Thursday, September 24, 2015

Do You Earn Too Much For An IRA?



I have received several questions about IRAs recently.  They can roughly be divided into two categories:

(1) Do I qualify?
(2) I converted to a Roth and it is worth less than what I paid tax on.

I wondered whether there is some way to blog about this without our eyes glazing over. IRAs are a thicket of seemingly arbitrary rules.

Let’s give it a try by discussing a couple of situations (names and numbers changed, at least a smidge) that came across my desk this year.     

Our first example:

Matt is single and makes around $200,000 annually. He is over age 50 and maxes-out his 401(k). He heard that he can put away an additional $1,000 in an IRA for being over age 50. He puts $6,500 into a Roth, and then he calls his tax advisor to be sure he was OK.

He is not.

His 401(k) is fine. There generally are no problems with a 401(k), unless you are one of the highly-compensated and the plan administrator sends money back to you because the plan went “top heavy.” 

It is the IRA that is causing headaches.

He has a plan at work (the 401(k)) AND he made an IRA contribution. The tax rules can get wonky with this combination.

You see, having a plan at work can impact his ability to make an IRA contribution. If there is enough impact, He cannot make either a traditional (which means “deductible”) or Roth IRA contribution.

 Is it fair? It’s debatable, but those are the rules.

What is too much?

(1) A single person cannot make a traditional IRA contribution if his/her income exceeds $71,000. 

CONCLUSION: He makes $200,000. He does not qualify for a traditional (that is, deductible) IRA.

(2) A single person cannot make a Roth contribution if his/her income is over $131,000.

CONCLUSION: He makes too much money to make a Roth contribution. 

Did you notice the two different income limits for a regular and Roth IRA? It is an example of the landmines that are scattered in this area.

What should Matt do?

Let’s go through example (2) and come back to that question.

Sam and Diane are married. They are both in their 50s and make approximately $180,000 combined. They did well in the stock market this past year, picking up another $15,000 from capital gains as well as dividends, mostly from their mutual funds. Diane and Sam were a bit surprised about this at tax time.

Diane has a 401(k) at work. Sam does not. Diane contributes $6,500 to her traditional (i.e., deductible) IRA, and Sam contributes $6,500 to his Roth.

There is a problem.

The 401(k) is fine. The 401(k) is almost always fine.

Again it is those IRAs. The income limits this time are different, because we are talking about a married couple and not a single person. The limits are also different because Sam does not have a retirement plan at work.

A reasonable person would think that Sam should be allowed to fully fund an IRA. To require otherwise appears to penalize him as he has no other retirement plan. Many would agree with you, but Congress saw things differently. Congress said that there was a retirement plan at work for one of the two spouses, and that was enough to impose income limits on both spouses. Seems inane to me and more appropriate for the Gilligan’s Island era, but – again – those are the rules.

(1) Since Diane has a plan at work, neither can make a traditional/deductible) IRA contribution if their combined income exceeds $193,000. 

Note that she would have had a deductible IRA (at least partially deductible) except for the dividends and capital gains. Their combined income is $195,000 ($180,000 + $15,000), which is too high. No traditional/deductible IRA for Diane.

(2) Roth contributions are not allowed for marrieds with income over $193,000.

OBSERVATION: Hey, that is the same limit as for a traditional/deductible IRA. Single people had different income limits for a traditional/deductible and Roth IRA. 

Q: Why is that? 

A: Who knows. 

Q: How does a tax person remember this stuff?

A: We look it up.

They went over $193,000. Sam cannot make a Roth contribution. 

Diane and Sam did their tax planning off their salaries of $180,000, which was below the income limit. They did not anticipate the mutual funds. What should Diane and Sam (and Matt) do now?

First, you have to do something, otherwise a penalty will apply for over-funding an IRA. Granted the penalty is only 6%, but it will be 6% every year until you resolve the problem.

Second, you can contact the IRA custodian and have them send the money back to you. They will also send back whatever earnings it made while in the IRA, so there will be a little bit of tax on the earnings. Not a worst case scenario.

Third, you can have the IRA custodian apply the contributions to the following year. Maybe they will, maybe they won’t.  It would be a waste of time, however, if your income situation is expected to remain the same.

Fourth, you can move the money to a nondeductible IRA.

Huh?

Bet you did not realize that there are THREE types of IRAs. We know about the traditional IRA, which means that contributions are deductible. We also know about Roth IRAs, meaning that contributions are not deductible. But there is a third - and much less common – IRA.

The nondeductible IRA. 

You hardly hear about them, as the Roth does a much better job. No one would fund a nondeductible if they also qualified for a Roth. 

There is no deduction for money going into a Roth IRA, but likewise there is no tax on monies distributed from a Roth. Let that money compound for 30 or 35 years, and a Roth is a serious tax-advantaged machine.

There is no deduction for money going into a nondeductible IRA, but monies distributed will be partially taxed. You will get your contributions back tax-free, but the IRS will want tax on the earnings.  The nondeductible IRA requires a schedule to your tax return to keep track of the math. 

The Roth is always better: 0% being taxed is always better than some-% being taxed. 

Until you cannot contribute to a Roth.

You point out that Matt, Diane and Sam are over the income limits. Won’t the nondeductible IRA run into the same wall?

No, it won’t. A nondeductible IRA has no income limit. 

And that gives the tax advisor something to work with when one makes too much money for either a traditional/deductible or Roth IRA.

Let’s advise Matt, Diane and Sam to move their contributions to a nondeductible IRA.  That way, they still make a contribution for the year, and they preserve their ability to make a contribution for the following year. Some retirement contribution is better than no retirement contribution.

BTW, what we have described – moving one “type” of IRA to another “type” – is sometimes called “recharacterization.” More commonly, it refers to moving monies from a Roth IRA to a traditional/deductible IRA. 

For example, if you made a Roth “conversion” (meaning that you transferred from a traditional/deductible IRA to a Roth) in 2014, you might be dismayed to see the stock market tanking in 2015. After all, you paid tax when you moved the money into a Roth, and the account is now worth less. You paid tax on that money!


There is an option: you can “recharacterize” the Roth back to a traditional IRA in 2015. You would then amend your 2014 tax return and get a tax refund. You have to recharacterize by October 15, 2015, however, as that is the extended due date for your 2014 tax return.  Does it matter that you did not extend your 2014 return? No, not for this purpose. The tax Code just assumes that you extended. 

You can recharacterize some or all of the Roth, and there are some rules on when you can move the monies back into a Roth.

The nondeductible IRA is also involved in a technique sometimes called a “backdoor” Roth. This is used when one makes too much money for a Roth contribution but nonetheless really wants to fund a Roth. The idea is to fund a nondeductible IRA and then convert it to a Roth. This works best with an IRA contribution made after December 31st but before the tax return is due.

EXAMPLE:  You make a $5,500 nondeductible IRA contribution on February 21, 2016 for your 2015 tax year. You convert it to a Roth the next day. Think about the dates for a moment. You made a 2015 IRA contribution (albeit in 2016). You converted in 2016. Even though this happened over two days, the two parts of the transaction are reported in different tax years.

BTW, converting to a Roth means that you literally move the money from one account to a different account. It is not enough to just change the name of the account. Formality matters in this area. 

There are rules that make the backdoor all-but-impossible if you have other IRA accounts. It is one of those eye-glazing moments in this area, so we won’t go into the details. Just be aware that there may be an issue if you are thinking about a backdoor Roth.

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