I'm Over the Contribution Income Limit - Can I Still Get Money Into a Roth IRA?
By Beverly DeVeny and Sarah Brenner
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This week's Slott Report Mailbag looks at the complications involved with pre- and after-tax contributions to different retirement plans and the rules involved with conversions and distributions. As always, we stress the importance of working with a competent, educated financial advisor to keep your retirement nest egg safe and secure. Find one in your area at this link.
If I take my after-tax contributions in my 401(k) plan and roll them directly into a Roth IRA, are they now subject to the 5-year rule or can I take those after-tax rollover contributions out of my Roth at any time?
Also, I was contributing after-tax money in my company 401(k) plan. Is there any way I can convert that amount in Roth IRA?
What are the rules?
We can answer both of these questions at once. You can only take distributions from an employer plan when the plan allows. Distributions will generally be pro-rata, partly pre-tax and partly after-tax. IRS guidance says that a distribution from an employer plan can be split to different accounts. Pre-tax funds will fund a direct rollover first, then a 60-day rollover and lastly those amounts that are not rolled over.
Example: Joy has $100,000 in her employer retirement plan - $80,000 is pre-tax and $20,000 is after-tax. She requests a distribution of $100,000. She asks to have $80,000 directly rolled over to an IRA and that $20,000 be moved to her Roth IRA. Under the rules, the $80,000 amount will come first from her pre-tax amounts so all of her pre-tax funds are directly rolled to her IRA. The remaining $20,000 will go to her Roth IRA, either as a direct rollover or as an indirect rollover, depending on the employer plan’s procedures.
When you convert after-tax funds in a 401(k) to a Roth IRA, you may take a distribution of the converted funds at any time. Generally, if you are under age 59 ½ and take that distribution within five years of the conversion, the distribution will be tax free but will be subject to the 10% early distribution penalty. A distribution of the converted amounts after age 59 ½ or after being held five years will be tax and penalty free. However, that rule applies only to funds that are taxable at the time of conversion. It will not apply to your after-tax funds that are converted from the 401(k) to a Roth IRA.
Due to income restrictions, I or my wife could not contribute in Roth IRA. I read somewhere that I can open a Traditional IRA account (backdoor), contribute and then convert in to Roth IRA. Is it true? Do you have any handout I can refer to?
Yes, there is a strategy called the back door Roth IRA. A contribution made to an IRA can be converted to a Roth IRA. BUT, if you have any other IRA funds, including SEP and SIMPLE IRAs, then you must use the pro-rata rule to calculate how much of the conversion is taxable.
Example: You have $5,000 in an existing IRA. You make an after-tax contribution of $5,000 to a different IRA and later convert the second IRA to a Roth IRA. You will owe income tax on $2,500 of the converted amount. Your total IRA balance is $10,000 of which $5,000 is after-tax. 50% of your account is pre-tax so a conversion of $5,000 is 50% taxable.
The formula can be found on IRS Form 8606, which you will have to file with your tax return for the year. You must file it because you made an after-tax contribution, because you took a distribution (the Roth conversion), and because you did a Roth conversion.