A Quick Way to Get Around the Income Limits on Roth IRA Contributions

I’ve had several clients want to put more money away for retirement but have been discouraged that they can’t buy a Roth IRA because their income exceeds the IRS limits. These are high salary folks who are interested in the benefits of a Roth IRA. As you know, Roth IRA contributions are not tax deductible, but withdrawals from Roth IRAs are tax-free (including the earnings) and there are no required minimum distributions. These benefits can be substantial if you have 20-30 years of tax-free growth!

Before contributing to a Roth IRA, however, my advice generally is to urge the client to contribute fully to their work retirement plan, such as a 401k or 403B plan. The full 2015 contribution ($18,000/year plus $6,000 in catch-up contributions if the client is 50 years of age or older) will make sure the client’s benefit from this substantial tax break, especially because these clients are in high tax marginal brackets.

So how can you sill make a Roth IRA contribution directly if you exceed the IRS income limits? The answer lies in two facts:  (1) there are no income limits on conversions from traditional IRAs to Roth IRAs and (2) everyone can contribute to a traditional IRA, it just may not be tax deductible.

The strategy is to contribute to a traditional IRA with post-tax dollars (because these clients also exceed the income limits for deductible traditional IRA contributions and they are covered by an employer retirement plan). Then convert the traditional IRA to a Roth IRA immediately. Here are the IRS income limits for Roth IRA and traditional IRA contributions.

This strategy works, however, if you don’t have any other traditional IRAs (made with pre-tax dollar).  If you do, then you have to convert all of your other IRAs proportionally. The IRS requires that when you convert a traditional IRA to a Roth IRA you recognize as income in the year the amount you are converting from pre-tax status to post-tax status. So if you have other pre-tax traditional IRAs, you must convert to Roth status on a proportional basis – you can’t pick and choose which traditional IRAs to convert!

For example, if you have $24,500 in a traditional IRA (that are pre-tax contributions as of the end of the prior year) and you make a post-tax contribution of $5,500, you will have $30,000 in your traditional IRA. If you want to convert $5,500 to Roth status, you include in your income for tax purposes that proportion of the conversion that is pre-tax. 24,500 / 30,000 = 81.67%. So if you convert 5,500, then $4,491.67 will be included in your income for that year.

But there is a way to get around this proportionality rule by eliminating traditional IRAs that were made with pre-tax dollars. You can roll over traditional IRAs into your current employer retirement plan (assuming it has low fees and a good mix of funds). The IRS does not look at work-based plans in making the conversion ratio, rather it includes only other IRAs. You must “clear the decks” of traditional IRAs with pre-tax dollars, however, in the year prior to making the Roth conversion or else the strategy won’t be successful to avoid the proportionality rule.

If you are over the Roth IRA income limit, you can use a three-step process to still get a Roth IRA.

First, make sure you don’t have any other traditional IRAs that were made with pre-tax dollars.  If you do, roll them over into your current employer retirement plan.  This rollover must be done in the year before you want to convert a traditional IRA to Roth status.

Second, contribute $5,500 ($6,500 if age 50 or older) to a traditional IRA using post-tax dollars. Make sure you file IRS Form 8606 indicating that you made your traditional IRA contribution with post-tax dollars. The IRS uses this form to keep track of your post-tax IRA contributions.

Third, convert the traditional IRA to Roth status. There won’t be any income tax effect because traditional IRA contribution was made with post-tax dollars and you have no additional taxable income.

Follow these three steps and you can avoid the income limits to contribute to a Roth IRA


Photo by Philip Taylor PT

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