Don’t Let the Income Limit Stop You From Taking Advantage of a Roth IRA

Roth IRAs are a great tool for saving and investing for retirement. They allow your money to grow with the ability of taking tax-free withdrawals in retirement, and that’s a perk that can easily save you money.

They also come with more freedom than other accounts, like 401(k) plans, because you’re essentially able to invest in any stock you choose, in a similar manner to a regular brokerage account. One of the Roth IRA’s downsides, however, is its income limit for eligibility.

If you’re eligible for a Roth IRA, you can contribute up to $6,000 a year into the account — or $7,000 if you’re 50 or older. Single people with a modified adjusted gross income (MAGI) of less than $129,000 can contribute the full amount. If you’re married and filing jointly, you can contribute the full amount if your MAGI is less than $204,000.

If your MAGI is $144,000 or higher ($214,000 or higher if married and filing jointly), you’re not eligible to contribute at all. Your contribution limit begins to phase out between $129,000 and $144,000 for singles and between $204,000 and $214,000 for married joint filers.

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Using a “backdoor” Roth IRA

However, even if you can’t contribute directly to a Roth IRA, there’s another way to use this type of retirement account. You can create a backdoor Roth IRA in two steps. First, you’ll need to contribute funds to a traditional IRA, which doesn’t have an income limit for contributions. If you don’t currently have a traditional IRA account, creating one is usually pretty simple — just check with your bank or brokerage company.

The next step is to convert your traditional IRA to a Roth IRA. The conversion process may vary slightly between IRA plan providers, but you can generally do it online or reach out to your provider to do it for you. You’ll open a Roth IRA account during conversion if you don’t currently have one.

Tax implications

One of the main benefits of a traditional IRA is that your contributions are often tax-deductible. The amount you’re eligible to deduct depends on your income and if you or your spouse are covered by a retirement plan at work. Roth IRAs, however, are funded with after-tax money. When you convert, any money that wasn’t from nondeductible contributions will generate taxable income.

If you were able to deduct your traditional IRA contributions and then convert them to a backdoor Roth IRA, then the resulting taxable income cancels out the deduction, leaving you with no tax impact.

However, if you’re looking to make nondeductible contributions to a traditional IRA that already has previously untaxed money, then the IRS will make you calculate the amount of taxable income on a pro-rata basis (meaning proportionally). Whatever percentage of your account(s) that’s pre-tax is the same percentage of the money you convert to a Roth IRA that you’ll owe taxes on.

For instance, if 75% of the money in your traditional IRA is pre-tax, 75% of the money converted to a Roth IRA will be taxable. There’s no way to only convert after-tax money. If you converted $6,000, you’d owe income taxes on $4,500.

Who should consider it

Backdoor Roth IRAs only make sense for people earning over the income limit. If you’re below the income threshold, you can save yourself the effort and potential tax consequences of the backdoor Roth strategy by simply contributing directly to a Roth IRA.

If you’re above the income limit, creating a backdoor Roth IRA may be well worth the effort because Roth IRAs don’t have required minimum distributions. Accounts can grow tax-free for as long as you choose.

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