By Andy Ives, CFP®, AIF®
We are just a few days into the new year, and many people are anxious to get their full IRA contributions in for 2021. However, a common question is, “It’s only the first week of the year and I haven’t received a paycheck yet. Can I still make my contribution now, or do I need to wait until I actually have earned income?”
There is no need to wait. You can go ahead and make an IRA contribution now if you’d like, with the expectation that you will have enough earned income by the end of the year. Anyone who wants to contribute up to the maximum $6,000 (plus another $1,000 for those age 50 and over) is good-to-go if they have at least that much earned income by year end.
The IRS will essentially “look back” over the year to see what happened in its entirety to determine certain transactions. This is beneficial when it comes to IRA contributions, as outlined above. Considering the year in its entirety will also impact recharacterizing a contribution.
Example 1: Anthony makes a $6,000 Roth IRA contribution in January. Later that year in November, he receives a large and unexpected bonus from work, which pushes Anthony over the Roth income limits for eligibility. Fortunately, he is not locked into or penalized for what would have been an excess contribution to the Roth IRA way back in January. Since the IRS considers Anthony’s entire year of income (they “look back”), Anthony has time to make the fix. Anthony decides to recharacterize his earlier Roth IRA contribution to a non-deductible traditional IRA.
There are other situations where “looking back” can negatively impact a transaction. The pro-rata rule can completely disrupt the best laid plans.
Example 2: Kaci has $20,000 in her IRA which is made up entirely of basis (after-tax dollars). She has no other IRAs, SEP or SIMPLE plans. Kaci does a Roth conversion of the full $20,000 IRA with the proper expectation that this will be a tax-free conversion. No tax due.
Kaci also has a $180,000 401(k) which consists entirely of pre-tax dollars. Where Kaci goes wrong is, later that same year in December, she rolls the full $180,000 pre-tax 401(k) into her IRA. She thinks that since she already did the Roth conversion well before the rollover, she is in the clear. Unfortunately for Kaci, the pro-rata rule will look back over the entire year. The rule dictates that Kaci had a $200,000 IRA with $20,000 basis – a 90/10 split. Every Roth conversion that year will be 90% taxable.
As such, Kaci’s $20,000 Roth conversion now generates taxable income of $18,000. Had she simply waited until the following year to roll over the 401(k), her Roth conversion would have stayed out of the unblinking look-back eyes of the IRS and remained 100% tax-free.
Know that the “look back” rules can be a positive force, such as when you want to make an IRA contribution early in the year. However, be careful when it comes to pro-rata and Roth conversions. In those situations, the same IRS look back rules could sneak up on you.