It is a very well known truth that in the US you have no-one to rely on but yourself when it comes to retirement.
Sure, you accumulate some Social Security benefits, but they’re nowhere near to bringing you to a comfortable retirement (check this page to calculate the estimate).
So what can you do? The usual: employer’s pension (if you’re lucky, not many left providing it), 401k and the IRA.
So lets look at the IRA: there are 2 kinds – Roth and Traditional. The difference is in tax treatment: for Roth you deposit after-tax money, and all the income is free when you’re retired. For traditional – you deposit money that may or may not be deductible on your tax return, and the amounts in excess of what you didn’t deduct on your taxes now will be taxable to you when you’re retired.
What does it mean? It means that with Traditional IRA, your account will provide you taxable income on retirement. With Roth – it will be non-taxable.
If you expect your retirement tax rates be lower than current, traditional IRA makes more sense to you. But there’s a problem: you can only deduct the contributions up to a certain (and fairly low) AGI limit. Especially if you also have a 401k at work.
There are additional benefits for having Roth IRA, for example – you’re not required to have distributions from them when you’re old (from a traditional IRA you’d be required to start distributing at the age of 70 and 1/2, whether you want it or not). So if you expect to not need the IRA distributions at all and just want to leave tax-free income for emergencies or as inheritance, Roth IRA is definitely better for you.
If you cannot deduct your IRA contribution – there’s no sense in having a traditional IRA. Roth is much better then. But, you cannot contribute to Roth IRA if you’re a high earner, especially if you’re covered by a 401k plan at work.
So what to do?
Utilize the loophole.
You can always contribute to a traditional IRA, with after-tax money in a non-deductible contribution. And, you can always convert a traditional IRA to a Roth IRA. So what’s the loophole? Simple: contribute to a traditional IRA and convert it to Roth IRA. This way you can maximize your retirement income while minimizing taxes on it.
There’s a catch: when you convert your traditional IRA to a Roth IRA, you’re taxed on the untaxed portion. If you have a traditional IRA balance in excess of your current non-deductible contribution (for example, you rolled over an old 401k into an IRA), it will be taxed proportionally to your contribution. So for the loophole to work best, you should not have any other Traditional/Rollover IRA other than the one you’re converting.
Here’s an example:
1. You don’t have any Traditional/Rollover IRA at all.
2. You deposit up to the yearly maximum (currently $5500) into a traditional IRA
3. You convert your traditional IRA to become Roth IRA ($5500 change designation from Traditional IRA to Roth IRA).
4. You fill IRS form 8606 and attach it to your yearly tax return, no tax due. You have a fully funded Roth IRA account.
Another example shows why it is important not to have any other pre-tax IRA when utilizing this scheme:
1. You have $55000 in your rollover IRA (traditional) from an old 401k.
2. You deposit $5500 (current yearly maximum) to a traditional IRA.
3. You convert the $5500 from step 2 to a Roth IRA.
4. You end up with $5500 in Roth IRA and the old $55000 in your rollover IRA.
5. You fill IRS form 8606 and attach it to your tax return, but there’s a tax due.
Because you had a pre-tax IRA ($0 basis), your tax is calculated like this: ($55000)*($5500/($55000+$5500)) = $5000 taxable. You’re calculating, in essence, what is the pre-tax portion of your total traditional IRA balance that you converted to Roth IRA, and how much of the total has been post-tax (i.e.: tax already paid). The proportion in this example is ~9.1%. Note that it doesn’t matter if the accounts are with the same custodian or not, you still have to count all of them together.
That makes ~91% of your conversion (in this example) taxable – $5000 out of the $5500.
To report Traditional IRA to Roth conversions, and non-deductible contributions, you should use IRS form 8606.
Always talk to your tax adviser before making any tax-related decisions. I’m not a tax adviser and this is not a tax advice. Always discuss your tax planning with a EA or CPA licensed in your State.
Your Little Advisor