ROTH Individual Retirement Accounts (ROTH IRAs) are attractive investment vehicles. While annual contributions are not tax-deductible, all the funds can still be invested without current or future income tax. For younger taxpayers, these accounts are beneficial since there is more time to take advantage of tax-free compounding. The annual ROTH contribution limits are the same as those for “traditional” IRAs: $5,500 per taxpayer with an extra $1,000 catch-up contribution allowed for someone 50 years and older. Taxpayers need to have earned income equal to the IRA contribution amount. Married taxpayers can both make annual contributions based on the earned income of either, even if one spouse has no earned income.
While very attractive, the ability to make ROTH contributions is limited for those with higher gross income amounts. ROTH contributions are phased out for married taxpayers with adjusted gross income between $184,000 and $194,000. For singles, the range is $117,000 to $132,000. For a married person filing separately, the phase-out is between $0 and $10,000.
While these income limits prevent many from using ROTH IRAs, all taxpayers can convert traditional IRA balances into ROTH IRA accounts as there are no income limits for making a conversion. This is a way for higher income taxpayers to end up with ROTH IRA accounts. These taxpayers can make annual non-deductible traditional IRA contributions up to $13,000 for married taxpayers at least 50 years old. Once the traditional IRA is funded, the taxpayer can elect to move funds into another ROTH IRA account. The conversion is a taxable IRA distribution but the total income recognized depends on whether the taxpayer already has other traditional IRA accounts. If there are no other traditional IRAs, the tax on the conversion could be very small or without any tax at all. Once in the ROTH, the funds grow tax-free and all future distributions may also be tax-free. ROTH accounts are subject to several operating rules, one of which requires an account to be in place for 5 years to obtain complete tax-free distributions.
A ROTH conversion can also be a good strategic move when taxable income will be low for a year. Someone with a large business loss, large charitable or extraordinary medical expense deductions can use these deductions to offset the income generated by a ROTH conversion. This strategy can allow larger IRA amounts to be converted into a ROTH account without a large tax bill. Once in the ROTH, all amounts compound without current or future income tax. A conversion may also make sense if a traditional IRA investment has declined in value. Those assets can be converted. A loss on an asset within an IRA is not deductible but if transferred to a ROTH, then future appreciation will be tax-free.
The deadline for making a ROTH IRA conversion for this year is December 31st. Don’t confuse this with the deadline for making a 2016 IRA contribution which is April 15, 2017. While you can make an IRA contribution for 2016 up to April 15, 2017, a ROTH conversion for 2016 needs to be completed by December 31, 2016. What happens if a ROTH conversion ends up being a bad idea when your tax return for the year is finally completed? Taxpayers can elect to “undo” the conversion and return converted amounts back to the traditional IRA without a tax penalty. The deadline for doing this, which is called a recharacterization, is October 15 of the following year. These are things to consider now before year end.