Having money in a Roth IRA can be very beneficial. After all, no one ever complains about being able to draw out tax-free money. Getting enough money in a Roth IRA, however, is another story. Currently, the limit for a contribution is still at $6,000 for anyone under 50 years of age who has earned income, or $7,000 for those over 50 years old.
However, if you make too much money during the year, you won't be able to contribute to a Roth IRA at all. Currently for 2022, a single filer with a (MAGI) of $144,000 or more, or $214,ooo or more for someone married filing jointly, cannot contribute to a Roth IRA.
For those who run into this problem, there is the option of a backdoor contribution explained here in a previous blog. If you don't have a traditional IRA at all, then this option will work great. However, if you have a traditional IRA with pre-tax dollars already existing in the account, the conversion doesn't work out as well since the conversion won't be tax-free.
How so?
Let's say you either made too much money to contribute to your Roth IRA directly, and decide to contribute to your traditional IRA, or you contributed to your Traditional IRA, but made too much to get the tax deduction. You now have non-deductible, after-tax dollars in your Traditional IRA. That is ok, it just needs to be tracked year to year on your tax return. That's because you don't want to pay tax on those dollars when you take a withdrawal later in life, since you already did.
Let's also say since you ultimately want that money in your Roth IRA, you elect to convert a portion of your Traditional IRA over to your Roth IRA. This is perfectly acceptable. But if you already have pre-tax contributions within your traditional IRA, the conversion will not be tax free.
Let's say you have $45,000 in pre-tax dollars within your traditional IRA, and then contribute $5,000 as a non-deductible contribution within the account since your income was too high this year. To take advantage of those after-tax dollars growing tax free in a Roth, you decide to convert $5,000 over from your traditional IRA to your Roth.
Pro-rata rule
While it would be amazing, and even sounds logical to be able to transfer the $5,000 over tax-free to the Roth IRA, it is not possible. The pro-rata rule the IRS has in place does not allow you to "cherry pick" your contributions you can convert. They make you "prorate" the amount of your conversion based on the percentage of your non-deductible IRA contributions to the amount of pre-tax contributions.
So in our example, your account is now worth $50,000. You convert $5,000 over to the Roth IRA. However, since 10% of $50,000 is $5,000, only 10% of the conversion will be tax-free. Come tax time, you will owe tax on $4,500, and only $500 will be tax-free. The remaining amount in the traditional IRA of $45,000 has a non-deductible basis of $4,500, or 10% of the balance.
Understanding these rules and tax implications are crucial when making decisions on which account to contribute to and how to get it there. Consequently, since a portion of these conversions also add to your taxable income, they can possibly send you into a higher tax bracket. The whole idea is to try and pay as little tax on these distributions and conversions as possible.
Before contributing to your IRA, either a Roth or Traditional, make sure you understand the benefits -- or perhaps at times, the drawbacks, of doing so. It's always beneficial to invest your money for your future self in these retirement accounts, but at times you may not get the full tax benefit you thought you might receive.
Content in this material is for general information only and is not intended to provide specific advice or recommendations for any individual. Our investment philosophy takes a forward-looking approach that may not transpire. The economic forecasts set forth may not develop as predicted and there can be no guarantee that strategies promoted will be successful. Investing involves risk and you may lose your principal.
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