What to Do if Your Income Exceeds the Roth IRA Income Limits

Don't let Roth IRA income limits prevent you from getting into this tax-free retirement vehicle.

Jun 7, 2014 at 10:00AM

Making your retirement planning a priority puts you one step closer to ensuring a prosperous financial future. There exists no better retirement vehicle than a Roth IRA. But Roth IRA income limits prevent some individuals from directly funding a Roth. Here's what you need to do if your income exceeds those limits.

Getting around Roth IRA income limits
Roth IRA balances are growing at twice the rate as those of Traditional IRAs, according to the Employee Benefit Research Institute. It's no wonder they've have gained popularity. Roth IRAs allow after-tax contributions in exchange for the potential for tax-free income in retirement.

But not everyone can contribute. Roth IRA income limits prevent high-income earners from doing so. To open, directly fund, and fully contribute to a Roth IRA, your annual income needs to be less than $129,000 if you're single or $191,000 for a married couple.

If your income rises above these limits, don't fret. Everyone is eligible to convert tax-deferred IRAs (including traditional, SEP, or SIMPLE IRAs) to Roth IRAs through a "backdoor" method. My Foolish colleague Matthew Frankel recently laid out a quick guide to "backdoor" Roth IRAs. But before getting started, make sure you fully understand the benefits and considerations of conversions.

Benefits of converting to a Roth IRA

  • Converting allows for tax-free accumulation as well as tax-free withdrawal in retirement, meaning you don't have to worry as much about future income tax rates.
  • Unlike traditional IRAs, Roth IRAs have no required minimum distributions for the original account-holder.
  • You can withdraw the money you converted (but not any gains) penalty-free before age 59-1/2 (so long as a five-year holding period has been satisfied for each conversion).
  • You can create a tax-free legacy for your heirs.

Tax considerations
Your income tax liability on a conversion is based on the value of investments held in your IRA when you convert to a Roth. The amount you convert will be included in your taxable income in the year you convert. For example, imagine a married couple who expect to file jointly with $98,850 in taxable income in 2014. They could convert up to $50,000 to a Roth IRA and stay within their 25% tax bracket (which for 2014 is taxable income between $73,801 and $148,850). Converting any more than $50,000 would bump them into the next tax bracket. Look to the IRS tax brackets for more info. And keep in mind that converting your tax-deferred IRA to a Roth IRA isn't an all-or-nothing decision: You may consider converting only part of your IRA.

Decision factors
Several factors that may play into your decision to convert include:

  • Will you be able to afford the taxes due?
  • What is your tax rate now, and what is it expected to be in the future? A Roth conversion may be best for you if you'll be in a higher tax bracket later in life.
  • When do you need to make withdrawals?
  • Do you want to leave a tax-free IRA to your heirs?

Oops! Undoing your conversion
If you convert to a Roth IRA and later need to undo it, you can. For instance, if you convert and later discover you're in a higher tax bracket than you anticipated, your tax bill for the conversion may be more than you projected. If that happens, you can undo the conversion through what's called recharacterization. You can do this by telling the custodian or financial institution holding your Roth IRA to transfer the amount you want to recharacterize to a traditional IRA. If you do this by the tax-filing deadline, you can treat the contribution as made to the traditional IRA for that year, essentially ignoring the Roth IRA contribution..

Foolish takeaway
Familiarize yourself with the Roth IRA income limits. But don't worry if your income falls above them. The "backdoor" method is designed for folks like you. Just be sure the benefits of the Roth conversion outweigh your costs.

Take advantage of one more little-known tax "loophole"
Recent tax increases have affected nearly every American taxpayer. But with the right planning, you can take steps to take control of your taxes and potentially even lower your tax bill. In our brand-new special report "The IRS Is Daring You to Make This Investment Now!," you'll learn about the simple strategy to take advantage of a little-known IRS rule. Don't miss out on advice that could help you cut taxes for decades to come. Click here to learn more.

Follow Nicole Seghetti on Twitter: @NicoleSeghetti. 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.

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