The Tax Impact of Roth Conversions on Making New Roth Contributions
There are two ways to get money into your Roth IRA: making annual contributions, which require you to have compensation during the year and have income that falls below the annual limits; and converting contributions made to other retirement plans. But don't worry, no matter how much you're converting from your other retirement plans, it won't affect your eligibility to keep contributing to your Roth IRA.
Eligibility Income Limits
If your income is too high, you're not allowed to contribute to your Roth IRA during the year. The limits are based on your modified adjusted gross income, which starts with your adjusted gross income and makes several additions and subtractions. For example, in 2013 if you're single, your Roth IRA contribution starts falling when your MAGI hits $112,000 and phases out completely at $127,000. If you're married filing jointly, the phaseout starts at $178,000 and your contribution limit hits $0 when your MAGI reaches $188,000.
Conversion Income Not Included
Taxable income from Roth IRA conversions isn't included in your modified adjusted gross income when you're determining whether you're eligible to make a Roth IRA contribution. For example, say you're single and your adjusted gross income is $130,000, but $20,000 of that income is from converting funds from a traditional IRA to a Roth IRA. Your MAGI drops down to $110,000 because the conversion income is excluded and, since that puts you below the phaseout range for your filing status, you can make a full Roth IRA contribution.
Tax Implications of Converting
Just because you're eligible to contribute to a Roth IRA doesn't mean you have the money to do so, especially if you're converting a significant amount in the same year. See, Roth IRA conversions count as taxable income, so you'll have to come up with the extra cash to pay that bill. For example, say you're in the 25 percent tax bracket and you convert $20,000. You're going to owe an extra $5,000 on your taxes -- money that you might have otherwise used to fund your Roth IRA contribution for the year.
If possible, you usually want to avoid taking money out of the Roth IRA conversion to pay for taxes, especially if you're under 59 1/2 years old. In general, paying the taxes from withdrawal from the other plan negates some of the advantages of the conversion because you're shrinking your retirement account. Worse, if you're under 59 1/2, you'll owe an extra 10 percent tax penalty -- on top of the regular income taxes.
Based in the Kansas City area, Mike specializes in personal finance and business topics. He has been writing since 2009 and has been published by "Quicken," "TurboTax," and "The Motley Fool."