Roth IRAs are amazing tax saving tools. Roth IRAs are a type of Individual Retirement Account that allow investors to grow their money tax-free. Even though there is no tax deduction for contributions, a Roth IRA provides the dual benefits of tax-free accumulation and tax-free distributions after age 59 1/2. The long-term benefits can be significant.

There are two main ways that you can put money into a Roth IRA: a Roth contribution and a Roth conversion.

The terms “contribution” and “conversion” sound so similar that which is which can be confusing. Here’s the difference:

What are Roth contributions?

Anyone can open a Roth IRA, but you can only contribute if you have taxable compensation, typically earned income, for the tax year or if you file taxes jointly with a spouse who has earned income.

You are allowed to contribute the lesser of your taxable compensation for the year or the contribution limit for that tax year. In 2022, the contribution limit is $6,000 plus an extra $1,000 if you are age 50 or older this year. If you make less than $6,000, you may only contribute up to the dollar amount you earned. For example, if you’re a student with a summer job in which you made $2,000, you could only contribute up to $2,000 to your Roth IRA.

Furthermore, if your Modified Adjusted Gross Income (MAGI) is over a certain limit, then your Roth IRA contribution limit begins getting phased-out.

In 2022, your ability to contribute directly to a Roth IRA starts to phase out at a MAGI of $204,000 if you are Married Filing Jointly and $129,000 if you are filing Single. You cannot contribute to a Roth IRA at all if you make above $214,000 married or $144,000 single.

If your MAGI is between this range, then the IRS has a worksheet to figure out how much you can contribute.

If your MAGI is over the top of this range, then although you are not allowed to make contributions to your Roth IRA directly, you may still be able to add funds to your Roth IRA with what is called a backdoor Roth. You can learn more about backdoor Roth funding by reading our article “What is a Backdoor Roth?”

In summary, whether you can make direct contributions to your Roth IRA is based on your or your spouse’s taxable compensation for the year, such as your W-2 earnings from an employer, and your MAGI for the year.

What are Roth deferrals?

Most employers offer a defined contribution retirement program such as a 401(k) or 403(b) plan. These plans are funded typically via employee paycheck deferrals and employer contributions. Employer contributions are always pre-tax traditional contributions which are excluded from taxable income this year but taxed when they are distributed from the retirement account in retirement. Employer contributions are outside of the employee’s control and face their own annual limitations.

Employee deferrals, however, are what you get to decide is contributed to your employer-sponsored retirement plan. Employee deferrals are limited to a specific contribution limit or 100% of your compensation from that employer, whichever is smaller. In 2022, the employee elective deferral limit for 401(k) or 403(b) plans is $19,500 plus an extra $6,500 if you are age 50 or older this year.

Some governmental or charitable employees are also lucky enough to have a 457(b) plan through their employer which permits a second deferred compensation limit of the same size. In addition to the age 50 catch-up, there also may be special 457(b) catch-up contributions when you are 3 years out from the plan’s specified retirement age.

While all employers offering defined contribution plans permit pre-tax traditional employee deferrals, some employers also permit Roth deferrals. If your employer offers Roth deferral as an option, we suggest that you select it. A Roth contribution is generally preferable.

Your ability to defer some of your income to an employer plan such as a 401(k) or 403(b) is not limited by your income regardless of whether you elect to defer in a pre-tax traditional way or in an after-tax Roth way. Unlike Roth contributions, there are no MAGI limits for Roth deferral.

In summary, whether you can make Roth deferrals to your 401(k) or 403(b) is based on your employee compensation for the year and your employer retirement plan options.

What are Roth conversions?

A Roth conversion is a type of rollover and is the process of moving assets from a pre-tax qualified retirement account into a Roth retirement account. This is a taxable transfer of retirement funds. Assets are moved from a pre-tax traditional retirement account into a post-tax Roth retirement account by paying the tax on those funds today. No new retirement contribution is made, assets are simply moved from a traditional retirement account to a Roth account. There is no limit to the amount of assets that can be converted from a traditional IRA to a Roth IRA. Also, most people can do any number of Roth conversions in one twelve-month period.

You can only convert assets from a traditional retirement account into a Roth retirement account. You cannot convert assets from a savings account, brokerage account, or Trust account (we often call these “taxable accounts”) to a Roth IRA because moving funds between these account types requires a Roth contribution of some kind.

Anyone with a traditional IRA can convert some or all of those funds to Roth. If you have a pre-tax retirement balance in your employer’s retirement accounts such as a 401(k), 403(b), or 457 plan, your plan documents may permit you to perform an in-plan Roth conversion, or if you are over age 59 1/2 or separated from employment there, they may permit you to roll out the funds to a Roth IRA by performing a Roth rollover.

In summary, whether you can perform a Roth conversion for the year is only based on whether you have traditional retirement account assets.

Summary

We think Roth contributions, Roth deferrals, and Roth conversions are all valuable and it is important to know the difference between these techniques to make sure you are maximizing your retirement savings.

If your employer plan offers Roth deferrals, talk to HR to set up your employee deferrals as Roth deferrals.

If you or your spouse have earned income or other taxable compensation, talk to your tax preparer about if you can make a regular Roth contribution or a backdoor Roth contribution.

If you have a traditional IRA balance, talk to your tax preparer or financial planner about if systematic Roth conversions could save you taxes over the long-haul.

Photo by Jess Bailey on Unsplash