What Happens When Your Income Exceeds Limits for a Roth IRA?
Roth Individual Retirement Accounts are tax-deferred investment accounts that allow you to make non-taxable withdrawals during your retirement years. Contributions to Roth IRAs are subject to income limits and if your income exceeds acceptable levels then your contributions are subject to tax penalties. However, you can take prompt action to avoid these penalties and there are also ways to fund a Roth despite your high level of income.
You fund a Roth IRA with after-tax contributions, but the money that you invest in a Roth grows tax-deferred. You can withdraw your principal from a Roth at any time without having to pay income tax or penalties. Your earnings are exempt from tax if you hold your Roth for at least five years and make no withdrawals prior to reaching the age of 59 1/2. Other withdrawals of earnings are generally subject to both regular income tax and a 10 percent withdrawal penalty.
Contributions to Roths are limited based upon your Modified Adjusted Gross Income. You calculate your MAGI by adding back some tax-deductible items such as pre-tax IRA contributions to your adjusted gross income. MAGI-based contribution limits vary based on your tax filing status and separate MAGI limits exist for married people filing jointly, married people filing separately and single taxpayers. If your MAGI stays below a certain level, you can make the maximum allowable annual contribution. If your MAGI exceeds the income limit, you may be able to make a partial contribution to a Roth. Income limits are revised on an annual basis.
If your Roth contributions exceed the allowable limit, then those contributions are subject to a six percent excise tax. You can avoid this issue by waiting until the end of the tax year to make your contributions. At this time, you should know precisely how much you can contribute based on your MAGI. If you make a miscalculation, you can withdraw your excess contributions during the next six months by filing a tax amendment. You get your contributions back in full, but your account earnings are subject to the 6 percent excise tax. Alternatively, you can re-characterize contributions for the current year as contributions for the next year, but your ability to do this depends on your MAGI for the upcoming tax year.
If your MAGI prevents you from contributing to a Roth in the short-term, you can still enjoy the long-term tax savings of these accounts by arranging a Roth rollover. This involves moving money from a pre-tax account, such as an IRA, to a Roth. You have to pay ordinary income tax on the money that you convert but your subsequent earnings grow tax-deferred and potentially provide you with future tax-free income. In the short-term, the conversion will cause your taxes to rise for the current year, but in the long-term, you may lower your overall tax burden.