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I No Longer Qualify for a Roth IRA, Now What?

So, you are interested in saving for your retirement, but you make too much to contribute to a Roth IRA. There are many rules surrounding this type of retirement account that limit who can use the account and how they can use it. The backdoor Roth IRA is a common solution that allows high earning investors to get post tax dollars into a Roth. They can also access all the benefits provided by such an account.

How does a Roth IRA work?

First things first, an individual retirement account (IRA) is a type of account that provides tax advantages for retirement savings. Traditional IRAs were created in 1974, and later the Roth IRA was introduced in 1997. Named after the legislations sponsor, Senator William Roth, the Roth IRA is an account that can contain a variety of post-tax investments. One common example is a Roth IRA that contains a portion of stocks and bonds purchased with post tax money that earns dividends. These do not need to be reported on a tax return. While there is no upfront advantage to putting money into this type of account, it is very popular because you can take all your investments and earnings out tax free.

There are plenty of rules that need to be followed in order to achieve these tax benefits, but generally you must wait to withdraw the funds until you turn 59½. Depending on your income now compared to what you expect it to be at retirement, a contributing post tax money might be worse than contributing to a pretax account. For more information on the pros and cons of the types of accounts read my blog

How to open a Roth IRA

There are many ways to open a retirement account, and it’s important to make an educated decision when doing so. If you are like me, deciding on how much to save each paycheck and figuring out your risk tolerance is as much work as you want to put into retirement saving. If you want to make trades yourself, you should look to open an account with minimal fees and low commissions as well as commission-free exchange traded funds. For hands off investors, you should consider opening a Roth IRA through one of the many companies that offer low fee robo-advisors. Robo-advisors offer a relatively cheap method of balancing your portfolio and helping you reach your goals.

When it comes to any professional, you get what you pay for. Opening your Roth IRA with the help of a certified financial planner will be key to personalizing your retirement investments to have the largest gains for your level of risk. Make sure to schedule a free financial consultation with our partner Centric advisors

Who qualifies for a Roth IRA?

Like a traditional IRA, a Roth IRA has income limits that determine who can contribute and how much. These limits are adjusted for inflation, and the most that can be contributed for tax years 2020 and 2021 is $6,000. The tax code allows for an additional $1,000 catch up contribution for taxpayers 50 and older for a total of $7,000. Your contribution may be limited if you or your spouse have a retirement plan at work. In order to qualify for the max contribution, single filers must have adjusted gross income (AGI) of less than $124,000 while married filers AGI must be below $196,000. While you might not qualify for the full $6,000, you may be able to contribute a reduced amount for single filers with AGI less than $139,000 and married filers with AGI less than $206,000. The amount of income reported affects your ability to contribute, but so does your type of income. In fact, you can only contribute to a Roth IRA if you or your spouse have earned income. So, what should you do if you earn too much to make these contributions? It is worth considering making “backdoor contributions”.

Backdoor Roth IRA

A backdoor Roth IRA is a strategy that high earning investors use to make post tax contributions through a series of steps. The first step is to deposit money into a traditional IRA even though you make too much to take a tax deduction on your tax return. Because the money you are contributing to a traditional IRA is post tax, you do not have to pay taxes on your earnings each year, but your earnings will be taxed when you take them out. If you do not already have a traditional IRA account, you will need to open one in order to fund it. Once your IRA is funded, you will need to convert the funds to a Roth IRA. This can be done indirectly by depositing the IRA funds into your account, and then depositing those funds into your Roth IRA within 60 days. Alternatively, the IRA can directly transfer the money directly to your Roth IRA. The final step in the backdoor Roth conversion is to pay taxes on any of your converted traditional IRA pretax dollars that you took as a tax deduction as well as any gains that your IRA recognized.

Reporting on your tax return

While you do not have to report Roth IRA contributions on your tax return, it is important to track the amount of your deposits minus withdrawals because this equals your basis. Any money you pull out of your account will first have to come from your basis and will not be taxable. It is possible to contribute more into a Roth IRA in a given tax year, and the law provides that these excess contributions are fixed or penalized. If you have contributed too much to a Roth IRA, you have until the due date of the return to withdraw the contributions and any earnings in order to avoid the 6% tax penalty. Even if you miss the filing deadline, it is important that you fix your excess contributions in order to avoid future penalties. As I mentioned, taking out basis contributions from your Roth IRA is not taxable, but earnings are taxed at your top tax bracket with an additional 10% early withdrawal penalty. You can avoid this penalty by withdrawing these funds by after age 59½ or through exceptions such as a first-time homebuyer distribution.

Austin Long
Tax Advisor, EA


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