Anyone can contribute to a Roth IRA, irrespective of their income. It is true that IRS has an income limit on who can contribute to the Roth IRA but it has a really neat (and simple) workaround.
For the year 2015, IRS rules (IRC – Internal Revenue Code, to be specific) specify that single filers making more than $131,000 and married filers filing jointly making more than $193,000 cannot contribute to Roth IRA.
Now here comes the neat trick and it has two parts - contribute to traditional IRA and do a Roth conversion.
Yes, it is that simple and achieves what you would have achieved by being able to contribute directly to a Roth IRA. Once the money is in Roth IRA, the money is there in the Roth IRA – irrespective of whether you made the contribution from your checking account or a rollover from your traditional IRA account.
Step-1: Make a contribution to traditional IRA (anyone with earned income can make a contribution to traditional IRA, there isn’t even an age limit). Earned income includes W-2 income, Self employment income from a business, Farming income, and alimony.
You will not be able to take a tax deduction in the current year because the Roth IRA contribution income limit is higher than the income limit for the traditional IRA to be deductible . So, no tax deduction in the current year.
Step-2: Do a Roth conversion; rollover the money from your traditional IRA to your Roth IRA account. What about taxes? IRS rules are clear that only those monies that lead to a tax deduction at contribution will be taxed. Yes, you guessed it correctly – since your original contribution was not tax deductible, you do not owe any taxed on the rollover as far as the original contribution is concerned.
You do owe taxes on interest and earnings that money has generated while it was there in the traditional IRA account. If you contributed $5,500 to the traditional IRA and bought stock that has appreciated to being $6,000 now; then you do owe taxes on the $500 earnings.
But hey – you do not have to invest the $5,500 traditional IRA into stock, you can roll it over as soon as the contribution is made. Yeah, that is right. For 2015, I contributed $5,500 to my traditional IRA. The money was lying there for a couple of days and then I did a Roth conversion of $5,500.02.
You will receive a 1099-R at year end with distribution code (box 7) as ‘2’ and ‘IRA/SEP/SIMPLE’ also checked. This means you will not owe taxes on the ‘principal contributions you made to traditional IRA that you are rolling over’. You still will owe taxes on any earnings.
Usually IRA and Roth IRA accounts are at the same brokerage firm. In which case, the question of taking ‘cash distribution from the IRA and depositing the proceeds into Roth IRA’ does not arise. In case, your IRA and Roth IRA accounts are with different brokerage firms, try not to take the ‘money’ yourself, ask the IRA brokerage firm to do a trustee-to-trustee transfer and send the proceeds to the Roth IRA brokerage firm ->this way chances of an error (or delay or mishap) are minimized.
Tax calculations can get complex
Tax calculations can get complex if your traditional IRA has prior contributions that were tax deductible and/ or there are earnings present in the account.
When you rollover assets from IRA to Roth IRA, you cannot choose which assets to rollover. If your IRA has contributions on which you got tax deduction in contribution years and other contributions that were not tax deductible; you cannot just choose to rollover either of them. The rollover has to be pro-rated. There is no way to differentiate dollars within IRA account.
Let us take an example – Let us say your total current balance in IRA (2014 contributions and before) is $25,000 – let us say 20k is principal contribution and 5k is gains part. Let us say, all of the 20k was tax deductible (you contributed 5k each for 4 years and were able to deduct the 5k when you filed your taxes).
Now you contribute 5.5k more for 2015 today (non-deductible), so total balance becomes 30,500. Tomorrow you convert all of that into Roth, you pay taxes on 20k ‘deductible’ contributions and 5k (profit).
If you were to convert only 5.5k tomorrow….then following is the calculation: Total balance = 30,500 out of which 25,000 is ‘taxable’ – so 82% is taxable…. so 82 cents of every dollar is taxable. Now if you convert 5500, then 5500 *.82 = $5,210 is taxable.
So let us summarize what I did
There are tremendous tax advantages of making Roth IRA contributions. Due to my high income levels (luckily) I am ineligible to make direct Roth IRA contributions. So I first contributed the maximum allowable amount. And then I immediately did a Roth conversion!
This is a no-brainer for high income earners. At such high income levels, you definitely need to be saving sizable amounts for retirement; this way $5,500 of it can be in an account which is not taxed at withdrawal.