Can I put money into a Roth IRA?

Roth IRAs are getting to be more and more popular, and for good reason.  We have no certain knowledge about future tax rates, but it seems quite likely that they've no place to go but up.  With a Roth IRA, you pay taxes now on the money that goes in, and in the future, that money -- and whatever it's grown to -- comes out tax free.

But wait, there's more!  Unlike traditional IRAs or other pre-tax employer-based retirement plans, there are no Required Minimum Distributions from a Roth IRA.  Once you turn 70-1/2, you must start taking money out of traditional IRAs -- and paying taxes on those distributions.  But since the government gets no taxes from Roth IRA distributions, the government has less incentive to require you to take those distributions.

And Roths are great for estate planning, too!

We're convinced.  Roth IRAs are great.  So how much money can you put into a Roth IRA, and who can put money into one?

First, how much?  If you are contributing directly to an IRA and/or a Roth IRA, your annual direct contributions to them may be no more than (a) your earned income and (b) $5000 per year (or $6000 if you are over age 50, and they call that extra $1000 a "catch-up" contribution).  We'll get to the income limits in a moment, but regardless of those income limits, and assuming your earned income is enough, that maximum total applies to the combination of contributions to both a traditional IRA and a Roth IRA.  You may put, say, $3000 in the Roth and $2000 into the traditional, but you could not put $5000 into each of them.

So who can contribute?  Nowadays, pretty much everyone can, though it's not always obvious how, exactly, one would go about doing it due to some income limits and possible conversion tax implications.

Regular, simple, direct contributions are the easy path.  If your Adjusted Gross Income (AGI) is below a certain threshold, and you (and/or your spouse) have earned income (ie. wages rather than investment income), you may simply contribute directly to a Roth IRA.  If you are married filing jointly, and your AGI is below $167,000 (in 2010), you may contribute the full $5000 ($6000 if you are over 50) directly to a Roth IRA.  If you are single, and your income is below $105,000, you may contribute the full $5000 (or $6000) directly to a Roth IRA.  If your income is above those levels, there is a phaseout range which reduces the amount you may put into a Roth IRA, and if your AGI is above $177,000/$120,000, you may not contribute directly to a Roth IRA at all.

So what if you do have income above those limits?  Until 2010, you were out of luck.  At of the beginning of 2010, the rules changed.  There is another way to get money into a Roth IRA now.  You may not be able to contribute directly to the Roth IRA, but now you may make a traditional-to-Roth IRA conversion. Until 2010, conversions were also not allowed if your AGI was above $100,000 but that limit is now gone.  Anyone with a traditional IRA may now convert all or part of it to a Roth IRA.  So here's the trick - if your income is above the direct-contribution limits for Roth IRAs, you may make a direct contribution to a traditional IRA and then immediately convert that amount from the traditional to the Roth IRA.

So what's the catch?  Naturally, there's a catch.  It has to do with the way conversion may be taxed.  If you already have assets in a traditional IRA, when you convert that balance to a Roth IRA, you may have to pay income taxes on some or all of the amount converted.  How much of the conversion will be taxable depends on how much money is in the traditional IRA (and that means the sum of all traditional IRA accounts you have, not the amount in that particular account from which you make the conversion) and how much or whether you deducted those contributions on your income taxes in the years in which you made the contributions.  This may appear a little bit messy, so we'll use an example with some made-up numbers to help clarify.

Suppose you made deductible contributions to a traditional IRA for several years, perhaps when you were a bit younger and were making less and were able to deduct them.  Over the course of several years, between the deductible contributions you made, plus the growth of the investments, you now have $20,000 in that traditional IRA.

If you convert any of that IRA to a Roth IRA, the entirety of the conversion will be taxable income.  In other words, if you converted $10,000 of the $20,000 balance, you'll owe income taxes on that $10,000.  You'll end up with a traditional IRA with $10,000, a Roth IRA with $10,000 and, hopefully you paid the taxes with money you had outside the IRA.  You almost certainly do not want to have to cash out any of the IRAs to pay those taxes.

Now let's return to the person who currently makes too much to contribute directly to a Roth IRA.  We'll start with the same situation - you've got $20,000 in a traditional IRA which was funded entirely with deductible contributions.  That means if you convert even $1 from that IRA to a Roth IRA, you'll owe taxes on the amount converted.  If you make a $5000 non-deductible current contribution to that traditional IRA, you now have a traditional IRA with a balance of $25,000 and a $5000 "basis".  Basis here refers to the amount in the account on which you've already paid taxes.  If you then wanted to convert $5000 from that traditional IRA to a Roth IRA, the rules require you to prorate the basis in the conversion.  This is the catch.  You cannot convert only the $5000 you've just added. Any amount you convert will be proportionally considered to be existing  money in the IRA plus the non-deductible amount you've just added.  And this happens even if the new contributions are  made to a new account.  Your IRA and its basis applies across all of your IRA accounts.  You cannot isolate it by having a separate account.

So in this case, to recap, you have $20,000 in the traditional IRA, which was funded with regular deductible contributions.  You add $5000 now, as a non-deductible contribution.  Now you have $25,000 in the traditional IRA with a basis of $5000.  You convert $5000 to a Roth IRA.  Since the proportions in the traditional IRA had you at $5000/$25,000 of it in after-tax money, 1/5 of the conversion is considered to be conversion of after-tax money and 4/5 of the conversion is taxable.  After the $5000 conversion, you now have a traditional IRA worth $20,000 with a $4000 basis, a $5000 Roth IRA -- and you owe income taxes on $4000.  I'll repeat that last bit:  you owe income taxes on $4000 -- because 4/5 of the conversion was deemed to have come from the part of the traditional IRA on which you'd never before paid taxes.

So how can this be useful to someone who currently earns too much to contribute to a Roth IRA but wants to use conversions to make it happen?  If you do not already have an IRA which was funded with pre-tax money, then you can make the conversion with no new taxes due.  In the example immediately above, the problem was that the person already had made deductible contributions to a traditional IRA.

If your only existing retirement accounts are employer retirement plans like a 401(k) or 403(b) or a qualified profit-sharing plan, and you have no existing traditional IRA at all, you've got an opportunity to get money into a Roth IRA without paying any taxes on the conversion.  The trick is that you have to first open up a traditional IRA account.  If you make a non-deductible contribution to a traditional IRA account and you do not already have any money in a traditional IRA account, your basis is exactly equal to the amount you contributed.  So it looks like this:  you have no traditional IRA at all.  You open the traditional IRA and make a non-deductible $5000 contribution.  You now have a traditional IRA worth $5000, with a basis of $5000.  Now you convert $5000 to a Roth IRA.  100% of the conversion is a conversion of money you've already paid income taxes on (because it was a non-deductible contribution).  After the conversion, you have $zero in the traditional IRA (and zero basis, because you converted the entire thing), and you have a Roth IRA with $5000, and you owe no new additional taxes.  You do not get to take any tax deductions -- your traditional IRA contribution was non-deductible.  But in the future, any distributions from that Roth IRA after you retire will be tax-free.

As you can see, by keeping the income-limit for direct contributions to Roth IRAs, but allowing conversions for anyone, the government has made it possible for high-income folks to put money into a Roth IRA -- but potentially with a substantial tax on the conversion if they already have IRAs.  For folks who don't already have substantial traditional IRAs, it's a great opportunity to fund Roth IRAs without any additional taxes.  For folks who do already have substantial traditional IRAs, though it's a much more complex decision as to whether it's worth paying taxes on the conversions.


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