Roth IRAs—Is Your Income Really Too High?

I had a nice couple—let’s call them John and Sarah, both in their early 40s—come in to my office to discuss how to develop a sound retirement system. Sarah is self-employed and owns a small business here in town, while John is employed by a mortgage company in Taunton. They have two kids: Tommy who is age 10, and Jessica who is 14 years old. Sarah had been managing their finances and investment portfolio for years, but thought it was time to “tighten things up,” she said. At first glance I was impressed with what she had been able to do for them so far. They have been taking the accumulation stage of their financial life cycle very seriously, having already amassed a combined million bucks. Talk about being vigilant and alert! Sarah was both of those things.
I asked what brought them in. Sarah said that she reads this column religiously and that, based on things she has read, she really wants each of them to contribute to a Roth IRA every year. Having taken a look at their portfolio, I was surprised that they hadn’t already been contributing to Roth IRAs. This is when John chimed in and said simply that they make too much and are over the income limit, but that Sarah was pretty sure there is a way to do it.
John was right. They do make too much to contribute directly to a Roth IRA, with Modified Adjusted Gross Income (MAGI) of about $205,000 as a married couple filing jointly. Sarah mentioned that she read a past article of mine, “The Gift of the MAGI” that reviewed strategies to reduce MAGI in order to receive breaks in the cost of Medicare, and was wondering if there is a way to reduce their MAGI for purposes of making Roth IRA contributions.
Sarah was one determined woman, looking to get the most from their investments—just the type of gal I enjoy chatting with.
I mentioned that in order to be able to make the full $5,500 contribution ($6,500 if over the age of 50), they need to get their MAGI below $186,000 ($118,000 for singles), which would be difficult. But I explained that we could get them closer to that number, which may allow them to at least make a partial contribution. We also talked about another potential option for them, which would allow them to fund a Roth IRA, all of which I want to share with you today.
One of the easiest ways to lower MAGI is with a contribution to either a healthcare Health Savings Account (HSA) or Flexible Spending Account (FSA).
For those of us who have a high-deductible health insurance policy, up to $2,600 for family coverage, we can contribute to a Health Savings Account. For John and Sarah, who have family coverage and are under age 55, they can contribute up to $6,750 yearly to their HSA. Generally, your contributions are pre-tax if made through your employer and tax-deductible if not. Either way, this strategy can help to chip away at MAGI. It also allows them to sock this money away and grow tax-deferred, if the savings are not needed to pay for qualified medical expenses.
This also works in a similar manner if you have an employer-sponsored FSA. Eligible employees can contribute up to $2,600, pre-tax, during the open enrollment period (or have a life-changing event) to help pay for healthcare related items. For John and Sarah, since Tommy is under the age 13, they may also qualify for a dependent-care FSA, which may allow them to contribute up to $5,000, pre-tax, to help pay for healthcare-related items for him. An important note here is that while any money in an HSA’s savings not used for medical expenses can grow tax-deferred, generally any unused portion of an FSA account not used for qualified medical expenses gets lost; so planning becomes critical.
Another way to reduce MAGI, which is oftentimes already being done, is to make a pretax contribution to an employer-sponsored 401(k), 403(b), 457(b) or Thrift Savings Plan. For John and Sarah who are under 50, they can contribute up to $18,000 in this manner, and those over 50 can contribute up to $24,000.
Since John and Sarah already contribute the maximum to their employer-sponsored retirement plans and a contribution to an HSA won’t get their MAGI down low enough, another option we discussed was having John and Sarah make what is known as back-door Roth contributions. Sarah told me she had considered this option before, but she was worried about the tax consequences. She was right to worry, as these can be trickier than they seem.
With a back-door Roth contribution, an individual who is above the contribution limit for a Roth IRA contributes to a (nondeductible) traditional IRA because unlike a Roth IRA, a traditional IRA has no income ceiling for contributors (income limits only affect the deductibility of any contributions if an individual is also an active participant in an employer-sponsored retirement plan). Next, the individual converts the traditional IRA to a Roth IRA. Oftentimes, people assume that since no time elapses between the contribution to the traditional IRA and the conversion to the Roth IRA, and therefore there are little to no earnings on those funds, it is a non-taxable event, unlike if you were to convert pre-tax IRA funds, (tax-deductible IRA money and earnings which have not been taxed yet), in which case all funds are taxed on the conversion, at current tax rates. But you know what they say about making assumptions . . . let’s save that for another column.
You see, the pesky little “pro-rata” tax rule comes into play when converting a nondeductible traditional IRA, if an individual also has one or more pre-tax traditional IRAs. Generally speaking, the pro-rata rule is the formula used to determine how much of a distribution is taxable when the account owner holds both after-tax and pre-tax dollars in their IRA(s). For the purposes of the pro-rata rule, the IRS looks at all your SEP, SIMPLE, and traditional IRAs as if they were one. Even if you have been making after-tax contributions to a separate account for years, and there have been no earnings, you cannot isolate your after-tax amounts and must take your other IRAs into consideration.
My conversation with Sarah and John reminded me that for most financial challenges—heck, this goes for life in general—if there’s a will, there’s a way. As I tell my kids, it is the little things in life that make the biggest difference and sometimes you need to be creative with your solutions.
If you are like my friend Sarah, and are being vigilant and staying alert, you will find that you do deserve more.