Many people love the idea of putting money in a Roth IRA, but they also want to make more money. Unfortunately, these two things can sometimes be mutually exclusive. Because of IRS restrictions, Roth IRA contributions are not allowed once you've reached a certain income threshold.
Roth IRA Income Thresholds
In 2017, for people who are single or file separately:
- If your income is below $118,000, you can make a full Roth IRA contribution ($5,500, plus $1,000 catch-up if over age 50)
- If your income is between $118,000 to $133,000, you can make a partial Roth IRA contribution based on your income.
- If your income is above $133,000, you are ineligible to make a Roth IRA contribution
For people who are married and file taxes jointly:
- If your income is below $186,000, you can make a full Roth IRA contribution.
- If your income is between $186,000 and $196,000, you can make a partial Roth IRA contribution based on your income.
- If your income is above $196,000, you are ineligible to make a contribution.
So if you're single, you can increase your income limits by hurrying up and getting married. Or, if a Roth IRA-based marriage isn't your thing, here are three other options for contributing to a Roth IRA when your income is too high. (For related reading, see: The Basics of Roth IRA Contribution Rules.)
1. Reduce Your Adjusted Gross Income (AGI)
Your adjusted growth income (AGI) is your income after specific deductions, including 401(k) and IRA contributions. If your AGI is nearing Roth IRA phaseout limits, then simply saving more to your 401(k) could have the added benefit of making you eligible for Roth IRA contributions.
For example, if you’re single and your annual income is $135,000, ordinarily you would be ineligible to put any money into your Roth IRA. However, if you max out your 401(k) at $18,000 for the year, your AGI (excluding any other potential deductions) drops to $117,000. Now you are eligible for a full contribution to your Roth IRA.
But maybe you make a lot more than the Roth IRA exclusion limit and no amount of 401(k) deductions are going to save you. There are still other options.
2. Contribute to a Roth 401(k)
Not every employer offers a Roth 401(k), but for those that do, it can be a great tool. A Roth 401(k) offers many of the same benefits as a traditional 401(k). The difference is deferrals to a traditional 401(k) avoid any federal or state taxes, whereas deferrals to a Roth 401(k) do not.
The benefit of contributing to a Roth 401(k) is there are no income limits to doing so. So unlike Roth IRA contributions that are capped by certain income limits, you can earn as much as you’d like and still contribute to a Roth 401(k). Here’s an added benefit: IRAs limit you to $5,500 per year plus $1,000 for catch-up contributions; with a Roth 401(k), you can contribute up to $18,000 per year plus an additional $6,000 for catch-up contributions if you’re over age 50. That can add up to a lot of tax-free money for retirement!
Keep in mind a couple things when you’re considering making contributions to a Roth 401(k). First, if you’re considering Roth 401(k) contributions because you make too much for a Roth IRA, then chances are you’re in a high tax bracket. That means you may want to consider contributing at least some of your income to the traditional 401(k) based on the tax savings it offers. Second, even if you make contributions to your Roth 401(k), any matching contributions from your employer will still be put into a traditional 401(k), not your Roth 401(k). (For related reading, see: A Closer Look at the Roth 401(k).)
3. The Backdoor Roth IRA Option
The backdoor Roth IRA concept emerged in 2010 when Congress made it possible for all people to convert their IRAs to Roth IRAs regardless of their income. There are many details and nuances to this strategy, but put simply it looks like this: If you make too much money to contribute to a Roth IRA, put it in a traditional IRA instead. The income limits that apply to Roth IRAs don’t apply to IRAs. Meaning even if you make $10 million per year you can still put money into your IRA.
You might not be able to deduct this IRA contribution on your taxes, but you can make the contribution nonetheless. If you’re unable to deduct the IRA contribution, it is considered “basis.” You then convert this basis to your Roth IRA, and because it’s already after-tax money you don’t owe any additional taxes on the conversion.
When you use the backdoor Roth conversion, the IRS aggregates the value of any other IRAs, SEP IRAs, and SIMPLE IRAs you have. They do this to help calculate the portion of the conversion that might be subject to taxes. If it’s only basis you’re converting to your Roth IRA, you don’t owe any taxes. But once you start converting pretax portions of your IRA, you become subject to taxes.
Say, for example, you have an old IRA from years ago and it’s worth $15,000. Then you set up a new IRA and make a non-deductible $5,000 contribution that you immediately convert to your Roth IRA because you’re a genius and you know the rules of the system. You would think the $5,000 would go into your Roth IRA tax-free while the $15,000 stayed in a pre-tax IRA, right? The IRS thinks otherwise. The IRS aggregates the value of all of your IRAs, which means they would view the conversion like this:
You have a total IRA value of $20,000. It doesn’t matter that they’re in separate accounts, and $5,000 of that $20,000 is after-tax basis. So 25% is after-tax basis and 75% is pre-tax. You then convert $5,000 of your total IRA to a Roth IRA; 25% of this will be tax-free and 75% will be taxable. What this means for you is $1,250 of that conversion will work out exactly like you planned, but the remaining $3,750 will be subject to federal and state taxes. (For related reading, see: Is a Backdoor Roth Suitable for You?)
The best way around this is to transfer all pretax IRA money into your 401(k) plan if you have that option. Completing a backdoor Roth IRA is a complex strategy and there are a lot of rules around it, but if done properly, it could help you save a tremendous amount in taxes over time!
Is a Roth IRA Right For You?
With the benefit of tax-free growth, the option of accessing Roth IRA contributions prior to age 59.5, and the control it provides, A Roth IRA can be a wonderful investment tool. And with the strategies we’ve covered above, the Roth IRA may be available for many people who don’t even know it. (For related reading see: 5 Secrets You Didn't Know About Roth IRAs.)