Roth IRAs are popular retirement savings vehicles, mainly due to their potential to deliver tax-free distributions. Individuals may fund a Roth IRA by making a direct contribution, converting funds from a traditional IRA or completing a rollover or conversion from an employer-sponsored retirement plan. Whether a Roth IRA makes sense for you and how to fund it are two questions that require careful consideration and an understanding of your financial condition and retirement savings objectives.
In general, you can make a 2020 contribution of up to $6,000 annually to an IRA—traditional, Roth or a combination of the two. If you’re over age 50, you may make an additional $1,000 “catch-up” contribution. However, your ability to make an annual contribution to a Roth IRA may be limited or eliminated, depending on your income. The phase-out of Roth contributions is based on individuals’ Modified Adjusted Gross Income, or MAGI, as shown below:
As the chart demonstrates, higher-income earners are eventually phased out of qualifying to contribute to a Roth IRA. But there is a workaround for those folks—namely, a Roth conversion. Regardless of your filing status or how much you earn, you can convert all or a portion of a traditional IRA to a Roth IRA. You might owe income tax upon the conversion, so consult on the advisability of conversion with your accountant or financial planner before implementing this strategy. The timing and amount of your conversions can play an important role in your retirement and tax planning.
What if you don’t have a traditional IRA?
You can still benefit from a Roth conversion by first establishing a traditional IRA and making a non-deductible contribution, then immediately converting the after-tax funds to a Roth. In this scenario, no income tax is due on the conversion. This unique planning strategy is known as a “back door” Roth IRA.
In addition to a direct contribution or a conversion from a traditional IRA, you can fund a Roth IRA by converting or rolling over funds from an employer-sponsored plan, such as a 401(k). This is typically reserved for those who have severed employment with a company, as often plan rules do not allow for in-service rollovers or distributions. If there are amounts held in a Roth employer plan account, those funds may be rolled directly to a Roth IRA. Or you may convert pre-tax employer plan assets to a Roth IRA; like a traditional IRA conversion, any pre-tax amounts converted will be subject to income tax in the year of the conversion.
Is a Roth IRA right for you?
It depends on several factors, including your current and projected future income tax rates, the length of time you can leave the funds in the Roth IRA without taking withdrawals, your state’s tax laws and how you’ll pay the income taxes due at the time of the conversion. Given the complexity of the rules surrounding Roth IRAs and the individual nature of one’s situation, it is wise to enlist the help of a qualified financial planner and tax advisor to figure out the best plan for you.
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