Retirement accounts are on their face a simple topic. Put in money you can’t touch until retirement, get a tax benefit. Like most matters in the tax code they are rarely that simple, particularly for higher income individuals. There are a web of phase-outs, catch-up contributions, joint and individual limits, and different titling options that can lead to confusion and sub-optimal behavior, especially as one’s income increases. This guide is for those who earn above the phase-out limits for a Roth IRA, but who still wish to take advantage of tax-free investment growth for the rest of their lives. As you dive in, we also recommend reading the second post in this series “Potential Issues When Converting to a Roth” prior to completing a Roth conversion.
A Roth conversion is the result of two transactions: a contribution to a Traditional IRA, followed by the conversion of that Traditional IRA into a Roth IRA.
Unlike Roth IRAs, the income limits for contributing to a Traditional IRA only limit whether your contributions are tax deductible, and only go into effect if you have a workplace retirement plan. Therefore, if one’s income exceeds the phase-out limit for contributing to a Roth IRA, one could make a non-deductible Traditional IRA contribution, then convert the Traditional IRA to a Roth IRA. In this scenario, the Roth conversion allows you to move money into a Roth IRA despite earning above the Roth phase-out limit.
For tax year 2023 the phase-out income limits for a Roth IRA begin at $138,000 for single filers, and $218,000 for joint filers. Meaning if you earn above that number, you may be unable to contribute to a Roth directly. Pro tip: if you file married filing separately then speak to your advisor regarding whether you are eligible to be considered unmarried for tax purposes.
You may make retroactive contributions for the prior tax year into an IRA up to the tax deadline without extension, which is April 18th in 2023.
For the 2023 tax year, the contribution limit is $6,500; if you are over the age of 50 you can make an additional $1,000 “catch-up” contribution. Beginning in tax year 2024 the catch-up amount will be indexed for inflation. Individuals aged 60-64 will be eligible for a $10,000 catch-up contribution, indexed for inflation, beginning in 2025.
Converting a Traditional IRA to a Roth IRA will trigger a tax liability on gains and pre-tax contributions. This means that you will not receive an extra tax bill when converting a fully post-tax IRA with no gains if it is your only IRA. You also do not need to limit your conversion amount to the annual contribution limits. If you have made non-deductible contributions for a series of years, you can convert the entire sum in a single year.
Check if you have any SEP ,SIMPLE, or Traditional IRA accounts with deductible balances before performing any conversion. These must be eliminated prior to December 31 of the year in which you perform the Roth conversion, otherwise a rule called the pro-rata rule goes into effect, resulting in taxation. For more details on the pro-rata rule, see our post “Potential Issues when Converting to a Roth”.
This part is easy, make a non-deductible contribution up to your limit into an account separate from any account which has held pre-tax contributions.
Due to a tax doctrine called “The Step-Transaction Doctrine” it is recommended you wait at least one statement period before converting a non-deductible IRA into a Roth. For more details see our separate post “Potential Issues when Converting to a Roth”.
Once you have successfully confirmed that you won’t have any money in a Traditional IRA by December 31, made your non-deductible contribution, and waited at least one statement period, you can log into your brokerage account and elect to convert your non-deductible IRA contributions into a Roth IRA. Be aware that any gains made while inside the traditional IRA will be taxable for the year of the conversion.
If you can’t get enough of Roth accounts, in some cases you can perform larger tax-free Roth conversions. A minority of 401K plans permit you to make after-tax contributions after hitting your 401K contribution limit which can then be used for an in-plan conversion to a Roth 401K. Using this strategy an individual over 50 can contribute up to $67,500 to a Roth IRA in 2022 in addition to using a non-deductible IRA conversion for a total of $74,500.
Access to this strategy will entirely depend on your 401K plan documents, and many 401Ks do not offer this option. Please contact your financial advisor if you would like them to investigate your 401K plan to determine if you would be eligible for larger Roth conversions.
It should be noted that in-plan Roth 401K conversions were slated to be banned for higher income Americans by the Build Back Better Act, H.R 5376 of 2022. That legislation has languished in the senate after being passed by the House of Representatives, and at this time has slim prospects of passing. This is an area likely to be subject to future regulation, so be sure to consult your financial advisor before attempting to execute one of these transactions.
Disclaimer
Transactions involving IRAs can be complex, and if done improperly can result in significant tax liability, interest, and penalties. They are also an area which is subject to significant regulatory change. This article provides information which is accurate as of the date of its last update. We recommend consulting with an advisor or tax professional prior to performing any transaction involving rollovers, conversions, or non-deductible contributions.
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Effective September 8th, 2022
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