Steve Hamilton is a Tampa native and a graduate of the University of South Florida and the University of Missouri. He now lives in northern Kentucky. A career CPA, Steve has extensive experience involving all aspects of tax practice, including sophisticated income tax planning and handling of tax controversy matters for closely-held businesses and high-income individuals.
Thursday, September 24, 2015
Do You Earn Too Much For An IRA?
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.
whether there is some way to blog about this without our eyes glazing over.
IRAs are a thicket of seemingly arbitrary rules.
it a try by discussing a couple of situations (names and numbers changed, at
least a smidge) that came across my desk this year.
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
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
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
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
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
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.
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?
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
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.
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
can move the money to a nondeductible IRA.
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.
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
The Roth is
always better: 0% being taxed is always better than some-% being taxed.
cannot contribute to a Roth.
out that Matt, Diane and Sam are over the income limits. Won’t the
nondeductible IRA run into the same wall?
won’t. A nondeductible IRA has no income limit.
gives the tax advisor something to work with when one makes too much money for
either a traditional/deductible or Roth IRA.
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
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.
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.
recharacterize some or all of the Roth, and there are some rules on when you
can move the monies back into a Roth.
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.
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