Q&A: Don’t get tripped up by invalid Roth IRA contributions

Dear Liz: A friend told me that when he takes out his required minimum distribution from his traditional IRA and pays the tax, he then puts the money in his Roth IRA. I believe since this was not earned income, this was wrong. Who’s right?

Answer: The money contributed to an IRA doesn’t have to be earnings, necessarily, but your friend or his spouse must have income earned from working to make an eligible contribution. Earned income includes wages, salary, tips, bonuses, professional fees or small business profits. Earned income does not include Social Security benefits, pension or annuity checks and distributions from retirement accounts.

Another restriction is that contributions can’t be greater than the amount of earned income. If your friend or his spouse earned $3,000 last year, that’s all he’d be allowed to contribute — not the $6,500 maximum allowed for people 50 and over.

The ability to contribute to a Roth begins to phase out when someone’s modified adjusted gross income exceeds certain amounts. In 2017, single filers’ ability to contribute phased out between $118,000 and $133,000. For married couples filing jointly, the phase out began at $186,000 and ended at $196,000.

The penalty for ineligible contributions is 6% of the ineligible amount. The penalty is owed each year the taxpayer allows the lapse without correcting the oversight. If your friend has been doing this for several years, the penalty will be pretty painful.

He could cross his fingers and hope the IRS doesn’t notice, but the error isn’t that hard for the agency to catch. The IRS would simply need to compare Form 5498, which IRA custodians issue to report contributions, to your friend’s income and the sources of that income to know whether he was eligible to put money in an IRA.

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  1. I am pretty sure that converting money taken out as a rmd after age 70 is specifically prohibited from being converted into a Roth account. Otherwise, this would be a great way to,more or less, convert a taxable IRA to a Roth after 70 which is prohibited.

    • Liz Weston says

      There’s no age limit for conversions. And while you can’t put RMD proceeds directly into a Roth, if you’re still working you can drop the money in your checking account and then send it right back out again to the Roth.

  2. I have not a clue how the new tax law will affect me. Right now I get $68,000 in pension and social security. I am right now working a cashier job at Target which is a hoot and I love it. Saying that, I am worried that I will make too much money there which will put me into a higher bracket for Medicare Part B. What are the income limits before Medicare B bites me.