Roth contributions versus Roth conversions

Regular Roth contributions require compensation

To make a regular annual contribution to a Roth IRA, you generally need taxable compensation, such as wages or net self-employment income, at least equal to the contribution. Annual contribution limits apply, and income limits can reduce or eliminate eligibility to contribute directly.

Sale proceeds alone do not count as compensation. A year in which your only income is gain from selling your business, plus investment income, generally does not qualify you to make a regular Roth contribution on that basis.

A spousal IRA rule can allow a spouse with little or no compensation to contribute based on the other spouse’s compensation when filing jointly, still within the limits.

Roth conversions follow different rules

A conversion moves money from a traditional IRA or eligible plan into a Roth IRA. Conversions do not require wages or other compensation, and there is no annual dollar cap on how much you may convert.

The converted pre-tax amount is generally included in taxable income for the year of conversion, so a conversion can create a significant tax bill. Converting in the same year as a large sale gain may push income into higher brackets. Separate five-year rules can apply to converted amounts and to tax-free treatment of earnings.

Why people consider conversions after a sale

Some owners find that the years after the sale year, but before Social Security and RMDs, have lower taxable income. Converting in those years may reduce future required distributions and give heirs Roth assets. Whether that makes sense depends on current and expected future tax rates, cash available to pay the tax, Medicare premium effects, and estate goals.