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Don't Let Roth IRA Income Limits Ruin Your Retirement

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A Roth IRA can give you the perfect opportunity to optimize your retirement savings strategy. But if you make too much money, then the IRS may not allow you to take advantage of that opportunity. These high-income taxpayers raise an obvious question: Is there any way around the Roth IRA income limits that the tax laws impose?

For many, the answer is yes. I'll explain in detail later in this article, but first, let's take a look at the income limits themselves and what exactly they stop you from doing.

Keeping a bottle on the Roth
IRAs have been around for a long time, but Roth IRAs are relatively new, having first become available just 15 years ago. When they were introduced in 1997, they were intended to give an additional incentive for people to save for retirement. In contrast to the way regular IRAs work, Roth IRAs don't give you an up-front tax deduction, but they provide completely tax-free growth and don't create tax liability when you withdraw your money in retirement.

But to prevent high-income taxpayers from using Roth IRAs to shelter huge amounts of retirement savings from tax for decades, Congress put limits on the ability for people to contribute to Roths. Specifically, if you file as a single person and make more than $125,000 in adjusted gross income for 2012, you're not eligible to contribute to a Roth at all. The corresponding figure for joint filers is $183,000. Moreover, even below those amounts, you're only entitled to a partial contribution if you make more than $110,000 as a single filer or $173,000 as a joint filer.

The sneaky way into a Roth
Still, there's a way for many high-income taxpayers to get into a Roth. It takes a bit more work, but it can lead to the same result.

Everyone is allowed to contribute to a traditional IRA, no matter how much money they make. The only question is whether you can deduct that contribution. If you aren't eligible to participate in a retirement plan like a 401(k) at work, then you can put money in a deductible IRA no matter how much you make.

So the strategy goes like this: Contribute to a regular IRA but then turn around and convert that IRA to a Roth. Because Congress took away the income limits for Roth conversions back in 2010, you can do that -- and if you do, then the added taxable income from the conversion will exactly offset the deduction from the regular IRA contribution, leaving you in exactly the same position you would've been in if you'd been allowed to contribute directly to a Roth.

Why it's worth the effort
That may seem like a lot to go through just to get money into a Roth. But consider the benefits:

  • Having a Roth means never having to worry about what tax rates will apply in future years. With the current fiscal cliff, that certainty is worth more than ever.
  • In particular, keeping certain stocks in a Roth has huge advantages over keeping them in taxable accounts. The obvious examples are mortgage REITs Annaly Capital (NYSE: NLY  ) , Chimera Investment (NYSE: CIM  ) , and American Capital Agency (Nasdaq: AGNC  ) , each of which yields well over 10%. With effective tax rates on their dividends set to move above 40% in 2013, the value of tax-free treatment will increase dramatically. The same is true for rural telecom stocks Frontier Communications (Nasdaq: FTR  ) and Windstream (Nasdaq: WIN  ) , both of which stand to lose preferential 15% maximum tax rates on their dividends if current tax laws are allowed to expire.
  • In retirement, Roth distributions don't add to your taxable income. That has huge implications for many things, including eligibility for benefits as well as taxation of Social Security and other income.

So if you've never looked at a Roth IRA because you figured that the income limits governing them were too strict, don't give up. With a little effort, having your own Roth could be just a few steps away.

High-yielding stocks like Frontier Communications can look very attractive for a Roth IRA, but is Frontier a buy right now? Find out in our premium report on Frontier, where we walk you through all of the key opportunities and threats facing the company. Better yet, you'll receive a full year of updates to boot. Click here to learn more.

Fool contributor Dan Caplinger has no positions in the stocks mentioned above. You can follow him on Twitter @DanCaplinger. The Motley Fool owns shares of Annaly Capital. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (13) | Recommend This Article (11)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On October 17, 2012, at 12:52 PM, BeefMcMann wrote:

    Keep in mind that other circumstances can keep you from contributing to an IRA other than AGI. I was an ex-pat in France for 5 years and my AGI was well below the Roth limits. However, with all the benefits and allowances I collected, my Modified AGI (MAGI) was way over the limit. I had to stop contributing for a while, even though my AGI was OK for a Roth IRA.

  • Report this Comment On October 17, 2012, at 1:26 PM, ouchtouch wrote:

    "Having a Roth means never having to worry about what tax rates will apply in future years" is a highly optimistic view considering that future Congresses will be hungry for cash and future rich folks with big Roth IRA's will be fair game. Always expect that Congress may grab back any loopholes it has created, especially for high net worth and high income people.

  • Report this Comment On October 17, 2012, at 1:33 PM, BxBruce007 wrote:

    "Everyone is allowed to contribute to a traditional IRA, no matter how much money they make."

    I don't think that's an accurate statement. I believe you must have earned income. If all of your income is from dividends and/or capital gains, for example, I do not believe you are eligible to contribute to an IRA. Am I wrong?

    And, even if you can't contribute to an IRA in 2012, would not having earned income prevent you from converting an existing IRA to a Roth? That seems like a complicated issue. Any insight?

  • Report this Comment On October 17, 2012, at 2:10 PM, bivio wrote:

    Interesting idea but it may not be quite this simple for everyone. First, while you can contribute to a traditional IRA, you may not be able to deduct the contribution if your income exceeds certain limits.

    And, if you have made deductible contributions in the past, you may owe tax on a conversion that is based on the total history of your contributions to traditional IRAs, not just the amount you are contributing this year.

    Your taxable percentage will be the total value of your traditional IRAs minus any non deductible contributions you made to them in the past, divided by the total value of your traditional IRA's.

    So there may still be taxes owed on the conversion.

  • Report this Comment On October 17, 2012, at 4:37 PM, DR1P wrote:

    Another way to contribute to a ROTH IRA is to contribute to a ROTH 401K and then roll it over when you leave that company. The company I work for doesn't do any matching and I always hear co-workers say "why would I want to contribute to the 401K, the company doesn't match". A matching amount of any size would be gravy, but I'm happy with at least getting my $17K plus $5500 (over 50) categorized as a ROTH each year. (I think those are the correct limits at this time)

    One thing you would want to ba aware of, however, is that if you have a foreign stock that pays dividends you might not want it in your IRA whether it is a regular or ROTH. Some countries (well, at least Canada) do not collect taxes on all dividends going into an IRA. If the foreign country does tax your dividends going into your IRA, the IRS will not allow you to deduct those taxes from your income taxes. Some Canadian dividends are tax exempt if going into an IRA and some aren't. You would have to contact the company's investor relations office and/or your broker to verify what the status is.

  • Report this Comment On October 17, 2012, at 5:18 PM, DeSisto07 wrote:

    Bivio is right on the money. I have been a CPA for 30 years and here's the simple explanation using real world numbers. If you have a $94,000 existing IRA with no basis (all contributions were deductible) and you contributed $6,000 to a N/D IRA and then convert that $6,000 to a Roth, you would have to include 94% of the $6,000 (since 94% of your total $100k of total IRAs has no basis)in your reportable income on the IRA line on page one of yor 1040.

  • Report this Comment On October 18, 2012, at 4:18 PM, Projectfool wrote:

    DeSisto07 is right on the money.

    Try this instead: make non-deductible (and therefore after-tax) contributions to a NEW or empty (such as one you fully converted in the past but left open) IRA acct and then immediately convert that amount into a new or existing Roth acct. No tax either way because you are contributing after tax dollars in the first place with full basis on the converted amount. I believe there is no income limitation on non-deductible IRA contributions, just the regular amount of the contribution ($6,000 currently).

    Doesn't that do the trick of neutralizing the income effect?

  • Report this Comment On October 19, 2012, at 2:29 PM, TMFGalagan wrote:

    @Bivio, DeSisto, you're right that it gets more complicated or unworkable if you both (1) can't deduct your IRA contribution and (2) have previous deductible IRAs. @Projectfool's idea doesn't work because the IRS aggregates *all* your IRAs, so you can't just open a new nondeductible one and argue you should be able to treat all of it as basis to avoid tax on the conversion.

    Another reader also pointed out that this method doesn't work if you're age 70 1/2 or older, because you're not allowed to contribute to a traditional IRA if you're above that age.

    best,

    dan (TMF Galagan)

  • Report this Comment On October 19, 2012, at 2:30 PM, TMFGalagan wrote:

    @BxBruce - Yes, if you don't have earned income, then you're not allowed to contribute to any sort of IRA.

    best,

    dan (TMF Galagan)

  • Report this Comment On October 23, 2012, at 5:41 PM, mkrezio wrote:

    I guess I'm missing something. This sounds like a one time deal. I already have a Roth, but soon won't be able to contribute due to the rules. In the future, each year I can just open a new IRA for $6k and roll it over? Or can I only do this once? If only once, I don't see the benefit.

  • Report this Comment On October 30, 2012, at 8:25 AM, TMFGalagan wrote:

    @mkrezio - Yes, it's something you can do each year, as long as they don't change the rules on us.

    best,

    dan (TMF Galagan)

  • Report this Comment On September 03, 2013, at 11:23 PM, jaredran wrote:

    What do you do if you participate in an employer-sponsored 401(k) and your income is over the deduction limit for a traditional IRA?

  • Report this Comment On October 31, 2013, at 11:33 PM, rcnigam wrote:

    Based on the current tax law situation, how would you change your advice from last year, given below:

    Last year you advised that keeping REITs (Annaly-NLY, Chimera-CIM, American-AGNC) in a Roth has huge advantages over keeping them in taxable accounts. You said, each of them yields well over 10%. With effective tax rates on their dividends set to move above 40% in 2013, the value of tax-free treatment will increase dramatically. You also said that rural telecom stocks Frontier-FTR  ) and Windstream-WIN , stand to lose preferential 15% maximum tax rates on their dividends if current tax laws are allowed to expire.

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Dan Caplinger
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Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.

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