Contributing to both a Roth IRA and an employer-sponsored retirement plan, such as a 401(k) or 403(b), produces an effective way to boost your retirement savings. In fact, the 401(k) contributions will lower your modified adjusted gross income — or MAGI — which might simplify the process for your nondeductible Roth contributions. The bottom line: Your 401(k) participation gives you tax savings now and your Roth account serves up tax-free distributions in retirement.
The IRS sets the maximum you can contribute to a Roth IRA each year. For example, in 2012, that limit was set at $5,000 or the total of your earned income, whichever is lower. If you're 50 or older, you can contribute an additional $1,000 catch-up contribution as long as you keep the total under your earned income: wages, tips, self-employment income and alimony. The IRS also sets 401(k) contribution limits — $17,000 in 2012, plus an additional $5,500 if you've over 50. Your total 401(k) plus Roth contributions for 2012 could be $22,000, plus $6,500 more in catch-up if you qualify.
The IRS sets annual MAGI limits restricting Roth contributions, too. But remember, every dollar you or your spouse contribute to your retirement plan at work is subtracted from your MAGI. For 2012, your MAGI must be less than $110,000, or less than $173,000 for couples filing jointly, to allow a full Roth contribution. If your income exceeds $125,000 or more than $183,000 for couples, you cannot make any direct contribution to a Roth.
If your income falls between the two levels, you can make a proportionate contribution. To determine your contribution percentage, subtract your MAGI from the disqualifying limit. Divide that result by $15,000 if you're single, or by $10,000 if you're filing jointly. Multiply your contribution percentage by your maximum contribution. For example, if you're under 50 and single with $112,375 MAGI, the numbers in the formula would look like this: (125,000-112,375)/15,000=84.17 percent. Your maximum contribution is 84.17 percent of $5,000 or $4,208.
Contribute And Convert
If your income exceeds the income limit, there's a backdoor path to a full contribution. With no income limits on after-tax traditional IRA contributions and no income restrictions for converting an IRA to a Roth, you can make a nondeductible contribution to a regular IRA, then convert it immediately to a Roth. If the after-tax contribution stands as your only IRA asset, the conversion will be tax-free.
The contribute-and-convert strategy gets more complex if you have deductible contributions or tax-deferred earnings in any IRA account registered with your Social Security number. The IRS doesn't allow you to isolate only your after-tax contributions for a conversion or permit you to create a stand-alone IRA simply to pass through conversions. The tax-free proportion of the conversion equals the percentage of nondeductible contributions in the total balance for all your IRA accounts. So, if you have $100,000 in all your IRAs and only $5,000 in after-tax contributions, then 95 percent of any conversion would be treated as taxable income.
If IRA assets comprised solely by a rollover from a previous employer's retirement plan scuttle your game plan for a tax-free, backdoor Roth contribution, there's a workaround. If your current employer-sponsored plan allows it, transfer that rollover IRA into your current company plan. Because assets in such plans as a 401(k) are not considered IRAs, reversing the rollover clears the path for a tax-free contribute-and-convert Roth strategy.
Although you can wait until April 15 to make any IRA contribution, conversions must be completed by Dec. 31 to be included on the same year's tax return. If you wait until after Dec. 31 to execute a contribute-and-convert strategy — on March 29, 2013, for example — the contribution could be for 2012. However, the conversion would be reported on your 2013 return with no tax liability. File Form 8606 with your return to report after-tax contributions.
- Internal Revenue Service: Publication 590, Individual Retirement Arrangements (IRAs)
- IRS: IRA Deduction Limits
- Tax Guide for Investors: Basic Rules for Regular Contributions
- Morningstar: Backdoor Roth IRAs Could Cost Some Investors at Tax Time
- Morningstar: The Ins and Outs of IRAs -- Income and Contribution Limits
Dale Bye has spent more than 40 years in journalism, including 25 supervising reporters and editors at metropolitan newspapers and eight years as senior managing editor at a national sports magazine. He directed five newspaper-sponsored personal finance fairs. His fields of expertise include business and personal finance, sports, fitness and theater. Bye holds a Bachelor of Journalism from the University of Missouri.