How to Make Roth IRA Contributions No Matter Your Income

How to Make Roth IRA Contributions No Matter Your Income

Many Americans are under the false premise that if your income is above $214,000 in 2022 and are married and file jointly that you cannot make Roth IRA contributions.  This is 100% false thanks to a solution known as the “Backdoor Roth IRA” conversion strategy.  This article will detail the basics of the Roth IRA and then explain how the Backdoor Roth IRA conversion strategy works.

Key Points
  • It doesn’t matter how much you make, you can always get money into a Roth IRA
  • The main advantage of the Roth is tax-free income during retirement
  • If you have too much earned income on the year, you can always use the backdoor

What is a Roth IRA?

The Relief Act of 1997 introduced the Roth IRA. It is an after tax IRA which allows any US person with earned income under a set income threshold (Under $144,000 if single and $214,000 if married/filing jointly) to make after-tax contributions up to $6,000 or $7,000 if at least age 50 for 2022. Unlike a pretax or traditional IRA, Roth IRA contributions are not tax deductible. However, so long as the Roth IRA owner is above the age of 59 1/2 and the Roth IRA has been opened at least five years, all Roth IRA distributions would be tax free.

Also, with a Roth IRA there are no required minimum distributions (RMDs) at age 72 like a pretax traditional IRA. This means you are not forced to pull money from the plan. Instead, you can let it grow, in full, for as long as you want.

For example, if a 66-year-old bought a parcel of land in 2021 and wished to sell it in 2022 after twelve months for a gain, the gains would be subject to the capital gains tax rate of 15% (or 20% if the individual has income over approx. $496,000), plus a 3.8% net investment tax for individuals with modified adjusted gross income over $250,000.  Whereas, if the individual owned the land in a Roth IRA all gains would be tax free. Of course, you cannot distribute those funds until you meet the above criteria or face taxes and penalties.

There are three ways one can fund a Roth IRA: (1) contributions, (2) rollovers, and (3) conversions.

Roth IRA contributions

As referenced above, if you are under the annual income restrictions for the year, you may directly contribute to a Roth IRA. Again, you may directly contribute up to $6,000 in 2022, plus an additional $1,000 “catch-up” contribution if you are at least age 59 1/2. If your income exceeds the annual limit, you cannot make direct contributions to a Roth.

The Backdoor Roth IRA Conversion Strategy

Nevertheless, there is a legal workaround known as the “Backdoor Roth IRA” conversion strategy. Beginning in 2010, there is no longer any income limitations on conversions.  Prior to 2010, if you had income above $100,000, you were not able to perform a Roth conversion. However, due to the financial crisis of 2008 and 2009, the Treasury needed additional tax revenue and recognized the effect Roth IRA conversions could have.

When one converts a pretax IRA to Roth, tax is due on the fair market value of the cash or asset being converted.  Eliminating the income limitations for Roth IRA conversions accelerated the payment of tax on those IRAs which was a big help to the Treasury Department. The Build Back Better bill, that was proposed in September 2021, sought to reimpose income limitations on conversions. Thankfully, the bill never became law.

The Backdoor Roth IRA conversion strategy is essentially a conversion of after-tax IRA funds to Roth.  Unlike a true Roth conversion, after-tax funds are converted to Roth, which should generally not trigger any income tax. More on this below.

Even if you have $1 million of net income, you can still make a Roth IRA contribution.

How it Works

Because of the income restrictions, you are not allowed to contribute to a Roth. Additionally, you will not receive a tax deduction when making traditional contributions. Instead, you contribute after-tax dollars to a traditional plan. You can immediately convert that to Roth. Since there are no gains yet, you do not owe any additional taxes.

One important item to remember is that if the IRA owner has other pretax traditional IRA funds, you will be subject to some tax on the conversion. When you convert, you cannot choose to only convert the after-tax contribution you made. Instead, you have to consider all IRA funds, both after-tax and pretax. The after-tax total will not be taxed again, however, the pretax portion will be subject to taxes. This is known as the backdoor Roth IRA pro rata formula.

For example, if you have $5,000 in pretax funds in your IRA, and contribute an additional $5,000 in after-tax funds, 50% of your conversion would be taxable since half of your IRA is pretax and half is after-tax. In the same scenario, if you have $10,000 in pretax IRA funds, 67% of the amount converted would be subject to tax.

Timing is Key

One last thing to consider is the timing of the Backdoor Roth IRA conversion. Assuming you do not have any pretax IRA funds, you must convert your after-tax contribution immediately to avoid further taxes. This is because earnings generated in your IRA would be subject to tax when you convert. Only the contributions are not taxable.

For example, your $6,000 contribution sitting in your traditional IRA grows to $7,500. That $1,500 in growth would be subject to tax when you decide to convert. Therefore, whenever you make after-tax contributions to an IRA, you want to convert it to Roth immediately, to avoid paying taxes twice.

Related: Can I still do a Backdoor Roth IRA in 2022?

Transfers and Rollovers

Roth IRA transfers and Roth 401(k) rollovers are popular ways to fund a Roth IRA.  Direct transfers between Roth IRAs can occur whenever you want, as many times as you want. You may do this if you want to switch IRA custodians. Maybe you wish to self-direct your Roth to invest in alternative assets, which your current provider does not allow.

In the case of a Roth 401(k) rollover, you will generally need to satisfy a plan triggering even to gain access to the plan funds for rollover purposes. Essentially, you need to reach age 59 1/2, separate from your employer or the plan gets terminated. Once a triggering event occurs, you can then choose to roll over your Roth 401(k) funds into a Roth IRA.

Conversions

This was touched on earlier with the Backdoor Roth strategy, however, anyone can convert traditional retirement funds to Roth. If you have a traditional IRA, you can convert any or all of it whenever you want. The conversion is treated as taxable income and income tax will be due when you file your return the following year.

Further, you can convert traditional 401(k) funds to a Roth IRA as well. You still need a triggering event to access those funds, and taxes will be due on the amount converted.

Related: Avoid These Costly Roth Conversion Mistakes

Conclusion

In 2022, anyone with income, irrespective of their income level can get money into a Roth IRA.  For most people, a direct contribution or conversion are the most prevalent ways to fund a Roth. Those with income above the annual threshold can utilize the “backdoor” to fund a Roth.

You must keep in mind that taxes will be due for most people on the amount converted. Lastly, remember the pro rata rule if performing a Backdoor Roth conversion – you will owe taxes, too.

Depending on your age, the ability to pay the tax and long-term investment expectations, Roth IRA conversions can be a popular retirement tax planning tool as a means of locking in tax-free gains. Plus, the younger you are, the more time you have to take advantage.

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