It would be nice to own a Roth IRA, where all investment profits are not just tax-deferred, they are tax-free. There are at least half a dozen ways to get money into a Roth IRA. Use this checklist to find the method that will work for your client. Planning tips and opportunities are highlighted with a “♦.”
Dollar limits are for 2022 contributions; all limits are adjusted annually for inflation.
All contribution methods described here refer to the original IRA owner or employee for whom the account was created, unless an “inherited” account or “beneficiary” is specified.
The maximum “regular” contribution an individual can make to a traditional IRA for 2022 is $6,000 ($7,000 if the client will be age 50 or older by Dec. 31, 2022). The maximum contribution to a Roth IRA is the same amount, minus whatever is contributed to the individual’s traditional IRA. Such annual contributions are referred to as “regular contributions” to distinguish them from rollovers and conversion contributions. There are two other limits that may reduce this maximum dollar amount:
- The dollar limit for a Roth IRA contribution is reduced if the individual’s adjusted gross income exceeds $129,000 (single) or $204,000 (married filing jointly), and it is reduced to zero if adjusted gross income exceeds $144,000 (single) or $214,000 (married filing jointly). Thus, high-income individuals cannot contribute to a Roth IRA other than by “rollovers” from a traditional account.
- A regular contribution (to any IRA) may not exceed 100% of the client’s compensation income for the year. Compensation income includes wages and self-employment income, alimony, and certain military payments, but does not include pensions, annuities, or nonqualified deferred compensation. Thus, a retired individual without compensation income cannot contribute to a Roth IRA, other than by rollover from a traditional account.
Conversion From a Traditional IRA
Anyone who has a traditional IRA can transfer funds from that IRA to a Roth IRA. That transfer (which can be accomplished via direct transfer or by “rollover” of an IRA distribution) is called a conversion. Unlike with regular contributions, there is (since 2010) no income limit on who can do a Roth conversion.
A Roth conversion is taxed in the year it occurs as if it were a distribution of the same amount from the traditional IRA. For most people, that means the converted amount is 100% included in gross income.
If the IRA owner has aftertax money in any of his traditional IRAs, a proportionate amount of the conversion will be tax-free as a return of basis. Unfortunately, there is generally no way to convert only the aftertax money from the IRA.
Thus, an IRA conversion can be costly, and (since 2018) a Roth conversion is irrevocable, so it is not a step to be taken lightly.
Note: If the IRA owner is subject to required minimum distributions in the year of the conversion (that is, he is age 72 or older), he must withdraw the RMD before doing the Roth conversion. There is no way to convert an RMD, because an RMD is not an eligible rollover distribution. And the first money distributed from the IRA in any year is applied to the RMD for such year. Thus, until the IRA owner has satisfied his RMD for the year, he cannot do a Roth conversion.
♦ Rare planning opportunity: If the client has aftertax money in his traditional IRA, and is a participant in an employer plan that accepts IRA rollovers, he may be able to take advantage of the only known way to separate the pre- and aftertax money in an IRA: He can “roll” the pretax money in the traditional IRA into the employer plan, leaving only aftertax money in the IRA. The traditional IRA can then be converted tax-free to a Roth IRA. This rare exception to the rules exists due to a quirk in the tax code that does not permit employer plans to accept rollovers of aftertax money. (Why? Who knows?) If doing this maneuver, remember not to add any money back into the traditional IRA until the taxable year after the conversion; any addition of pretax money to the account in the same year will cause part of the conversion to be taxable.
♦ Popular planning opportunity: If the client’s adjusted gross income is too high to permit a direct regular contribution to a Roth IRA, and the client does not own any traditional IRA, an indirect contribution (also called a backdoor Roth contribution) should be considered. The client contributes the maximum to a traditional IRA, then immediately converts the traditional IRA to a Roth IRA. Assuming the IRA contribution was nondeductible, the traditional IRA will consist only of aftertax money (plus whatever minimal amount of pretax “earnings” that may accrue between the date of contribution and date of conversion), so the conversion will be tax-free (or minimally taxable). This loophole exists because the tax law has an income limit on direct Roth IRA contributions but no income limit for Roth conversions.
Caution: As a reminder, this only works for someone who does not already own a traditional IRA. If the client already has a traditional IRA, the conversion (even if it is made from a brand-new account established with the current year’s contribution) is deemed a distribution from all of the client’s IRAs collectively. Thus, it will be income-taxable, and nothing will have been gained by using the backdoor method.
Recharacterization of a Traditional IRA Contribution
Any individual who made a regular contribution to a traditional IRA has the option to “recharacterize” that contribution as a contribution to a Roth IRA instead. Recharacterization is accomplished by moving the contribution amount (plus its earnings) out of the traditional IRA to which it was contributed and into a Roth IRA. The only restrictions are that the individual must have been eligible to make the contribution to a Roth IRA (that is, the investor’s income was under the applicable limit), and the deadline for recharacterization must be met. This deadline is the extended due date of the individual’s tax return for the applicable year.
Here’s an example: Lucy, 60, contributes $7,000 to her traditional IRA in 2022. When doing her tax return in early 2023, her accountant points out that her 2022 adjusted gross income was low enough that she was eligible to contribute $7,000 to a Roth IRA. Before Oct. 15, 2023, Lucy “recharacterizes” her 2022 IRA contribution by moving the $7,000 (plus its earnings) from the traditional IRA to a Roth IRA.
In the good old days before 2018, Roth conversions could also be “recharacterized” (reversed). That is no longer permitted. Now, the only IRA contributions that can be recharacterized as contributions to a different IRA are traditional IRA and Roth IRA contributions (and certain botched rollovers, but that’s another story).
As noted above, generally, an IRA distribution carries out pre- and aftertax money proportionately, and the proportions are based on the combined balances of all traditional IRAs the individual owns. In contrast, the individual’s IRAs are not aggregated for purposes of determining the pre- and aftertax portions of a recharacterized contribution. Rather, the proportions of pre- and aftertax money are determined based only on the account to which the original contribution was made. Also, the recharacterized contribution and earnings must actually be drawn from the account to which the contribution was made; the IRA owner can’t move funds from a different IRA and treat the transfer as a recharacterization.
Conversion From a Qualified Plan
A client who has funds in an employer plan (such as a 401(k) plan) can move those funds to a Roth IRA provided two conditions are met. First, he must be entitled to take a distribution from the plan; a 401(k) plan, for example, will not allow any distributions before age 59½ to an active employee (except for “hardship distributions,” which are not eligible for rollover or conversion). Second, if the client is subject to RMDs, he must take the 401(k) plan’s RMD for the year before he does the conversion.
If funds are moved from a “traditional” account in the employer plan to a Roth IRA, the transfer is a Roth conversion, and (as with conversions from a traditional IRA) it is generally taxed the same as a distribution would be taxed, and it is irrevocable.
♦ Planning tip: If this employee has a “designated Roth account” in the employer plan, funds from that account may be transferred only to a Roth IRA. It is advisable to move designated Roth account funds to a Roth IRA before the year the employee becomes subject to RMDs (age 72 year), since designated Roth accounts are subject to lifetime RMDs while Roth IRAs are not.
♦ Rare planning opportunity: If the employee has aftertax money in his traditional employer plan account, there is a unique one-time-only planning opportunity. At the time funds are to be transferred from the employer plan to the employee’s IRA, the employee can request that the plan divide the pretax money from the aftertax money and send the pretax money to the employee’s traditional IRA and send the aftertax money to the employee’s Roth IRA—thus completing a tax-free Roth conversion of the aftertax money. It is unusual for an employee to have aftertax money in a traditional employer plan account, but for any employee who is in that situation, this is a once-in-a-lifetime opportunity to get a tax-free Roth conversion.
Inherited Accounts: IRAs vs. Qualified Plans
The surviving spouse who inherits the decedent’s IRA can roll over the inherited IRA to the surviving spouse’s own IRA—or Roth IRA. Nonspouse beneficiaries, however, cannot do any type of Roth conversion with an inherited IRA.
With an inherited qualified plan account, once again, the surviving spouse (if the beneficiary of the account) can roll over the inherited account to a traditional IRA or convert it to a Roth IRA. A nonspouse designated beneficiary who inherits a qualified plan has a one-time opportunity to convert the inherited plan to an inherited Roth IRA. The tax code allows the designated beneficiary to direct the plan administrator to transfer the inherited account to an inherited IRA, including a Roth IRA, thus permitting a Roth conversion of the inherited account. This unique planning option is available only for a “designated beneficiary,” meaning an individual named as beneficiary or a qualifying see-through trust. If the plan is inherited by the decedent’s estate (or a trust that does not qualify as a designated beneficiary), the plan cannot be transferred to an inherited IRA, and no Roth conversion is possible. A designated beneficiary who is arranging for transfer of the inherited plan to an inherited IRA can use the technique previously discussed to transfer the pretax money in the decedent’s account to an inherited traditional IRA (tax-free rollover) and the aftertax money to an inherited Roth IRA (tax-free Roth conversion).
And All the Other Ways
Those are the mainstream ways to get money into a Roth IRA, but not the only ones. See IRS Publication 590-A for more ways, such as contribution by one spouse for the other (nonworking) spouse and contributing “repayment of qualified reservist payments.” Finally, don’t forget that anyone who received a coronavirus-related distribution, or CRD, (up to $100,000) in 2020 has three years within which he can roll over all or part of that distribution (instead of the usual 60 days). If the recipient of the CRD finds his fortunes have changed so he can afford to repay that distribution, he can still roll that distribution back into an IRA throughout 2022. It is not clear whether that permitted rollover would include a Roth conversion, but it’s worth looking into.
The author or authors do not own shares in any securities mentioned in this article. Find out about Morningstar’s editorial policies.