Tax-Diversify Your Portfolio Part 1: IRAs and Roth IRAs – The Basics

We never know what the future will hold, but it is clearly possible that tax rates in future years could be higher than those we have today.  Between new taxes and higher rates, and the elimination of certain deductions, planning for tax diversification has become critical.  Effective IRA planning is one way to achieve this.  In Part 1, we’ll cover the basics of the three types of IRAs and whether you can contribute directly to a Roth IRA.

Your level of income may limit your ability to get an up-front tax deduction for a contribution to a Traditional IRA or contribute directly to a Roth IRA, but you can contribute to a Traditional IRA (with no tax deduction) regardless of your income.  Using a strategy to convert traditional IRAs to Roth can shift taxable savings to tax-free savings.

Here are the basic things to remember about IRAs:

  • For a contribution to any IRA, you must have earned income (wages or self-employment income[1]).
  • Your eligibility to contribute to the different types of IRAs also depends on your Modified Adjust Gross Income (MAGI). For IRA purposes, MAGI is your Adjusted Gross Income (AGI), the number on the bottom of your 1040, with some income added back.  For detail, see http://fairmark.com/retirement/roth-accounts/contributions-to-roth-accounts/modified-adjusted-gross-income/
  • For 2013 and 2014, the maximum contribution you can make to any IRA is $5,500 ($6,500 if you are age 50 or older at the end of the tax year). 
  • Participation in an employer’s retirement plan (like a 401k or 403b) doesn’t affect how much you can contribute to an IRA, but whether you can deduct a contribution to a Traditional IRA

Three Types of IRAs

Individual Retirement Accounts (IRAs) come in three main flavors: 

                Traditional-Deductible                   Traditional-Non-Deductible                         Roth 

Traditional IRAs can be deductible or non-deductible.  Your eligibility to deduct contributions will depend on your income.  So will your eligibility to contribute to a Roth IRA. You can always contribute to a Traditional IRA, though you may not be able to deduct the contribution.  You can never deduct a Roth contribution.

 

Planning Tip #1: You May Be Eligible for Roth IRA Contributions

Savings in a Roth IRA grows tax-free FOREVER, and is never taxed again under current tax law.  You may be able to contribute the maximum or a reduced amount to a Roth, depending on your modified adjusted gross income (MAGI).  Find your filing status below and learn what IRAs you are eligible for:

IF YOU ARE SINGLE and …

 Your MAGI is Are you in an employer plan  You can contribute Amount you can deduct
Any No  Up to max to TRAD IRA All
<$59,000 Yes Up to max to TRAD IRA All
$59,000-$69,000 Yes Up to max to TRAD IRA Partial
>= $69,000 Yes* Up to max to TRAD IRA Zero
<$112,000 Yes* Up to max to ROTH IRA Zero
$112,000-$127,000 Yes* Reduced amount to ROTH IRA; Balance to Trad IRA Zero
>=$127,000 Yes* Cannot contribute to ROTH IRA;Can contribute to TRAD IRA Zero

 

IF YOU ARE MARRIED and …

Your MAGI is Are you in an employer plan  You can contribute Amount you can deduct
Any No  Up to max to TRAD IRA Full
<$59,000 Yes Up to max to TRAD IRA Full
$59,000-$69,000 Yes Up to max to TRAD IRA Partial
>= $69,000 Yes* Up to max to TRAD IRA Zero
<$112,000 Yes* Up to max to ROTH IRA Zero
$112,000-$127,000 Yes* Reduced amount to ROTH IRA; Balance to TRAD IRA Zero
>=$127,000 Yes* Cannot contribute to ROTH IRA;Can contribute to TRAD IRA Zero

*participation in an employer plan does not matter at these income levels; you won’t be able to deduct an IRA contribution

Roth IRAs provide tax diversification for your portfolio, and flexibility regarding WHEN you have to use the funds.  Roth IRAs are not subject to minimum distributions and can continue to grow even after you die: your heirs will have to take out minimum distributions, but those distributions are tax-free to them.

Planning Tip #2: You Can Always Contribute to an IRA for Tax-Deferral – See Part 2

 


[1] Note married taxpayers may use their spouse’s compensation for IRA contribution eligibility.