A questioner asked, “Do Roth conversions create MAGI (modified adjusted gross income) for purposes of determining whether someone exceeds the MAGI thresholds to make an annual contribution to a Roth IRA?” during a recent Econome Encore presentation. It made me double take.
I did a double take for several reasons. First, the presentation was early on a Sunday morning . Second, for reasons we will address later, the issue rarely arises in practice. Third, since income from a Roth conversion is taxable, why wouldn’t it be considered MAGI for this purpose? Fourth, I believed the rule to say that, no, Roth conversions do not, for this purpose, create MAGI.
I quickly said that, based on my understanding, Roth conversions are not included in MAGI under the rule, but I double-checked. My initial take was correct. When calculating if a person is eligible to make an annual contribution to a Roth IRA, Roth conversions are excluded from MAGI. See IRC Section 408A(c)(3)(B)(i).
Converting a traditional IRA or 401(k) to a Roth IRA can be a strategic move for many individuals, offering tax-free growth and tax-free withdrawals in retirement. However, before making this decision, it’s crucial to understand how a Roth conversion affects your Modified Adjusted Gross Income (MAGI) and potentially triggers the 3.8% Net Investment Income Tax (NIIT). This article delves into the intricacies of Roth conversions and their impact on MAGI, empowering you to make informed financial decisions.
What is MAGI and How Does it Relate to Roth Conversions?
MAGI, or Modified Adjusted Gross Income, is a key factor in determining your eligibility for certain tax benefits and deductions. It is calculated by taking your adjusted gross income (AGI) and adding back certain deductions and exclusions, such as student loan interest and tuition and fees deductions.
When you convert a traditional IRA or 401(k) to a Roth IRA, the converted amount is considered taxable income, increasing your MAGI for the year of the conversion. This increase in MAGI can have several implications, including:
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Impact on the Net Investment Income Tax (NIIT): Individuals with a MAGI exceeding certain thresholds may be subject to the NIIT, a 3.8% tax on investment income such as dividends, interest, capital gains, and rental income. The income thresholds for the NIIT vary depending on filing status:
- $250,000 for married couples filing jointly
- $125,000 for married individuals filing separately
- $200,000 for single filers and heads of household
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Impact on Other Tax Benefits: A higher MAGI may affect your eligibility for other tax benefits, such as the deduction for traditional IRA contributions or the premium tax credit for health insurance.
Factors to Consider When Evaluating a Roth Conversion’s Impact on MAGI:
- Your Current and Projected MAGI: Analyze your current and projected MAGI to determine if a Roth conversion would push you into a higher tax bracket or subject you to the NIIT.
- The Amount of the Conversion: The larger the conversion amount, the greater the impact on your MAGI. Consider converting smaller amounts over multiple years to mitigate the impact.
- Your Investment Income: If you have significant investment income, the NIIT could be a significant factor in your decision.
- Your Tax Bracket: If you are in a lower tax bracket now than you expect to be in retirement, a Roth conversion may be advantageous despite the immediate tax impact.
Strategies to Minimize the Impact of a Roth Conversion on MAGI:
- Convert in Lower-Income Years: If possible, consider converting during years when your income is lower, minimizing the impact on your MAGI and potentially avoiding the NIIT.
- Spread the Conversion Over Multiple Years: Instead of converting your entire traditional IRA or 401(k) in one year, spread the conversion over several years to reduce the impact on your MAGI in any given year.
- Contribute to a Roth IRA Instead: If you have the financial capacity, consider contributing directly to a Roth IRA instead of converting an existing retirement account. This avoids the immediate tax impact of a conversion while still enjoying tax-free growth and withdrawals in retirement.
Understanding how a Roth conversion affects your MAGI and the potential implications for the NIIT is crucial for making informed financial decisions. By carefully analyzing your current and projected financial situation and exploring various strategies, you can minimize the tax impact and maximize the benefits of a Roth conversion.
Additional Resources:
- Fidelity Viewpoints: Roth IRA Conversion – What to Know Before Converting: https://www.fidelity.com/viewpoints/retirement/roth-ira-conversion-after-50
- Bogleheads Forum: Roth Conversion – Does it affect MAGI?: https://www.bogleheads.org/forum/viewtopic.php?t=400964
Disclaimer: This article is for informational purposes only and should not be considered financial advice. Please consult with a qualified financial advisor to discuss your specific situation and determine the best course of action for your financial goals.
Changes to Roth IRAs
With effect from 2010, Congress removed the MAGI restriction on the ability to perform Roth conversions in 2006. Refer to the Tax Increase Protection and Reconciliation Act of 2005’s pages 21 and 22 in this PDF. This is what made the Backdoor Roth IRA possible to use beginning in 2010.
It’s interesting to note that the kick out of Roth conversion income from the MAGI limitation on the ability to make an annual contribution to a Roth IRA might not exist if there had never been a MAGI limitation on the ability to do a Roth conversion. First, there would have been no need to address the circular definition issue. Second, it would have been more organized to just make a reference to the MAGI definition of the deductible traditional IRA contribution and stop there.
However, that is not how the Roth IRA’s history has played out. We’ll never be able to determine if the current regulations had been the original Roth IRA regulations, or if there would not have been a kick out of Roth conversion income when defining MAGI for annual Roth contribution purposes.
The Creation of the Roth IRA in 1997
It’s a bit of an odd rule, though. It is particularly strange to separate Roth conversion income from the Roth IRA MAGI test when actual taxable withdrawals from a traditional IRA or 401(k) generate MAGI for this purpose. Why should one set aside money from traditional IRA and 401(k) conversions to a Roth account?
It has to do with how Roth IRAs were created. In 1997, Congress created the Roth IRA to be effective starting in 1998. Roths were new. There was likely a concern along the lines of “a vehicle with tax-free growth could be abused.” Thus, there were two features of the Roth IRA subject to a MAGI limitation. Both the ability to make a direct annual contribution to a Roth IRA and the ability to convert amounts from a traditional retirement account to a Roth IRA were subject to a MAGI limitation. See page 40 of the 1997 Taxpayer Relief Act text.
The MAGI limitations begged the question: how to define MAGI for this purpose? The bill drafters started with a common technique: they found another relevant definition of MAGI already existing in the Internal Revenue Code. Why reinvent the wheel? They started with the MAGI definition used to determine the ability to make a deductible traditional IRA contribution.
By itself, however, this definition would create a circular definition problem with respect to Roth conversions, as the IRA deduction MAGI definition used starts with AGI and then kicks out certain items. Roth conversions are included in AGI, so to avoid a circular calculation, the bill drafters had to kick Roth conversion income out of the Roth MAGI definition.
For example, if AGI was $90K prior to a $40K Roth conversion, the $40K Roth conversion would disqualify itself because the MAGI limitation on the ability to convert was $100K of MAGI. If Roth conversion income was included in the MAGI definition, then the taxpayer would have to test Roth conversions against themselves to determine if Roth conversions were allowed!
Additionally, the bill drafters chose to combine the two distinct limitations into a single MAGI definition. They could have produced two distinct MAGI definitions, but doing so would have resulted in an even longer and more intricate new Code section. Recall that in 1997, when the bill was drafted, none of this was in place. Thus, there was only one MAGI definition for both limits in the final bill. In order to avoid the circular definition issue with regard to Roth conversions, that one definition eliminated Roth conversion income.
Do Roth conversions affect my ability to make Roth IRA contributions?
Are Roth conversions included in Magi?
Roth conversions are not included in MAGI for purposes of determining whether one can make an annual contribution to a Roth IRA. See IRC Section 408A (c) (3) (B) (i) . It’s a bit of an odd rule, though. Why carve out Roth conversion income from the Roth IRA MAGI test?
What is modified adjusted gross income (MAGI) in a Roth IRA?
Your modified adjusted gross income (MAGI) as it relates to your Roth IRA is nothing more than your adjusted gross income (AGI) as shown on your tax return, along with a few modifications. For instance, when making a Roth IRA conversion or rollover, you must report any retirement account distributions as taxable income.
Is Roth conversion included in modified adjusted gross income?
However, according to the Lacerte IRA deduction worksheet, my client’s Roth conversion is not included in modified adjusted gross income and references publication 590. First, I can only find publication 590-A and 590-B. I can’t find this rule in either publication. Can anyone point me to the right direction? Thanks. 09-10-2021 08:31 AM
Are Roth conversions included in AGI?
Roth conversions are included in AGI, so to avoid a circular calculation, the bill drafters had to kick Roth conversion income out of the Roth MAGI definition. If Roth conversion income was included in the MAGI definition, then the taxpayer would have to test Roth conversions against themselves to determine if Roth conversions were allowed!