How High-Income Earners Can Make Roth IRA Contributions

For many retirees, taxes comprise one of the largest expenses they face after they stop working. Managing your tax situation and using a tax efficient withdrawal strategy is important to maximizing your investment portfolio. A key component to this is having money in a Roth IRA. Distributions from a Roth IRA are tax-free (so long as you are over 59.5 and the money has been in the account for at least 5 years). But how do you get money into a Roth IRA during your working years if you earn too much money and don’t qualify?

Here’s the strategy:

First, make a contribution to a Traditional IRA. Individuals filing single with modified adjusted gross income of $64,000 or less and individuals filing jointly with income of up to $103,000 can deduct their full contribution for the 2019 tax year. Deductions thereafter decrease and phase out completely once income reaches $74,000 for single filers and $123,000 for joint filers. If your income is above these amounts the IRS will still allow you to make a contribution, but you won’t get a deduction. Effectively, you make a non-deductible contribution to your Traditional IRA. Then, convert the Traditional IRA to a Roth IRA. This ultimately accomplishes the goal of funding the Roth IRA without making a direct contribution to a Roth IRA.

Here are two important things to consider when using this strategy:

1. Aggregation Rules – IRC Section 408(d)(2):  Typically, when you convert money from a Traditional IRA to a Roth IRA, you must pay taxes on the amount you convert. In this strategy, you are converting non-deductible contributions (contributions you already paid tax on) so no taxes are due at the time of conversion or when you withdraw the amount from your Roth IRA in the future. However, if you have pre-tax contributions in any Traditional IRA, that money will be subject to the Aggregation Rule. The IRS will aggregate those contributions with your non-deductible contributions, thereby making part of your conversion taxable. In order to bypass the Aggregation Rule, avoid commingling pre-tax contributions in your Traditional IRA with after-tax (i.e. non-deductible) contributions. Essentially, this means you don’t want to have any pre-tax money in a Traditional IRA. In addition, the IRS will look at ALL your Traditional IRA accounts as one bucket of money. This means you can’t convert just the after-tax portion on its own. If you have pre-tax money in a Traditional IRA and you have a 401k available to you through your employer, you can roll this pre-tax amount into your 401k without incurring a tax liability.

2. Step Transaction Doctrine:  Doing these steps individually is acceptable. However, the Step Transaction Doctrine allows the IRS to view separate transactions done in rapid succession as a single tax event and treat them as such. There is a risk that the IRS could view the transactions as an attempt to make a non-permissible Roth IRA contribution and disallow it. How do you avoid this? Don’t contribute to a non-deductible IRA and then immediately convert to a Roth IRA. Give it some time to season. How much time is appropriate? Consider waiting 6-12 months to convert the non-deductible piece. You might also want to invest the contribution immediately and then convert 6-12 months later.

As you can see, there are many important details to take into consideration when deciding whether to utilize this strategy. For a more in-depth analysis of whether this makes sense for you please give our office a call and we will be happy to work through it with you.