How To Contribute To A Roth IRA If You Make Too Much

January 21, 2021

There are multiple reasons to contribute to a Roth IRA, but if you make too much money, the Roth may not seem to be an option. However, there are a few things to keep in mind before completely writing off the Roth IRA.

The limit is based on MAGI, not total income

One is that the income limits are based on MAGI (modified adjusted gross income). That means if you contribute enough to a pre-tax 401(k) or similar qualified retirement plan, you may be able to bring your MAGI below the income limits. (Here is a little more on MAGI.)

Income limits apply to contributions, but not to conversions

The bigger point here for people whose MAGI far exceeds the income limits is the fact that there is no income limit to converting a traditional IRA into a Roth IRA. This is the key that allows people who make too much money to put money directly into a Roth IRA to still participate.

How it works

You can simply contribute to a traditional IRA and then convert your traditional IRA into a Roth IRA. Anyone can contribute, regardless of income levels, but many people don’t because it’s not tax-deductible if you earn too much to contribute to an IRA and are covered by a retirement plan at work.

This is called a “backdoor” Roth IRA contribution. Since it’s really a conversion rather than a contribution, you may have to wait 5 years before you can withdraw the amount you converted penalty-free before age 59 1/2. You’ll have to file IRS Form 8606 to document the non-deducted contribution to the traditional IRA, which will offset the 1099-R form you’ll receive for the conversion.

If you already have a traditional IRA, beware the pro-rata rule

There is a potentially huge caveat to this strategy though. If you have other funds in a traditional (pre-tax) IRA already that you aren’t converting, you have to pay taxes on the same percentage of the conversion amount as you have in total IRA dollars that are pre-tax. That means you could end up owing taxes on the conversion even if all the money you convert was nondeductible and thus after-tax.

Here’s what I mean

For example, let’s say that you have an existing IRA with $95k of pre-tax money and you contribute $5k to a new IRA after-tax. Since 95% of your total IRA money is pre-tax (because it was already there before and presumably contributed pre-tax), 95% of any money you convert to a Roth IRA is taxable even if you convert the new IRA with all after-tax money.

In other words, the IRS looks at all of your IRAs as if they were one account and taxes your conversions on a pro-rata basis. In this case, you would owe taxes on 95% of the $5k you convert — basically you’d have $4,750 of taxable income. So you can still do it, and $250 would be converted without causing a tax effect. It’s just not a tax-free transaction.

One way to avoid the pro-rata rule

The good news is that there may be a way to avoid this. If your current job’s retirement plan will allow you to roll your existing IRA money into your existing employer’s retirement plan, then you’d be eliminating the need to pro-rate by no longer having an existing pre-tax IRA. If you move your IRA into your 401(k), then complete the “backdoor” transaction, the only IRA money you would have in this example would be the $5k after-tax IRA, so you won’t pay any taxes on the conversion since 0% of your total IRA money is pre-tax.

Still not a bad deal

Even if you can’t avoid the tax on the conversion, it’s not necessarily a bad deal. After all, you or your heirs will have to pay taxes on your IRA money someday. By converting some (or all) of it into a Roth, at least future earnings can grow tax-free. It’s probably not worth it if you have to withdraw money from the IRA to pay taxes on the conversion.

So there you have it. You can contribute to a Roth IRA one way or another as long as you have some type of earned income. Otherwise, you won’t be able to contribute to a traditional IRA either.