The Difference Between IRA Contributions and Rollovers

Often there is confusion about what constitutes a “contribution” and a “rollover” into an IRA.  This post is intended to clear up the difference.

While both activities are technically contributions, there’s a major difference between the two.  The most significant of the differences is that with a regular annual contribution there are several limits imposed that can be quite restrictive.

Annual Contribution Limits

For an annual contribution to a traditional IRA or a Roth IRA, you are limited to the lesser of $5,000 or your actual earned income for the year.  If you have no earned income, you’re not allowed to make an annual contribution to an IRA.  Above that amount, if you happen to be 50 years old or better, you can add $1,000 more to your annual contribution (2012 figures).

Astute readers will point out that there is the option for a spouse to make a spousal IRA contribution in the event that one member of the couple has low or no income for the year.  As long as the other spouse has earned income, IRA contributions are allowed on behalf of the other spouse up to the limits mentioned above.

In addition, if the taxpayer has a retirement plan available in his or her job, there are further income limits that impact deductibility of traditional IRA contributions.  For 2012, the limit is Modified Adjusted Gross Income above $92,000 (for married filing jointly) or $58,000 for single filers.  Above these limits, deductibility is gradually reduced to zero when the Modified Adjusted Gross Income (MAGI) is at $112,000 (or $68,000 for singles).

For Roth IRA contributions, if the MAGI is greater than $183,000, contributions are not allowed for those who are married filing jointly.  For Single filers, the limit is $125,000.

Rollovers

Rollover contributions don’t have an annual limit.  You can rollover literally as much as you like from a qualified retirement plan (QRP) or IRA into another IRA.  In addition, there is no requirement to have had earned income for the year when making a rollover.

In addition, rollovers have no impact on your annual contribution amounts and vice versa.  You can rollover any amount without having to worry about annual limits, and then you can make regular annual IRA contributions up to the limits mentioned above.

Conversions

You are further allowed to convert any amount that you wish from a traditional IRA or QRP into a Roth IRA without limits and without impact to annual contributions.  The problem is that you have to pay tax on pre-taxed amounts that you convert, and this can amount to a sizable tax burden – all pre-tax amounts converted to Roth IRA are subject to ordinary income tax.

Conclusion

So the major difference between annual contributions and rollover or conversion distributions is that annual contributions represent “new money” being contributed into the IRA or Roth IRA account.  Rollovers are simply the transfer of money that was already in a tax-deferred account, into another tax-deferred account.  Or in the case of a Conversion, this is the transfer of existing tax-deferred funds into a tax-free Roth IRA.

Limits on contributions do not apply to rollovers or conversions; the two types of money are not related in any way.