Thursday, March 28, 2013

2012 IRA Contributions: Not Too Late

This is a reminder that you have until April 15 to make your IRA contributions for 2012. This could result in a lower 2012 tax bill if you make a deductible  contribution to a traditional IRA (TIRA), or lower future taxes if you make a contribution to a Roth IRA (Roth). While you're at it, go ahead and make your 2013 IRA contributions if you have the money. The rest of this post summarizes your options and my thoughts on what makes the most sense.

Don't agonize over which type of IRA to use (traditional or Roth). Most importantly, make sure you are making a contribution that is allowed by IRS regulations. Secondarily, you want to try and minimize your taxes, long-term as well as short-term. You can look up the 2012 contribution and deduction limits on the IRS web site here: Retirement Topics - IRA Contribution Limits. Here are a few quick highlights; specific numbers apply to the 2012 limits unless otherwise noted.

The maximum you can contribute to all of your traditional and Roth IRAs is $5,000 ($6,000 if age 50 or older). These limits increase to $5,500 and $6,500 for 2013. So a married couple could contribute up to $10,000 ($12,000 if both are age 50 or older).

If you (and your spouse if married) are not covered by an employer sponsored retirement plan (e.g., pension, 401K, 403B, etc.), you can make a fully deductible contribution to a traditional IRA regardless of your income, lowering your current taxable income.

If only one spouse is covered by an employer sponsored retirement plan (ESRP), the your filing status is "married filing jointly" (MFJ), the non-covered spouse can make a fully deductible TIRA contribution if your modified adjusted gross income (MAGI) is $173,000 or less.

If you (and your spouse if married) are covered by an employer sponsored retirement plan, you (and your spouse) can (each) make a fully deductible TIRA contribution if your MAGI is $58,000 or less ($92,000 or less if married filing jointly, $173,000 if not covered by an ESRP but spouse is covered). For higher MAGI, the deduction phases out and is eliminated at $68,000 ($112,000 if MFJ, $183,000 if not covered by ESRP but spouse is covered by ESRP).

Roth IRA contributions are not deductible, but may lower your taxes later, since all withdrawals are tax-free if you follow the rules. You can contribute directly to a Roth IRA up to the annual limit if your MAGI is less than $110,000 ($173,000 if MFJ). Partial Roth contributions can be made if your MAGI is up to $125,000 ($183,000 if MFJ). If MAGI is greater than these limits, you cannot contribute directly to a Roth IRA, but you may be able to make what is referred to as a "backdoor Roth contribution", described in the next paragraph.

Backdoor Roth. If you exceed the MAGI limits in the previous paragraph, and you don't have any existing traditional IRAs that include deductible contributions, you can make a non-deductible contribution to a TIRA, then shortly after that convert it to a Roth IRA. You will only be taxed on the earnings between the time you make the TIRA contribution and the time you convert to a Roth, and this is likely to be a small amount. If you have existing TIRAs that include deductible contributions, it gets more complex, and your Roth conversions will be partially taxed. This is one reason to keep retirement savings in traditional 401K/403B plans, rather than rolling them over to a traditional IRA.

Traditional or Roth?

This is debated endlessly on the Bogleheads investment forum, but here is my quick take on this topic.

In general, I think Roth IRAs are great, but I also think they are oversold relative to traditional IRAs. For example, some people are likely to be able to save on taxes in making a TIRA contribution, and yet pay little or no taxes on distributions in retirement; from a tax perspective only, this is the best of both worlds. Some people just hear "tax free" with respect to Roth IRAs, and don't realize they may be giving up valuable tax savings now while sacrificing little to nothing when taking distributions in retirement.

If you are eligible to make a fully-deductible contribution to a traditional IRA (TIRA), then I probably would do so, unless you are fairly certain that you will be in a higher tax bracket when you retire (which generally is unlikely to be the case), or unless you value the additional flexibility of a Roth (can withdraw contributions, but not earnings, penalty-free and tax-free at any time, and are not required to take distributions in retirement).

If you are not eligible to make a deductible TIRA contribution, but are eligible to make a direct Roth contribution, then a Roth is a no-brainer, assuming you have the  money, and have maxed out your deductible 401K/403B contributions.

If you are not eligible to make a deductible TIRA contribution ordirect Roth contribution, and you have made the maximum 401K/403B contribution for 2012 ($17,000 for 2012, and an additional $5,500 if age 50 or older), then a backdoor Roth is the way to go.

Some people like to contribute to a Roth after contributing enough to their 401K/403B to maximize the employer contribution, and then resume 401K/403B contributions after maxing out their Roth contributions for the year, but depending on how good your 401K/403B plan is, I'm not sure I agree. This is a gray area that is highly dependent on your personal situation. Don't agonize too much over this; if in doubt, flip a coin.

Happy Tax Season!

1 comment:

Kevin said...

Here's a nice table from Vanguard providing a summary comparison of Traditional and Roth IRAs: https://investor.vanguard.com/what-we-offer/iras/traditional-iras-and-roth-iras?WT.mc_id=2013IRA2