In my last article, I wrote about how you can make your kid a millionaire with the help of a Roth IRA. Some of you thought it was a great idea; and for the rest of you…the feeling I got was that I had you at “millionaire” and lost you at “kid.” After all, you did support them for the first two decades of their lives so I think that will do. So for this article we’re going to focus on making your own millions with a Roth IRA.
Before delving into the subject, we should understand the basic differences between a Roth IRA and a traditional IRA. With a traditional IRA, the contributions may be tax deductible on your federal and state tax returns if you qualify (whether you can deduct it depends on various factors such as income limits and whether your work offers a 401k). So you may get a deduction in the years you contribute but when you retire and start withdrawing you’ll pay taxes on all those funds that’s been growing for decades. Even if you don’t qualify for a deduction for the contributions you’ll still pay taxes on all the earnings. So in short, there’s a fair amount of tax implications with a traditional IRA.
The Roth IRA is just the opposite—there’s absolutely no tax implications. You fund it with post-tax dollars so you don’t get that deduction when you contribute but you also pay zero taxes when you eventually withdraw the funds. Now, whether it’s better to pay taxes now (in the form of using post-tax dollars with the Roth IRA) or later (in the case of the traditional IRA) really depends on many factors. On one hand, you’ll most likely be in a lower tax bracket when you start withdrawing the funds (advantage traditional IRA), but on the other hand you have a lot less deductions that can offset some of your income later in life (advantage Roth IRA). Just think about it, you may have paid off your mortgage by then so you won’t be able to deduct the interest, you (hopefully) won’t qualify for the child care tax credit, and if you’re not working then you won’t be able to deduct state income taxes that come out of your paycheck now. (Thankfully, those of us residing in Bergen County can always count on ridiculously high property taxes that we’ll be able to deduct.) So even though your tax bracket may be lower later in life, you still could end up paying more taxes anyway due to less deductions. But the most important factor in this decision may be how long you have to grow these funds before you need them. If you won’t need to touch your IRA for another twenty to thirty years and it can grow 11 percent on average each year (the average rate of return for the S&P 500 for the past fifty years), then getting all these earnings tax-free can save you tens of thousands of dollars in taxes.
But here’s the kicker—you may be making too much money to contribute to a Roth IRA. If you file married filing joint and your modified adjusted gross income is over $193,000 ($131,000 for those who file single) then you’re not eligible to contribute because the IRS decided you’re too rich. While $193,000 is a very nice salary, raising a Jewish family on the East Coast can be very costly. This may seem like a familiar predicament you’re in—everyone seems to think you’re rich. The school seems to think you’re rich and wants your money, the shul thinks you’re rich and wants your money, your kids think you’re rich and want your money. You may even think you’re rich. That is until you look at your bank account at the end of the month and then realize maybe you’re not so rich. Well, now you can add the IRS to this list.
Lucky for you, there’s a way to get around this restriction by rolling over your traditional IRA to a Roth IRA. In 2010, Congress removed the income restriction for rollovers so now everyone is eligible to roll over their traditional IRA to a Roth IRA. But when you roll over these funds you will pay taxes now, and if you don’t know what you’re doing you can get clobbered with a hefty tax bill. In short, all the contributions you received a deduction for and all the earnings you haven’t paid taxes on yet will be included in your taxable income in the year you roll over. So you need a strategy so you won’t feel the sting of those taxes when you make this election.
There are a number of strategies you can implement but I will go over two in this article. The first strategy is the gradual conversion. Using this method, you would gradually convert a portion of the traditional IRA funds over several years. This allows you to have complete control over your tax bill. You can convert $100 or $100,000, do it over two years or twenty years. If you find that you have extra cash on hand one year then you can convert more funds that year. If you have less cash one year then you can convert less funds. This allows you to convert your retirement fund to a Roth IRA without getting hit with a massive tax bill at one time.
Another strategy is the charitable contribution method. If you plan on making a large donation to a charity one year, then by timing your rollover to coincide with this donation you can completely wipe out the taxes you would pay when rolling over your IRA. For example, let’s say by rolling over your IRA you would have to include an additional $60,000 in your taxable income. But why pay the IRS when you can help out a charity instead? So you make a donation of $60,000 to charity that year as well. This donation will negate the additional income from the rollover and your tax bill will be zero.
Although the law says you can’t contribute to a Roth IRA if your income is too high, that doesn’t mean you can’t convert your traditional IRA to a Roth IRA. This is a great way to grow those earnings in your fund without having to pay any taxes whatsoever when you withdraw upon retirement. But when you roll over those funds to a Roth IRA, Uncle Sam is going to want his piece of the pie—and that piece of pie may be larger than you care to hand over. However, with a bit of tax planning you can minimize those taxes and even eliminate them altogether sometimes.
Daniel Magence, CPA, Esq. is a principal at Pristine CPA Solutions, LLC (www.pristinecpa.com). Pristine CPA Solutions offers tax and accounting services to individuals and businesses of all sizes, whether it’s tax returns, bookkeeping, payroll services or personal income budgeting. He can be reached at [email protected] or 201-326-6908 if you have any questions or comments, or are interested in using Pristine CPA’s services. Feel free to contact us for a free consultation.
By Daniel Magence, CPA, Esq.
