We’ve all heard of the potential tax-saving benefits of a Roth IRA. But did you know that not everyone can open one of these accounts?
The Roth IRA was introduced with the Taxpayer Relief Act of 1997. It was named after Sen. William Roth, who introduced the bill. The Roth IRA was created as an alternative to the traditional IRA, and unlike the traditional IRA, a Roth IRA allows individuals to invest after-tax dollars and benefit from tax-free disbursements in retirement. The account was designed to entice more people to save and invest.
Many people prefer the Roth over a traditional IRA because of the benefits. For starters, distributions in retirement don’t contribute to taxable earnings. And if you ever need the money for something before you reach retirement age (say, tuition or a large down payment), the contributions made to a Roth can usually be used without tax or penalty.
However, not everyone is able to participate in a Roth account. If you’re a high-earner, you may have a reduced contribution amount or you may not be able to contribute to a Roth IRA at all. It all depends on where you are on the IRS scale.
Read on to see if you qualify to participate in a Roth for 2018. We’ll also discuss what you can do to get around those income limits if you don’t qualify to participate.
Earned Income and the Modified Adjusted Gross Income
First off, to qualify for a Roth IRA, you must have something the IRS terms “earned income” in the year in which you want to make a contribution.
The definition of “earned income” is pretty broad: It includes payment or wages you received for work that you’ve performed, any profit distributions from a small business you might own, tips, bonuses, commissions and even some government benefits, such as disability. However, “earned income” does not include income you might have received from rental properties or interest from your investments.
Next, in order to determine if you qualify for a Roth, you need to find your modified adjusted gross income, or MAGI. You can do this by looking at your most recent IRS Form 1040. There will be an item for “adjusted gross income,” or AGI. Take this number and subtract the amounts found in lines 37 and 8b of your 1040 (these represent tax-exempt interest income you may have received).
What Are the Income Limits?
The IRS breaks taxpayers down into three marriage-related categories: married filing jointly, married filing separately, and single or head of household. Doubtless, you’ve put yourself into one of these categories at tax return time.
Your filing status category determines the income limits when it comes to the Roth IRA. Here are the current limits for the three categories:
Income Limits for Single or Head-of-Household Filers
If you’re a single or head-of-household filer — or it you’re married and filing separately and haven’t lived with your spouse at anytime during the year) — and your MAGI is less than $120,000, you can contribute the maximum amount: $5,500 (or $6,500, if you’re 50 or older).
If your MAGI is between $120,000 and $135,000, you can contribute to a Roth IRA, but for a reduced amount. To calculate this amount, see this worksheet.
If your MAGI is over $135,000, you do not qualify to participate in a Roth IRA.
Income Limits for Married Joint Filers
If you’re married filing jointly, and your MAGI is less than $189,000, you can contribute the maximum amount: $5,500 (or $6,500, if you’re 50 or older).
If your MAGI is between $189,000 and $199,000, you can contribute a reduce amount. To calculate this amount, see this worksheet.
If your MAGI is more than $199,000, you do not qualify to participate in a Roth IRA.
Income Limits for Married Separate Filers
If you are married but file separately and have lived with your spouse at anytime during the year and your MAGI is less than $10,000, you can contribute a reduced amount to a Roth IRA. To calculate this amount, see this worksheet.
If your income is more than $10,000, you do not qualify to participate in a Roth IRA.
A quick note on the difference between AGI and MAGI: AGI (adjusted gross income) is used to calculate income, so your tax bill can be calculated. Your MAGI is used to see if you qualify for certain tax deductions and tax credits. It also determines whether you qualify to contribute to a Roth.
Unlike AGI, your MAGI is determined by taking AGI and adding back specific deductible items such as foreign income, student loan deductions, IRA contributions and some higher education costs. For most of us, our AGI and MAGI are the same. So, if you are a high-earner, file joint taxes or carry a lot of foreign income or higher education deductions, you may want to take a closer look to see if your AGI and MAGI differ.
Note: Contributions to a traditional IRA reduce your AGI, because they are tax deductible and made with pre-tax dollars.
This chart breaks it all down:
The Backdoor Roth IRA
If you’re not able to contribute to a Roth because of income limits, all is not lost. There is still a way to take advantage of this tax-free investment vehicle. It’s called the backdoor Roth IRA. With the help of a financial advisor, you can successfully take advantage of a Roth account.
There are limits and restrictions, but a backdoor Roth allows high-earners to get around income limits. This is done by converting portions of a traditional IRA into a Roth IRA in increments. You still pay taxes on the money you transfer, but you end up with all the benefits of a Roth IRA in the end.