Traditional IRA Income Limits

Welcome to week four of You Ask, I Tell. Tune into my podcast and you will often hear me recommending a Roth IRA. It is such a great way to save for retirement. Some listeners have been sending me this question:

Suze, I know you love the Roth IRA but my income is above the limit. Am I out of luck?

Maybe not. There is a way for higher-income savers to invest in a Roth IRA.

But first, let’s review the income limit on saving in a Roth IRA. In 2019 an individual with income below $122,000 can invest the maximum $6,000 in a Roth IRA. (If you are at least 50, the limit is $7,000.) If your income is between $122,000 and $137,000 you can still make a limited contribution. For married couples filing a joint tax return you can each make the maximum annual contribution if your joint income is less than $193,000. Between $193,000 and $203,000 you can each make a reduced contribution based on your income.

If your income is above those limits you technically can’t contribute directly to a Roth IRA. But you may want to consider a strategy called a Backdoor Roth IRA.

Here’s how it works:

     1. You make a non-deductible contribution to a Traditional IRA. (Note, you can only contribute to an IRA if you have earned income.)

     2. You then immediately (like the next day) do a Roth Conversion: you move that traditional IRA you just contributed to into a Roth account.

If that’s your only Traditional IRA account, you will not owe any tax when you make the conversion, because you made the conversion with after-tax (non-deductible dollars) and you sold the shares without a gain when you immediately moved them into the Roth IRA.

That’s the good news. But the tax bill when you convert gets trickier if you have other money in any Traditional IRA accounts.  You will owe tax on the converted amount based on the percentage of your total IRA funds that are in Traditional accounts.

For example, let’s say you contribute and convert $6,000, but the total amount of money in all your Traditional accounts (including this new contribution) is $100,000. The tax you owe will be based on the proportion of your total Traditional IRA assets that is tax-deferred. In this example, you would owe income tax on 94% of your $6,000 conversion, because 94% of your total remains in Traditional IRAs.  I want to be clear: your tax rate isn’t 94%, it’s that you owe tax at your income tax rate on 94% of the amount you converted. That works out to owing income tax on $5,640 on a $6,000 conversion.

This is where a trusted tax pro can be a big help. Paying the tax today may still make sense, depending on your tax bracket and how much you are converting. Having to report an extra $6,000 or so as taxable income might be worth the long-term advantage of having money in a Roth IRA where retirement withdrawals will be tax-free.

But please be very careful if you are considering a full-blown Roth conversion of your existing Traditional accounts. Every penny you convert will be taxed as income for that year. Using our example of $100,000, if you convert all of it, your taxable income for the year will be $100,000 higher. That is going to bump you into higher federal (and where applicable, state) tax rates.

Again, a tax pro with experience in Roth conversions can help you decide if you should do it, and how much. You can always do “partial” conversions in any year. Choosing to convert an amount that won’t bump you into a higher bracket is a smart way to go. Or if you have a big drop in income in a year—say you stop working but your spouse still has earned income—you likely will fall into a lower tax bracket. That’s a great opportunity to consider a conversion.

And one last important thing you need to know when you do a Roth conversion: You can always take out your contributions without any tax bill. But to make tax-free withdrawals of any earnings in a Roth account, the converted account must be five years old. As an example, if you convert $6,000 today and it grows to $8,000 in two years you could make a $6,000 tax-free withdrawal at any time. But the $2,000 in earnings will be subject to income tax until the account is 5-years old. You might also owe a 10% early withdrawal penalty if you take money out before you reach age 59 ½.