Do you earn too much for a Roth IRA?

Consider this indirect strategy if you earn too much to contribute directly to a Roth IRA.

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Key takeaways

  • Roth IRAs offer multiple benefits, including the opportunity for tax-free investment growth and withdrawals in retirement, plus no required minimum distributions (RMD).
  • People with high incomes generally can’t contribute directly to Roth IRAs due to income limits on eligibility.
  • Contributing to a traditional IRA and converting to a Roth IRA is one way for high income taxpayers to take advantage of a Roth IRA.
  • You can also convert 401(k) balances to a Roth IRA—usually after you leave the employer who provided the 401(k).

The Roth IRA offers potential tax advantages: tax-free investment growth with no taxes on withdrawals in retirement.1 Roth IRAs also have no RMDs, making them an attractive vehicle for tax-savvy estate planning.

Not everyone, however, can make a direct contribution to a Roth IRA because of income limits on eligibility.2 The news for high income taxpayers is that they can still benefit from a Roth IRA if they're willing to take 1 of 2 indirect routes to get there: converting either traditional IRA or 401(k) dollars to a Roth IRA.

Roth IRA basics

Unlike a traditional IRA, a Roth IRA doesn't provide a tax benefit today: Contributions are made after taxes have been paid. But once the account holder turns age 59½, assuming the first contribution has been in the Roth for at least 5 years, withdrawals are considered qualified. That means that any withdrawals—of contributions and investment earnings—are free of income taxes.

And unlike a traditional IRA, there are no RMDs in a Roth IRA (at least during the life of the original owner), so there is no time limit on how long the funds can potentially grow on a tax-advantaged basis. This is especially meaningful to those planning to leave Roth assets to their heirs.

Under the basic rules for both traditional and Roth IRAs, you can contribute up to $6,000 for tax years 2019 and 2020, collectively across all of your IRAs, assuming you have at least that much earned income. An additional $1,000 "catch-up" contribution is available to taxpayers who are at least age 50 by December 31.

Not everyone can contribute directly to a Roth IRA. For single taxpayers, eligibility phases out for modified adjusted gross incomes (MAGIs) between $122,000 and $137,000 for the 2019 tax year. If you are married filing jointly, the phaseout is between $193,000 and $203,000 for 2019. In 2020, eligibility phases out between $124,000 and $139,000 for single taxpayers and between $196,000 and $206,000 for a married couple filing jointly.

However, these taxpayers can still contribute to a Roth indirectly by converting money in a traditional IRA or 401(k) into a Roth IRA. There are no income limits on Roth conversions and no limits to how much you can convert, as long as you pay any required taxes.

Converting a traditional IRA to a Roth IRA

Converting a traditional IRA to a Roth IRA lets you transfer all or a portion of your traditional accounts into a Roth IRA. But it comes with a tax bill. Because contributions to a traditional IRA may be tax-deductible, income taxes are typically due on distributions from the account—and that includes conversions. You would have to pay income taxes on all of the pre-tax contributions and tax-deferred investment earnings transferred to the Roth account.

You can also make nondeductible contributions to an IRA and then convert them to a Roth.

Converting a nondeductible IRA contribution to a Roth IRA

You may know that if you or your spouse have a retirement plan available at work, it limits the deductible contributions you can make to a traditional IRA.3 If you're in that boat and want to make the most of your tax-advantaged saving options, you can still make nondeductible IRA contributions. Earnings on these contributions will be tax-deferred but you do have the option of converting to a Roth IRA. In that case, your nondeductible contributions won’t be taxed again, although any earnings on them would be treated as pre-tax balances, which means they would be taxable when converted. This type of conversion is sometimes called a backdoor Roth IRA.

If you do decide to convert, the timing can be a little bit tricky. Some time should pass between the date of the contribution and the date of the conversion, but it's not completely clear how much is enough. If you do decide to convert, consult your tax advisor first to ensure that you understand the full scope of potential tax consequences.

If you have more than one IRA: IRA aggregation rule and pro rata rule

When it comes to conversions and distributions, the IRS views all of your traditional IRAs as one account. If you have 3 traditional IRAs and a rollover IRA spread across different financial institutions, the IRS would lump all of them together. It's called the IRA aggregation rule and it can complicate your conversion to a Roth—or make it more costly than you may have anticipated.

If you have existing IRAs, like a rollover, and also want to make nondeductible contributions and later convert them to a Roth, you won't be able to convert only the after-tax balance. The conversion must be done pro rata—or proportionally split between your after-tax and pre-tax balances, including contributions and earnings.

For instance, let's say you have an existing traditional IRA worth $10,000. You've just made a nondeductible contribution to a new IRA in the amount of $5,000 and plan to convert it to a Roth IRA. You can convert $5,000 of your IRA dollars but you would have to pay taxes on about $3,333 of the money being converted.

    Total IRA balance: $15,000
    After-tax IRA balance: $5,000

$5,000 is one-third of your total IRA balance. That means that one-third of your conversion will be after-tax dollars and two-thirds will be pre-tax dollars.

There is some potential good news if you only want to convert after-tax IRA balances to a Roth IRA and leave any pre-tax IRA balances as they are. If you have a retirement plan at work, like a 401(k), you may be able to roll your existing IRAs into it. Any after-tax IRA balances would be ineligible to be rolled into your plan. The after-tax balances would thus be the only remaining balances in your IRA, and they could potentially then be converted to a Roth without incurring any tax liability, assuming there isn't any growth in the account’s value between the time of the roll to the 401(k) and the conversion. The only catch is that the workplace plan has to allow this type of rollover.

It may sound complicated but the silver lining is that after converting, any future earnings in your Roth IRA will be free from taxes as long as the rules are followed. You can withdraw the money in retirement tax-free, or let your Roth account grow without taking RMDs.

Converting a 401(k) to a Roth IRA

You can also convert traditional 401(k) balances to a Roth IRA. Generally, you'll only be able to transfer a 401(k) to a Roth IRA once you've left the company that provided the 401(k) or once you reach the age of 59½, which is the age most plans allow for in-service withdrawals. That's not always the case, however, so check the rules of your employer's 401(k) plan.

Another option that may be available to you: an in-plan Roth conversion. If your employer offers a Roth 401(k) option, you may be able to convert your existing pre-tax and after-tax balances to a Roth account within the plan. Some employers even offer an auto-convert feature inside their plan. You can set it up so that any after-tax contributions are automatically converted to a Roth 401(k) at regular intervals.

Taxes on a 401(k) to Roth IRA conversion depend on the type of contributions involved:

Pre-tax contributions only
If your 401(k) account is composed entirely of pre-tax money (your pre-tax contributions, any company match and/or profit sharing, plus earnings), then you'll be subject to current-year income tax on the entire amount converted to a Roth IRA.

After-tax contributions only
If the contributions made to your 401(k) account were made entirely in after-tax dollars, you can roll them directly into a Roth IRA, as long as any tax-deferred earnings associated with them are also distributed from your employer-sponsored plan at the same time to another eligible retirement plan. If this is a traditional IRA, tax deferral can continue; but if it's a Roth IRA, taxes will be incurred on the distribution.

Pre-tax and after-tax contributions
If you have both pre-tax and after-tax contributions, you may be able to take a partial distribution from your retirement plan consisting of just one or the other, if the plan separately tracks the sources of all of your contributions. In that case, you may want to roll out only the after-tax source balances and associated earnings.

Even if your plan does not track sources separately, you can still roll over the after-tax contributions directly into a Roth IRA. The pre-tax contributions, along with the earnings from both the pre-tax and the after-tax contributions, can be rolled to a traditional IRA, incurring no current income tax.

Alternatively, you can roll everything into a Roth IRA, paying income taxes on the pre-tax contributions and all of the earnings. Either way, if sources are not tracked separately, the after-tax contributions along with the earnings on them, plus the pre-tax contributions and their earnings, must be transferred out of the employer’s plan at the same time.

In many cases, the process of rolling out of a 401(k) plan can be a tricky one, particularly when rolling to more than one IRA. So investors should consult with a qualified tax professional to avoid costly errors.

Finally, investors should be aware that taxes are not the only factor when it comes to rolling funds from a 401(k) plan to an IRA, of any type. There may be considerations related to fees, investment choices, creditor protection, RMDs, and other factors that need to be weighed in deciding whether a rollover is appropriate for you. It's advisable to consult a financial advisor before making any decisions.

Read Viewpoints on Rolling after-tax money in a 401(k) to a Roth IRA

Roth conversion: Things to be aware of

There is at least one important difference between dollars contributed directly to a Roth IRA and those that arrive there via a conversion. It relates to how soon you can access a portion of your funds.

With a direct Roth IRA contribution, you can access the money you put into the account without fear of taxes or penalties, from day one, no matter how old you are or how long you have held the account. Of course, you wouldn't be able to take a qualified distribution of earnings until age 59½ and at least 5 years after your first Roth contribution—unless you qualified for a handful of exceptions. In contrast, the funds that end up in a Roth IRA through a conversion (whether the source was a traditional IRA or pre-tax 401(k) money) are considered to be "converted funds," as opposed to Roth contributions. In this case, if you are under the age of 59½, you'll need to wait 5 years before you can withdraw that money without incurring a 10% penalty. Note that this only applies to taxable money that was converted; it does not apply to any balances that were not taxable when converted.

Another common misunderstanding involves undoing Roth conversions, also known as recharacterizations. Before the Tax Cuts and Jobs Act was enacted in December 2017, you could undo a Roth conversion. That option is no longer available. If you do undertake a Roth conversion, it's important to understand that you won't be able to reverse it.

There are no guarantees when it comes to tax law, of course. What Congress gives, it can ultimately take away. It's impossible to predict what might happen in the future. So, if the myriad tax and planning benefits of a Roth IRA appeal to you, be sure to consult your financial and tax advisors.

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