(Chuck Saletta)
A Roth Individual Retirement Account (IRA) is one of the most powerful ways to invest for your retirement. Once your money is legally in this type of account, it can potentially grow tax-free for the rest of your life.
Unlike other retirement accounts, you are not required to withdraw money from your own Roth IRA during your lifetime. If you reach age 59½ and have funded a Roth IRA for at least five years, you can withdraw up to the full value of your account and owe absolutely no tax on that withdrawal.
This combination means that, as a general rule, if you can fund a Roth IRA, you should fund a Roth IRA. If there’s a serious downside to Roth IRAs, it’s that you can only save up to $6,000 per year in one ($7,000 if you’re 50 or older). This annual limit means that if you want to build up a decent balance, you should contribute to it whenever you can. Fortunately, if you’re eligible, you can still fund your Roth IRA for 2021.
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In fact, you have until April 15, 2022
The contribution deadline for your 2021 Roth IRA is April 15, 2022. Your money must be in your account by this date or you cannot consider it a 2021 contribution. This extra time gives you a great window to take advantage of the recent market decline by looking for opportunities made available by this decline.
Of course, the real reason for the April deadline has nothing to do with recent market performance. It’s more because there are income limits to your eligibility to contribute to a Roth IRA. Allowing you to contribute until the tax filing and payment deadline for the year allows you to understand if you are eligible to contribute before you inadvertently lose your hard-earned money illegally.
After all, there’s a 6% penalty for over-contributing to your Roth IRA — and that penalty continues every year until you rectify the situation. This can make it very expensive to deposit money into this account if it turns out that you are really not authorized to do so.
What are these income limits?
First, you can only contribute directly to the Roth IRA from taxable compensation, such as money earned by you or your spouse working as an employee or as an independent business owner. Even if you have enough money to contribute to a Roth IRA, your contribution cannot exceed your taxable compensation amount.
At the other end of the income spectrum, your ability to contribute begins to disappear when you reach certain income thresholds. For 2021, your ability to contribute starts to disappear at $125,000 if you’re single, $198,000 if you’re married and filing jointly, or if you have any income and are married and file separately.
Note that these upper income thresholds are based on what is known as your modified adjusted gross income (MAGI). This number includes things like interest, dividends, and capital gains, in addition to what you earn through work.
Since your MAGI can often change until the very end of the year, you might have good reason to wait until the end of the calendar year to make your Roth IRA contribution. Now that the year has safely passed, it’s a great time to start doing the math and see if you qualify to make this contribution.
If your income is too high, are you locked out?
If your income is too high for directly contribute to a Roth IRA, you might still be able to get money using a technique known as backdoor Roth IRA contribution. With this approach, you make a traditional IRA contribution and then immediately convert the money into a Roth IRA. Since there is no upper income limit for traditional IRA contributions, this technique is available regardless of the amount of your income.
If you had no balances in traditional IRAs before making this Roth IRA backlog contribution, the treatment of this backdoor contribution is almost identical to a standard contribution. The biggest difference is that you can withdraw a standard Roth IRA contribution at any time for any reason, and pay no tax or penalty on that withdrawal. With a stolen Roth IRA contribution, that money must stay in your account for five years (unless you’re over 59½) or you could face a penalty.
If, on the other hand, you had a balance in your traditional IRAs before making that disguised Roth IRA contribution, things get a little complicated. The big difference is that money withdrawn from a traditional IRA must follow a pro-rating rule when determining the taxable impact of that withdrawal. Depending on how this rule works, your immediate tax costs may increase at the top when you make a stealth contribution to the Roth IRA compared to what you would have faced if you had contributed directly.
It’s not necessarily a deal-breaker, but it’s a cost you need to recognize before proceeding.
Note that you can make a contribution to your traditional IRA for the 2021 tax year for the purpose of making it a disguised Roth IRA contribution. If you do this, the Roth conversion portion will be considered a 2022 tax year conversion, even if the contribution counts toward your 2021 limits.
Time is running out, so put your plan in place now
Although the contribution window for Roth IRAs for 2021 is still open, you only have until April 15 to get your money in the account to qualify for this tax year. So if this is something you’re eligible for and would like to do, start now and give yourself a good shot at achieving it before that window closes.
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Chuck Saletta has no position in the stocks mentioned. The Motley Fool has no position in the stocks mentioned. The Motley Fool has a disclosure policy.
