Last update on: May 28 2020
By Bruce Miller
The previous articles in this series about Individual Retirement Accounts (IRAs) – quick guide article and quick guide Q & A — focused on describing fund sources you can use as contributions to Traditional IRAs (TIRAs), as well as differentiation and handling of those contributions from a federal tax standpoint. Now it is time to dive into a different type of a retirement account – a Roth IRA. Roth IRAs (RIRAs) are like TIRAs in the way the accounts are administered but the main difference is how these two types of accounts are taxed.
Unlike TIRAs, which investors usually fund with pre-tax dollars and pay taxes on the withdrawals during retirement, the RIRAs are funded only with after-tax dollars and the retirement withdrawals are tax-free. Here is a quick reference guide with additional considerations for Roth IRAs.
- Direct annual contributions to the RIRA must be in cash and made anytime between Jan. 1 of the contribution year and April 15 of the following year.
- Direct contributions that are delayed and made between Jan. 1 and April 15 of the following year must be designated for the previous year. The default year for the custodian is always the current year unless instructed otherwise by the IRA owner.
- Individuals are not allowed to contribute directly if their modified adjusted gross income (MAGI) exceeds $196,000 (married filing jointly) or $133,000 (single or head of household) for 2017. For 2018, the limits will rise to $199,000 and $135,000, respectively.
- If married filing separately, the ability to contribute to a RIRA begins phasing out immediately and is gone after a MAGI of $10,000. Thus, most who elect to file ‘Married Filing Separately’ may not contribute to their RIRA.
- The MAGI is the taxpayer’s AGI plus certain deductions taken just above the AGI (called “above the line” deductions) on the front of form 1040, including
- Deductible TIRA contribution
- Employer provided adoption expenses
- Student loan interest
- Foreign earned income
- Series EE bond interest excluded when used to pay for qualified education expenses
- Any qualified tuition taken as a deduction
- Foreign housing taken as a deduction
- After adding these deductions back, you must then SUBTRACT from this total any income from a Roth Conversion from a TIRA or employer retirement plan.
- It is noteworthy that deductible business-related expenses and contributions to one’s self-employment retirement plans “above the line” on form 1040 do not have to be added back to the AGI to obtain the modified AGI.
- A full contribution may be made if the taxpayer’s MAGI are less than $186,000 (married filing jointly) or $118,000 (single or head of household). For 2018, these amounts are $189,000 and $120,000, respectively.
- No contribution may be made if the IRA owner has a MAGI greater than $196,000 (married filing jointly) or $133,000 (single or head of household).
- A MAGI between these two limits will allow a proportional amount of one’s IRA contribution to be made to the RIRA. The remainder must be contributed to a TIRA.
- Conversion Contributions.
- Any amount may be converted from a TIRA to a RIRA for each individual who holds a TIRA.
- There is no AGI restriction for RIRA conversion.
- Prior to 2010, those with a MAGI over $100,000 could not do a RIRA conversion contribution.
- A “back-door” RIRA contribution for those whose MAGI exceeds the above maximums is a strategy by which the individual makes a non-deductible contribution to a TIRA and then promptly converts this to a RIRA. However, all TIRAs, SEP IRAs and SIMPLE IRAs, if any, must be considered for purposes of a RIRA conversion, meaning the “back-door” RIRA conversion contribution may involve including some or all of the conversion amount as income for that year. Thus, the “back-door” RIRA conversion works best when the IRA owner has little or no amounts in other non-ROTH IRAs.
- Direct RIRA conversions for employer retirement plans to the individual’s RIRA is also allowed, but the transfer must be direct between the employer plan and the RIRA custodian to avoid the 20% withholding the employer would be required to withhold and send to the IRS if the retirement plan distributes the conversion amount to the employee.
- Each conversion amount will not become part of the RIRA basis until 5 years have passed or until the IRA owner attains age 59.5, whichever comes first.
- A non-qualified Roth withdrawal that exceeds the RIRA direct contribution basis will be considered to have withdrawn the conversion basis, which will be any amount converted to the Roth during the previous five years – again assuming the IRA owner is not yet 59.5 – and will be subject to a 10% penalty, but not to taxation. The reason taxation is avoided is because the conversion basis already was taxed when converted..
- Following a RIRA conversion, the IRA owner may wish to undo the conversion, usually because the converted amount has lost value, yet the amount subject to taxation is the full conversion amount.
- Recharacterization must recharacterize both the base conversion amount PLUS any associated earnings or minus any associated losses.
- The best way is to convert the funds into a separately established RIRA and use it to hold the highest risk portion of your overall investment allocation. If the value declines, up until Oct. 15 of the next year, you can recharacterize this RIRA conversion back into the TIRA from whence it came originally and undo the tax liability of the conversion.
- The recharacterized amount may not be reconverted until the next year or – if recharacterized in December – may not be recharacterized for at least 30 days.
- Recharacterization of a RIRA conversion after one has filed a tax return will require filing an amended tax return, which must be done within 3 years of the recharacterization tax year.
Some of the RIRA rules – especially the conversion rules – are slightly more complex than we saw with TIRAs. Therefore, in my next article and before I move to the next topic of IRA investments, I will answer a few specific questions about RIRAs that I have encountered while dealing with real customers over the years. These questions and answers should provide more clear insights into how to handle some aspects of managing Roth IRAs.
Bruce Miller is a certified financial planner (CFP) who also is the author of Retirement Investing for INCOME ONLY: How to invest for reliable income in Retirement ONLY from Dividends and IRA Quick Reference Guide.