Roth IRA’s are one of the best retirement saving tools. You can’t deduct contributions from your taxable income, but you get to withdrawal them, and the earnings, tax-free in retirement. Because of your contributions ability to grow exponentially over time, that can be a big benefit.
However, not everyone is able to contribute directly to a Roth IRA. In this article I’m going to explain how the IRS limits your Roth contributions, as well as a workaround called the Backdoor Roth IRA.
Advantages of Roth IRA’s
There are several advantages to Roth IRA’s even if contributions aren’t deducted from your taxable income.
- You can withdraw your contributions at any time without incurring a penalty. While it is best to avoid taking money from your retirement account, if an emergency arises that flexibility can be valuable and save you thousands of dollars in taxes and penalties.
- Withdrawals in retirement aren’t taxable. The obvious benefit is that you won’t pay taxes on them. However, the additional benefit is it won’t drive up your taxable income and expose more of your Social Security benefit to income tax.
- You have more flexibility when it comes to when and how you withdrawal from your Roth IRA since Roth IRA’s are not subject to required minimum distributions.
Because of these advantages, you may want to contribute to one. As mentioned though, you may not be able to due to the income limitations.
Roth IRA Income Limits
If your income is above a certain threshold each year, you are not eligible to contribute DIRECTLY to a Roth IRA. For 2019, that limit is $203,000 of modified adjusted gross income (MAGI) for someone who is married and files jointly. For single taxpayers, the limit is $137,000.
Your ability to contribute starts to phase-out at income levels lower than these maximums, but at this point you are entirely excluded.
Roth IRA Contribution Limits
Even if you can contribute to a Roth IRA because your income is below the limit, you are still limited by the amount you can contribute. For 2019, you are able to DIRECTLY contribute $6,000 . If you are 50 or over you can contribute an additional $1,000.
Backdoor Roth IRA
So if your income is too high and you can’t contribute directly to a Roth IRA, do you have other options?
Yes…the Backdoor Roth IRA.
As the name suggests the Backdoor Roth IRA gives you a way in when the front door, contributing directly, is closed.
Here is how it works:
1. If your income exceeds the limit in a given year, simply contribute to a Traditional IRA.
2. Convert your Traditional IRA to a Roth IRA.
You now have a Roth IRA even though you earned over the income limit.
This can be a good way to save Roth dollars and diversify your tax liability in retirement. If you decide to use this strategy there are a few things to be aware of.
You Normally Pay Taxes on the Conversion
When you convert a Traditional IRA to a Roth IRA, you’ll normally have to add the conversion to your taxable income. Remember though that you would not have deducted a Roth contribution anyway.
Be mindful that at the 2019 tax rates someone who exceeds the income limit for Roth IRA contributions is in at least the 24% tax bracket. At that rate you’ll owe $1,440 on your $6,000 conversion, but you’ll never pay taxes on that money again if you withdraw it in retirement. That goes for any gains on that money as well. You’ll get the most benefit here if you pay that tax with other money so that you can convert the entire $6,000.
You will not owe a 10% early withdrawal penalty because it isn’t a withdrawal, it’s a conversion. That difference matters.
What About Non-Deductible IRA Contributions?
There is a special situation you should be aware of that will change how your conversion is taxed.
The typical assumption, and the one we made above, is that a contribution to a Traditional IRA is tax-deductible. However, that isn’t always the case. If you are covered an employer’s retirement plan (like a 401k) you may not be able to make tax-deductible traditional IRA contributions.
If you are covered by an employer plan, there is an income test that determines whether you are able to deduct traditional IRA contributions. This is very similar to the income limit rules for Roth IRA contributions, but the limits are different.
For 2019, if you are covered by an employer plan you are not able to deduct traditional IRA contributions if:
- You are married filing jointly and your AGI is $121,000 or more.
- You are single and your AGI is $73,000 or more.
Notice that the deductibility income limits are lower than the Roth IRA contribution income limits. That means if you contribute to a Traditional IRA for the sole purpose of converting it in a year in which you exceed the Roth IRA income limit, you won’t be making a deductible contribution.
That isn't the case if you AREN'T covered by an employer plan. You can deduct Traditional IRA contributions regardless of your income.
How Are Non-Deductible IRA Conversions Taxed?
If you weren’t able to deduct the contribution, you aren’t taxed on it when you convert it. That is straightforward enough.
However, if you have other IRA’s or there is money already in the IRA you just contributed to, it’s different. The IRS will treat the conversion as though it were prorated from all of you contributions.
For a simple example, assume you made a $6,000 deductible contribution to an IRA last year. This year you make a $6,000 non-deductible contribution.
For simplicity sake, assume no growth in last years account so you have a combined $12,000. Half was deducted, half wasn’t… 50/50.
If you convert $6,000 it will not come entirely from this year’s non-deductible contribution. It will be prorated and treated as though it comes 50/50 from each type of contribution. You’ll owe income tax on the $3,000 that came from your deductible contributions.
Can I Avoid the Tax on the Conversion?
Possibly, you do have a few options. First, if you don’t have any other money in IRA’s then there is nothing to prorate the conversion with. You’ll only have your non-deductible contribution and as previously mentioned it alone isn’t taxed.
If you have other IRA’s, you could possibly roll those into your 401k if your employer allows it. That’s the opposite direction we typically think of rolling but it could make sense in this case in order to avoid paying income tax on the conversion.
Mega Backdoor Roth
You have a similar option to convert after-tax contributions through your 401k or other retirement plan. The mega backdoor Roth allows you to take advantage of the higher contriubtion limits of a qualified retirement plan.