Because anyone (regardless of income) can make non-deductible contributions to a Traditional IRA. For most people, the advantage in making a Traditional IRA contribution is that it’s tax deductible, but odds are that you can only make non-deductible contributions due to your high income. And that’s good, because those are exactly the type of contributions you want to make.
Once you fund your Traditional IRA with non-deductible contributions, you can then convert your Traditional IRA to a Roth IRA and… Presto! You just funded your Roth IRA.
Done right, you should avoid income taxes on the conversion since you haven’t had time to generate any investment earnings, and you don’t owe conversion taxes on contributions which were originally non-deductible.
For example, let’s say you’re married, 40 years-old, and earn $300,000 per year. Under IRS rules, you’re prohibited from making a direct contribution to your Roth IRA since your $300,000 income exceeds the $183,000 income limit for married couples.
However, you can still contibute $5,000 in after-tax non-deductible contributions to a Traditional IRA, and then convert that Traditional IRA into a Roth IRA tax-free.
Is it really that simple? Yes, and… no.
Such a conversion isn’t always a tax-free event. It is if you don’t already have a Traditional IRA. But if you already have one, it can get complicated.
Why? As previously stated, most people make Traditional IRA contributions in order to take advantage of the tax break. So if you already have a Traditional IRA, in all likelihood, it’s funded with tax deductible contributions.
You can still make your non-deductible Traditional IRA contribution, but the IRS won’t let you convert only your non-deductible contributions. Any Roth IRA conversion you perform will trigger income taxes on those portions of the conversion amount which represent original tax deductible contributions and earnings, and the IRS requires you to treat your cost basis as a percentage of tax deductible and non-tax deductible contributions.
For example (and this is a simplistic example), let’s say you’re married, 40 years old, and earn $300,000 per year. You decide to make an indirect Roth IRA contribution by following the steps outlined above, but you also already have a Traditional IRA worth $30,000 – of which $10,000 represents earnings, while the remaining $20,000 represents your original tax deductible contributions.
If you make a $5,000 non-deductible contribution to your Traditional IRA, then attempt to convert $5,000 of your Traditional IRA to a Roth IRA, you will owe the IRS income taxes.
Why? Because the IRS determines the cost basis of your conversion by looking at your total contributions – in this case, $20,000 in deductible contributions and $5,000 in non-deductible contributions.
In percentage terms, this means that 80% of your contributions are tax deductible, while the remaining 20% are not. As such, if you attempt to convert a portion of your Traditional IRA, 80% of your conversion is taxable, while the other 20% is not. In addition, if you convert any of existing funds which are the result of past investment earnings, those are subject to income taxes as well.
In the above example, we now have $45,000 in your Roth IRA – $20,000 in deductible contributions, $5,000 in non-deductible contributions, and $10,000 in earnings.
Assuming an effective tax rate of 35%, converting your entire Traditional IRA to a Roth IRA will trigger a $10,500 income tax bill. Why? Because your deductible contributions are taxable ($20,000 x 35% = $7,000) and your earnings are taxable ($10,000 x 35% = $3,500).
So if you decide to go this route, make sure you seek the advice and guidance of a certified financial professional. Also, make sure you have plenty of cash on hand to pay your conversion taxes if you still wish to move forward with a conversion.
Act Before the Conversion Limit Comes Back!
A Roth IRA can be a great place to grow your retirement savings, so don’t give up if you earn too much to make a direct Roth IRA contribution.
You can always make non-deductible Traditional IRA contributions and then convert to a Roth IRA. However, take advantage of this “backdoor” contribution method while you can. Don’t simply assume that it will always be available. Congress can always legislate a new income limit for Roth IRA conversions, and then you’ll be shut out again.
So don’t take your current opportunity for granted.