Why is there an income limit on Roth IRA?

A Roth IRA is a type of IRA that offers workers a way to save for retirement. If you have a workplace retirement plan with your employer, you can also open a Roth IRA with a brokerage to make additional contributions towards your retirement. However, to be eligible to make Roth IRA contributions, your income should not exceed the IRS income limits for Roth IRA.

The IRS limits contributions to a Roth IRA to prevent highly compensated workers from benefiting more from the tax-advantaged Roth IRA than the average worker. You may be eligible to contribute to a Roth IRA if you meet the IRS income limit requirements. However, if your income exceeds the set limit, you can make phased contributions up to a certain upper limit, beyond which you won’t be allowed to contribute to a Roth IRA.

How a Roth IRA Works

A Roth IRA allows workers to pay taxes upfront when they contribute to the plan. Once you retire and take distributions from your Roth IRA account, you won’t pay taxes on the distributions as long as they are qualified distributions. You must be above 59 ½ and have held the Roth IRA account for at least 5 years to make qualified distributions.

For 2022, retirement savers can contribute up to $6,000 to a Roth IRA. You may be allowed to make an additional $1000 catch-up contribution if you are above age 50. If you have both Roth IRA and traditional IRA, the total contribution to both accounts cannot exceed the annual IRS limit i.e. $6,000.

Why does the IRS set income limit on Roth IRA?

The IRS limits contributions to a Roth IRA based on set income limits to enforce fairness. It prevents highly paid workers from benefiting more than the average worker.

Unlike a 401(k) that is subject to nondiscrimination testing, IRAs are not subject to this testing. However, IRAs enforce rules to encourage the average worker to contribute towards their retirement, while preventing highly paid workers from benefiting unfairly from the IRA rules.

Roth IRA Income Limits

Generally, the IRS considers the modified adjusted gross income (MAGI) to determine who is eligible to contribute to a Roth IRA. If the income exceeds the set limits, taxpayers may be limited in the amount they can contribute or barred from contributing to the Roth IRA account.

For 2022, singles or heads of household can make full contributions to a Roth IRA if their MAGI is below $129,000. However, the contributions start phasing out from $129,000 to $144,000. If the income exceeds $144,000, a taxpayer is barred from contributing to a Roth IRA.

Married couples filing jointly can make the full contributions if their MAGI is below $204,000. However, the contribution amounts start phasing out from $204,000 to $214,000. If the income exceeds $214,000, you can’t make further contributions to a Roth IRA.

A married couple, filing separately and who don't live with their spouse can make full contributions to a Roth IRA if their MAGI is below $129,000. However, contribution amounts start phasing out for income levels from $129,000 to $144,000. The contributions phase out if the income exceeds $144,000.

How to calculate modified adjusted gross income (MAGI)

If your MAGI is below the IRS income limit, you can make full contributions to a Roth IRA. The MAGI is calculated by taking your gross income- the sum of all money earned during the year, less certain tax-deductible deductions.

Some of the incomes considered when calculating the gross income include wages, business income, dividends, retirement distributions, capital gains, etc. Some of the tax-deductible expenses that are subtracted from the gross income include student loan interest, educator fees, alimony payments, health savings account contributions, early retirement account withdrawal penalties, etc.

Backdoor Roth IRA strategy

If you are a highly compensated worker and your income exceeds the IRS limit, you won’t be allowed to contribute to a Roth IRA. However, you can overcome this hurdle by using the backdoor Roth IRA strategy. This strategy involves converting retirement savings held in a nondeductible IRA into a Roth IRA.

A Roth IRA strategy involves the following steps:

Open a traditional IRA

Start by opening an IRA with a brokerage of your choice. You can opt to open the IRA with the same custodian where you plan to open a Roth IRA.

Make non-deductible contributions

The contributions you make to a traditional IRA should be fully non-deductible, meaning that you should not claim a tax deduction on your Form 1040 even if you are eligible to do so. For 2022, you can contribute up to $6,000 yearly, and an additional $1000 if you are above 50.

Roth conversion

Convert the traditional IRA money to a Roth IRA. There is no limit on how much you can convert since the income limit does not apply. You can do a Roth IRA conversion every year when your income exceeds the IRS income limits for Roth IRA.

What if you contribute too much to your Roth IRA?

If your income for the year was higher than expected, your Roth IRA contribution could exceed the IRS contribution limit.

If you identify your mistake before the deadline for tax returns, you can withdraw the excess amount and any accumulated earnings attributable to the excess contribution. You won’t pay a penalty on the excess contribution, but you will owe taxes.

However, if you realize the mistake after filing taxes, you should remove the excess contribution and any earnings within 6 months. You should file an amended tax return to fix the mistake.

If the excess contribution remains in the Roth IRA, the IRS will impose a 6% penalty annually until you withdraw the excess amount.