If you expect to be in a relatively high tax bracket during your retirement years, you should consider pumping as much money as you can into Roth IRAs. However, your ability to make annual Roth contributions may be reduced or eliminated by a phase-out rule that affects high-income individuals. Good news: You can circumvent the phase-out rule by making an annual non-deductible contribution to a traditional IRA and then converting the account into a Roth IRA. This article explains that strategy after first covering some basics about Roth IRAs and the contribution rules that apply to them.
Roth IRA Basics
Advantage No. 1: Qualified Withdrawals Are Tax-Free
Unlike withdrawals from traditional IRAs, qualified Roth IRA withdrawals are free from federal income tax (and usually state income tax too). What is a qualified withdrawal? In general, it’s one that is taken after you’ve met both of the following requirements:
- You’ve had at least one Roth IRA open for over five years; and
- You’ve reached age 59 1/2. For purposes of meeting the five-year requirement, the clock starts ticking on the first day of the tax year for which your initial contribution to any Roth account is made. That initial contribution can be a regular annual contribution or a conversion contribution.
While we already had a federal income tax rate increase this year for upper-income individuals, there’s a possibility that income tax rates will be raised again for high-income individuals in the future. If rates go up again, loading as much money as possible into Roth IRAs will be even smarter.
Advantage No. 2: Exemption from Required Minimum Distribution Rules
Unlike with a traditional IRA, there’s no requirement to start taking annual required minimum distributions (RMDs) from a Roth account after reaching age 72 (previously age 70 1/2). So you are free to leave as much money in your Roth account as you wish for as long as you wish. This important privilege allows you to maximize tax-free Roth IRA earnings, and it also makes the Roth IRA a great asset to leave to your heirs (to the extent you don’t need the Roth IRA money to help finance your own retirement).
Making Annual Roth IRA Contributions
The idea of making annual Roth IRA contributions makes the most sense if you believe you’ll pay the same or higher tax rates during your retirement years. Higher future taxes can be avoided on Roth account earnings, because qualified Roth withdrawals are federal-income-tax-free (and usually state-income-tax-free too).
The downside is you get no deductions for Roth contributions.
The maximum amount you can contribute for any tax year to any IRA, including a Roth account, is the lesser of:
- Your earned income for that year or
- The annual IRA contribution limit for that year. For 2020, the annual IRA contribution limit is $6,000 or $7,000 if you’ll be age 50 or older as of year-end (unchanged from 2019).
If you’re married, both you and your spouse can make annual contributions to your separate IRAs as long as you have sufficient earned income. For this purpose, you can add your earned income and your spouse’s earned income together, assuming you file jointly. As long as your combined earned income equals or exceeds your combined IRA contributions, you’re both good to go.
For 2020, eligibility to make annual Roth contributions is phased out between modified adjusted gross income (MAGI) of $124,000 and $139,000 for unmarried individuals (up from $122,000 and $137,000 respectively in 2019). For married joint filers, the 2020 phase-out range is between joint MAGI of $196,000 and $206,000 (up from $193,000 and $203,000 respectively in 2019). To calculate MAGI, start with your “regular” AGI from the last line on page 1 of Form 1040. Then add back:
- Deduction for traditional IRA contributions;
- Deduction for higher-education tuition and fees;
- Deduction for student loan interest;
- Tax-free employer adoption assistance payments;
- Tax-free interest from U.S. Savings Bonds redeemed to pay higher-education costs;
- Education for domestic production activities; and
- Certain tax-free allowances for foreign earned income and housing. The last four add-backs are probably unlikely to affect you.
Circumvent the Income Restriction on Annual Contributions
What if you love the idea of Roth IRAs, but your high income prevents you from making annual Roth contributions due to the phase-out rule? No problem. Here’s what to do.
First, make an annual non-deductible contribution of up to $6,000, or $7,000 if you’re age 50 or older, to a new traditional IRA. There’s no income restriction on non-deductible contributions to traditional IRAs.
Next, immediately convert the new non-deductible traditional IRA balance into Roth status. Since the new non-deductible traditional IRA’s tax basis equals the amount that was just contributed to that account, the conversion of the account balance to Roth status is a tax-free maneuver, assuming you don’t have any other traditional IRAs.
In this indirect fashion, you can make annual Roth contributions of up to $6,000 or up $7,000 if you’re age 50 or older, even though you have a high income. If you’re married, your spouse can probably do the same drill. If so, you can double the fun by together contributing up to $12,000 or up to $14,000 if you’re both over age 50.
With most tax strategies, there are some catches. Here are three:
First, you must have earned income each year that at least equals your non-deductible traditional IRA contribution for that year. As explained earlier, you can count both your earned income and your spouse’s earned income if you’re married and file jointly.
Second, you can only do this drill if you’ll be under age 72 at the end of the year in question (this was previously age 70 1/2). Once you hit 72, you become ineligible to make traditional IRA contributions, and that shuts down this strategy.
Third, if you have one or more existing traditional IRAs, converting the new non-deductible traditional IRA into Roth status will generally not be a tax-free maneuver. That makes this strategy somewhat less-attractive, but it might still be a good idea because your new Roth IRA can be used to earn tax-free income and gains. Consult your tax adviser if you’re in this situation.
As explained in this article, individuals who expect to pay the same or higher tax rates during their retirement years should consider loading as much money as possible into Roth IRAs. The annual Roth contribution strategy facilitates that goal.
You may also have one or more existing traditional IRAs. If so, consider converting them into Roth IRAs too. That will trigger an income tax hit, but it may be a reasonable price to pay to avoid higher future taxes on the income and gains that will build up in the resulting Roth IRA(s). However, before making a conversion transaction, consult with your tax advisor to examine all the relevant variables.