Can I Contribute to an IRA if I Make Too Much?

IRA

I graduated from college with a Finance degree but felt woefully unprepared when it came to personal finance.  Most of my classes had a concentration on corporate financial classes.  After I graduated, I consistently heard from financial pundits that I needed to contribute to a Roth IRA (Individual Retirement Account).  Even the yearly tax software I was using asked if I contributed to a Roth IRA for the year.  By then, the marketing machine for the Roth IRA had persuaded me to contribute.  That first year, I was able to scrape together $3,000 to contribute to a Roth IRA and have maximized that amount ever since.

 

The Roth IRA was not established until the Taxpayer Relief Act of 1997, which meant the first year individuals could contribute was 1998.  Since it is a fairly new retirement plan, people are still trying to figure which is better- a Traditional or Roth.

 

Features Traditional IRA Roth IRA
Who can contribute? You can contribute if you (or your spouse if filing jointly) have taxable compensation but not after you are age 70½ or older. You can contribute at any age if you (or your spouse if filing jointly) have taxable compensation and your modified adjusted gross income is below the phase outs
Are my contributions deductible? You can deduct your contributions if you qualify. Your contributions aren’t deductible.
How much can I contribute? The most you can contribute to all of your traditional and Roth IRAs is the smaller of:
$5,500 (for 2016), or $6,500 if you’re age 50 or older by the end of the year; or your taxable compensation for the year.
What is the deadline to make contributions? Your tax return filing deadline (not including extensions). For example, you have until April 15, 2017, to make your 2016 contribution, but please see IRS Publication 509, Tax Calendars, for how statewide holidays may delay this deadline.
When can I withdraw money? You can withdraw money anytime.
Do I have to take required minimum distributions? You must start taking distributions by April 1 following the year in which you turn age 70½ and by December 31 of later years. Not required if you are the original owner.
Are my withdrawals and distributions taxable? Any deductible contributions and earnings you withdraw or that are distributed from your traditional IRA are taxable. Also, if you are under age 59 ½ you may have to pay an additional 10% tax for early withdrawals unless you qualify for an exception. None if it’s a qualified distribution (or a withdrawal that is a qualified distribution). Otherwise, part of the distribution or withdrawal may be taxable. If you are under age 59 ½, you may also have to pay an additional 10% tax for early withdrawals unless you qualify for an exception.

Source: IRS.gov

 

Which is better: Traditional or Roth?

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I wish the answer was easy, but it is just not that black and white.  

 

If you are currently in a high-tax bracket and believe that your tax rate will decrease when you are in retirement, it would make sense for you to contribute to a Traditional IRA.  Therefore, you would be able to reduce the amount of taxes you pay immediately.  And, in retirement, you would pay less taxes when you withdraw your investment.

 

One thing to note with a Traditional IRA is in the future if you decide that you would like to convert your Traditional IRA into a Roth IRA, you have the ability to do this rollover.  This will allow you to take tax-free withdrawals, but you will be required to pay taxes on the contributions that you made over the years.  Most people, if they choose to do the rollover, do so when their tax rate is at the lowest point in order to minimize the amount of taxes that they pay to IRS.

 

If you are in a lower tax bracket and believe that your tax rate will increase when you are in retirement, it would make sense for you to contribute to a Roth IRA.  Therefore, you would pay taxes lower initially with the anticipation that when you are in retirement, you should save money on the taxes you would have paid on the withdrawn investment.

 

Another major benefit of utilizing the Roth IRA is up to $10,000 during your lifetime can be withdrawn tax-free in order to purchase a principal residence as a first-time homebuyer.  The funny thing about this rule is you don’t actually have to be a first-time homebuyer.  The only requirement is that you haven’t previously owned a home within the last 24 months.  So, for those individuals who have previously owned a home, you can still withdraw up to $10,000 during your lifetime to take advantage of this benefit.

 

Finally, with a Roth IRA, you are not required to take required minimum distributions (RMD) at 70 1/2 like you are with a Traditional IRA.  This is a huge benefit if you become wealthy and no longer need the distributions.  That way if you do not need the funds in your Roth IRA, it can continue to grow until you die.  

 

Eligibility Requirements

As you can see on the below chart, the Traditional IRA has a much lower MAGI than does the Roth IRA.  The IRS is very concerned about receiving their money today and is clearly not worried about the future when it comes to economic matters.

 

2016 Roth IRA income requirements
Filing Status Modified adjusted gross income (MAGI) Contribution Limit
Single individuals < $117,000 $5,500
≥ $117,000 but < $132,000 Partial Contribution
≥ $132,000 Not eligible
Married (filing joint returns) < $184,000 $5,500
≥ $184,000 but < $194,000 Partial Contribution
≥ $194,000 Not eligible
Married (filing separately) Not eligible $5,500
< $10,000 Partial Contribution
≥ $10,000 Not eligible

 

2016 Traditional IRA deduction limits
Filing Status Modified adjusted gross income (MAGI) Deduction Limit
Single individuals ≤ $61,000 Full deduction up to the amount of your contribution limit
> $61,000 but < $71,000 Partial Deduction
≥ $71,000 No deduction
Married (filing joint returns) ≤ $98,000 Full deduction up to the amount of your contribution limit
> $98,000 but < $118,000 Partial Deduction
≥ $118,000 No deduction
Married (filing separately) Not eligible Full deduction up to the amount of your contribution limit
< $10,000 Partial Deduction
≥ $10,000 No deduction
Non-active participant spouse (i.e., those with spouses who earn no income) ≤ $183,000 Full deduction up to the amount of your contribution limit
> $183,000 but < $193,000 Partial Deduction
≥ $193,000 No deduction

 

I unfortunately do not know what the future holds.  If I did, it would be a no brainer to utilize basic math skills to deduce which made more sense between the Traditional and Roth.  Since I don’t know what the future holds, I tend to spread out my risk.  Therefore, I contribute money to my Traditional 401(k) and also my Roth IRA to diversify my tax rate risk.  

 

Another Option- Nondeductible IRA

If you are ineligible to contribute to either a Traditional IRA or Roth IRA, you can do a nondeductible IRA, which has the worst features of all IRAs.  You end up paying taxes immediately like a Roth IRA, and when you withdraw, you end up paying taxes again like a Traditional IRA.  This would really stink, but thankfully there is a loophole.  

 

You can open up a Traditional IRA, and for tax purposes, it will be non-deductible when you file taxes.  However, the very next day, you convert the Traditional IRA into a Roth IRA.  If you leave the contribution in as cash and didn’t buy any stock or earn any interest, you will not be required to pay any taxes on the earnings.  Therefore, you will essentially have created a backdoor Roth IRA, which is completely legal.  Yes, you can really do this!! If you couldn’t, why is Vanguard showing you exactly how to create a backdoor Roth IRA on their website?

 

Now, let’s say you have an existing Traditional IRA with $20,000 in the account.  Let’s say you now make too much money but still wanted to contribute.  So, you decide to do a non-deductible contribution of $5,000 and try to convert just the $5,000 over into a Roth IRA.  Well, the IRS is going to tax you on a percentage of the total amount in your Traditional IRA.  For this example, let’s assume you are in the 25% tax bracket.  Then, the formula would be $5,000, which is your non-deductible IRA contribution, divided by the total amount in the IRA, which will include the $5,000 you contributed from the non-deductible IRA, plus the existing $20,000 that is in the Traditional IRA account.  Therefore, your tax-free rate will be 20% based on $5,000/($5,000+$20,000).  So, $1,000 will go tax-free into your conversion Roth IRA, and then of the remaining $4,000 that you convert into the Roth IRA will be taxed at the 25% tax rate, which means you will have $1,000 that you have to pay in taxes.

 

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So now that I have walked you through how to do a non-deductible to Roth IRA conversion, be careful.  There have been rumors that Congress is going to try to close this loophole at some point, so make sure you are following along with the latest laws before you put this into action.

 

Do you have a preference on the IRA that you utilize?  Have you done a non-deductible to Roth IRA conversion?

Mustard Seed Money

Welcome to the website. A mustard seed is a very small seed but astonishingly grows very large over time. My hope is that through your financial journey that your small investment in time, money and faith will grow beyond anything that you could ever imagine.

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