Would you like to contribute to a Roth IRA, but been told you make too much money to do so?
According to the IRS, your Roth IRA contribution limits can be affected by how much you earn as well as your tax filing status. In other words, the more money you and your spouse earn, the greater the chances your ability to put money into a Roth will be reduced … all the way down to zero.
However, I’m here to tell you: You CAN still contribute to one; even if you earn more than the IRS Roth IRA income limits. You just have to use a little known technique of what’s known as a Backdoor Roth IRA conversion. More on that below.
First, let’s go over the conventional rules for how much you can contribute to a Roth IRA.
Roth IRA Contribution Limits for 2017
In general, for 2017, most non-higher income earners will be able to contribute a maximum of $5,500 to a Roth IRA. If you’re age 50 or older, than you get to bump this number up by $1,000 for a maximum contribution limit of $6,500.
Note that this number is always the upper limit whether you contribute to a traditional IRA or Roth IRA. In other words, you CAN’T contribute $5,500 to a traditional and $5,500 to a Roth. You could however contribute $4,000 to a Roth IRA and $1,500 to a traditional IRA for a total of $5,500.
If you happened to earn less than $5,500 for the year, then your maximum contribution limit drops to whatever the maximum taxable amount you made was. For example: If you are a young adult who only worked a part-time summer job and earned $3,000, then your maximum Roth IRA contribution limit is $3,000 for the year.
I should point out that in this specific example, the young adult doesn’t necessarily have to be the one making the contribution. A parent could make the $3,000 contribution while the minor uses their earnings for other purposes (i.e. college, room and board).
Roth IRA Income Limits for 2017
The amount of money you earn and report on your income tax return (known as your MAGI) will affect whether or not you can contribute to a Roth IRA. The official IRS rules are as follows.
Start of the contribution phase out
You can contribute to your Roth IRA up to the full amount if your MAGI is LESS THAN the following:
- Married filing jointlyorqualifying widow(er): $186,000
- Single,head of household: $118,000
- Married filing separately (not living together): $118,000
- Married filing separately(living together): $10,000
End of the contribution phase out
As you earn beyond the prior list of MAGI limits, the amount of money you can save into your IRA will be reduced by fractional amounts until you’re no longer eligible anymore. Here are the maximum boundary income limits:
- Married filing jointlyorqualifying widow(er): $196,000
- Single,head of household: $133,000
- Married filing separately (not living together): $133,000
- Married filing separately(living together): $10,000
Phase-Out Example: Let’s say you’re married filling jointly and earned $190,000 for the year. You fall right in-between the $186,000 and $196,000 income boundaries. According to the IRS, your reduced contribution limit is:
$190,000 – $186,000 = $4,000
$4,000 / $10,000 = 0.4
$5,500 x 0.4 = $2,200
$5,500 – $2,200 = $2,300
Don’t worry too much about the math. Your tax professional or tax preparation software will be able to help you figure out what the reduced amount should be.
However, as I mentioned earlier, you can still contribute to a Roth IRA even if you exceed these limits. You have to use a trick that’s known in the financial community as the Backdoor Roth IRA.
Backdoor Roth IRA Conversions
A Backdoor Roth IRA conversion is a perfectly legal “loophole” that allows high income earners the opportunity to move money into their Roth IRA.
The process for using one is fairly straight-forward.
How a backdoor Roth IRA conversion works
1- You start by contributing to a traditional IRA instead of a Roth IRA. The same contribution limits would apply: $5,500, or if you’re 50 and older, $6,500.
Because you are going to exceed the IRS traditional IRA income limits, this amount will be considered a non-deductible IRA. This means you will still owe taxes on this contribution when you file your income taxes.
At this point, if you left the money in the traditional IRA, you would owe taxes on the gains when you retired someday. That’s where the Roth conversion comes in.
2- Per the IRS rules, you are allowed to convert your traditional contributions over to a Roth if you wish. So your next step is to contact your financial institution and start the conversion.
With non-deductible IRA contributions, this is a no-brainer to do so. It gives your savings the ability to grow tax-free as well as being eligible for tax-free withdrawals once you reach retirement.
Hence, the name “backdoor” implies you worked your way around the system instead of making a conventional contribution.
Very few restrictions
Currently, there are no income restrictions on who can do this. In addition, there are also no restrictions on how much or how often you can convert your IRA assets. You can convert as much or as little of your traditional IRA to a Roth IRA anytime you want.
Act quickly
Your best bet would be to convert your non-deductible traditional IRA over to a Roth IRA immediately. Since you’ve already paid taxes on this savings, then you wouldn’t owe any taxes on the conversion.
If some time passes and your contributions gain value, then the process can become a bit more tricky. The IRS will want to collect on any money you haven’t paid taxes on already. Therefore, getting them into a Roth as quickly as possible would be your best bet.
Again, most tax-professionals and brokers can help you with this process. Usually the conversion simply involves filling out a form to authorize the transaction.
Early Retirement Advantages
Backdoor Roth IRA conversions can be very useful – especially if you plan to retire early.
One of the common challenges to early retirement is how to get to your money out of your retirement accounts before age 59-1/2 without having to pay the pesky 10% early withdrawal penalty. One trick for doing this is to use a Backdoor Roth IRA Conversion Ladder. This is where you systematically make Roth IRA conversions each year to create a steady stream of tax-free, penalty free income.
You can find out lots more on the Backdoor Roth IRA Conversion Ladder here.
Roth Conversions May Only Be Around for Limited Time
Again, note these backdoor conversions to side-step the Roth IRA contribution limits is simply a legal loop-hole. If at any time the IRS wanted to close it by changing the laws, then the regular IRS Roth IRA income limits would apply. Let’s hope that doesn’t happen anytime in the near future.
Readers – How many of you are affected by the Roth IRA contribution limits? What are you doing to work around them? Has anyone tried the Backdoor Roth IRA technique? Please feel free to share.
Featured image courtesy of Flickr
