How to (Legally) Exceed your Roth IRA Contribution Limits

I’ve written before that the easiest way to set yourself up with tax-free income (and the way that offers you the most investment freedom) is a Roth IRA. However, one of the most frustrating limitations of a Roth IRA is that your annual contribution limits just aren’t that high. Finally, after years of it languishing at $5500, it’s being raised in 2019 — to $6000. And starting the year you turn 50, you get to contribute a whole extra $1000! However, I do have some good news on this front: there’s a loophole that allows you add an unlimited sum of money to your Roth IRA! That’s right — I said unlimited!

(Photo by ‪Dima Visozki‬‏ from Pexels)

It’s called a Roth conversion or a conversion rollover. Here’s how it works:

1. You take money from a pretax account (such as a 401(k) or IRA) and roll it over to a Roth IRA.
2. The amount of the rollover is added to your tax bill for the year.
3. Once the money arrives in your Roth IRA, all future growth on it will be tax-free (provided you wait till you’re at least 59½ and five calendar years from the year you make the rollover).

I should add here that if you're contributing to a workplace retirement plan (401(k), etc.) that allows both pretax and Roth contributions, then the plan might allow you to convert some of your money on the pretax side of your account over to the Roth side. To see if your plan allows this (and what rules have to be followed to make it happen), check the summary plan description, which is a document your HR Dept. is required to make available to you. (It's probably downloadable from your employer's online benefits portal.) Search the document for terms like "in-plan Roth conversion" or "in-plan Roth rollover".

Obviously, there’s a downside: you have to pay tax on money that would otherwise continue to be tax-deferred. But remember: “tax-deferred” simply means the tax is postponed. It’s going to come due eventually. And consider the upside. There’s no limit on how much you can convert from pretax to Roth in a single year (you’ll just want to make sure you can absorb the tax hit). And this is true even if you make “too much” money to make contributions to your Roth IRA! This is because rollovers aren’t considered contributions. In fact, rollovers don’t even count towards your contribution limit. For example, I once rolled over $15,000 from an old 401(k) to my Roth IRA, and then deposited another $5500 to max out my contributions for the year. Hence, my total additions to the Roth IRA that year were $20,500 — almost four times my contribution limit! And even if you’re younger than 59½, it’s still considered a rollover, so it’s exempt from the 10% penalty on “early withdrawals” from a pretax account!

Another reason to seriously consider converting pretax money into Roth money is that when you turn 70½, any pretax money you have left in your possession gets locked into a cycle of RMDs (required minimum distributions). These are mandatory withdrawals from your pretax accounts each year, and any amount of an RMD that you fail to take out gets added to your tax bill anyway, plus you get slapped with a penalty of 50% of the amount you failed to take out! For example, if you were supposed to take out $5000 but only took out $3000, then the remaining $2000 will still be included in your tax bill, and you’ll owe an extra $1000 (half of $2000) as a penalty. And the adverse effects of RMDs aren’t limited to the tax hit they impose in and of themselves; as taxable income, they increase the risk of your Medicare premiums going up and the likelihood that 85% of your Social Security benefits will have to be included in your tax bill each year. (Unless you’re pulling in less than $25K/year as a single person or less than $32K/year as a married couple, expect to include 50% of your Social Security benefits in your tax bill each year.)

Now, if you’re willing to donate your RMD to charity, then you can transform it from a tax liability into a tax deduction by consolidating your pretax accounts into a Traditional IRA or Rollover IRA (which is basically a Traditional IRA that was initially funded by a rollover instead of a contribution) and having the custodian (the company holding the IRA for you) send the RMD (up to $100K) directly to the charity. It's an elegant solution — if you won't need the money. But what if, like most people, you will need that money? Once you’re 70½, the only thing you can do to lessen the tax hit from RMDs is to roll some of your pretax money into a QLAC (qualifying longevity annuity contract). The money inside a QLAC can stay where it is (and thus stay tax-deferred) until the month after your 85th birthday. At that point, the QLAC is required to start sending you monthly income checks for the rest of your life (like a personal pension), and each of those checks gets added to your tax bill the year you receive it. So a QLAC does provide some tax relief — at least until you’re 85. But a QLAC lets you shelter no more than 25% of your pretax money or $130K, whichever is less. And unless you select a “refund” option when starting the stream of monthly income checks, any amount of your money that hasn’t made its way back to you by the time you die gets forfeited to the insurance company that sold you the QLAC. (A “refund” option will refund the balance of your money to a beneficiary of your choosing. However, QLACs aren’t required to offer this option, so make sure to get one that does.)

If you’re less than thrilled with your options for mitigating RMDs after you’re 70½, your best course of action is to take steps beforehand to limit how much pretax money you’ll have at age 70½. The lower the percentage of your wealth occupied by pretax money, the smaller the impact from RMDs. If you’ve already accumulated a lot of money in the pretax category, but still have time before you turn 70½, then Roth conversions can permanently shelter a significant chunk of your wealth from RMDs. What’s more, tax-free withdrawals from a Roth IRA don’t run the risk of upping your Medicare payments or upping the percentage of your Social Security benefits that gets added to your tax bill.

Of course, the more pretax money you convert to Roth in one go, the more tax you’ll owe in a single year. (That’s why there’s no limit on how much you can convert.) But it’s not like you only get to make a Roth conversion once in your life. You can spread Roth conversions over multiple years to keep the tax burden manageable. And don’t wait too long to start making them, as they generate taxable income the year they’re made, and that could negatively impact your Medicare premiums and Social Security benefits. (Note that Medicare premiums are based on your income in the two preceding calendar years, so any Roth conversions made during that two-year window will be counted.) Also, be aware that when pretax money is converted and rolled over into a Roth IRA, you have to wait until you turn 59½ and until the fifth calendar year after the conversion before you can withdraw the earnings on that money tax-free. This is true regardless of how long you've been contributing to the Roth IRA (whereas for contributions and rollovers from other Roth IRAs, you only have to wait till the fifth calendar year after your very first contribution to a Roth IRA). And each conversion is on its own five-year clock (which is also true, by the way, of rollovers from a Roth 401(k), Roth 403(b), Roth 457(b), or Roth TSP to a Roth IRA). But the good news here is that withdrawals from a Roth IRA are seen as being taken out first from money that has already been taxed (contributions and conversions), and then from money that hasn’t been taxed (and never will as long as you follow the rules). For example, if the combined total of contributions and conversions to your Roth IRA is $100K, then the first $100K of withdrawals will be considered a return of money that you’ve already paid taxes on, and you therefore won’t have to pay any further taxes (or early withdrawal penalties) on that sum. Also, if the clock on any 5-year waiting period on Roth money starts at least 5 calendar years before you turn 59½, then it doesn't really affect you, because by the time you reach 59½ (which you have to wait for anyway), the 5-year wait will be over.

Addendum: If you're still working at that age of 70½, and your employer offers a workplace retirement plan such as a 401(k), you may be able to delay the start of the RMD cycle on that specific account until April 1 of the year after you part from the employer. (You might even be able to continue making contributions into that account until you separate from the employer, whereas Traditional and Rollover IRAs don't allow further contributions past the age of 70½.) However, this option won't be available if (a) the rules of the plan have been written so as not to allow it (employers aren't required to allow it); (b) the plan is some type of IRA, such as a SEP or SIMPLE IRA, or (c) the employer is a company that you own 5% or more of. Furthermore, even if this option is available to you, how long you continue working for the employer may not be entirely up to you. So if you're less than thrilled with this as well as your other options for mitigating the tax impact of RMDs once you're past the age of 70½, then executing Roth conversions before you get to that point could be an appealing alternative.