- If your Adjusted Gross Income* (AGI) is above the threshold — $183,000 for Married Filing Jointly in 2012 you can’t contribute to a Roth IRA
- You can however contribute to a Traditional IRA (most likely non-deductible, if you are covered by a retirement plan at work)
- You then take the IRA contribution and “convert” it to a Roth IRA
- If your contribution to the Traditional IRA was non-deductible, there is no tax due (assuming your Traditional IRA didn’t go up in value)
That is how the plan works, and everything above is correct…except when it isn’t.
If you have other IRAs or more funds in the Traditional IRA that you contributed to, you can’t “Cherry Pick” which funds you convert. You have to convert “proportionally”. An example may illustrate better.
- You were on Active Duty and when you retire/separate you decide to rollover your Thrift Savings Plan (TSP) balance of $45,000 into a Traditional IRA
- In 2012 you make an $5,000 non-deductible contribution to a Traditional IRA (it can be the same IRA or different one)
- You immediately convert your $5,000 contribution and transfer it to a Roth IRA
- You assume that there is no tax consequence as you immediately converted the contribution and there were no gains
- The IRS will not agree with you
- The IRS requires that you proportionally convert the funds
- The IRS will say that there is a $4,500 taxable conversion and you owe somewhere around $1,000 in taxes on the transaction
There are a couple of ways to avoid this situation
- If you plan on using the back door entry into a Roth IRA leave your TSP/401k/403b funds where they are
- If you already have a Traditional IRA you MIGHT be able to transfer the IRA to your TSP/401k/403b at work…maybe…if you have one
Something to think about as you ponder what to do with funds in tax-deferred accounts
* Technically the measure threshold is determined using Modified Adjusted Gross Income (MAGI)…for illustration purposed AGI and are very close. Of course when you actually calculate your taxes, you’ll need to use MAGI.