Hi Gail-

I know we make too much money to qualify for a tax-deductible IRA, so our only choice is to make an after-tax contribution. The question is- can this go into a Roth or is our only option a regular IRA?

I’ve already sent in our 2007 tax return. Our AGI (adjusted gross income) last year was $159,000.  I know that sounds like a lot of money, but we’ve got three kids and live in California and I’m sure you know what taxes are like out here!

 Since we’ve got to send this in by April 15, I’m hoping you can answer this pretty quickly.

 Thanks in advance,

Ginger
 
Hi Ginger,

You’re correct: I explained how to figure out if you qualify to make a tax-deductible contribution to a traditional IRA in my previous column and your joint income definitely exceeds the limit. But I wouldn’t be too disappointed if I were you. In fact, even if you did qualify to deduct your IRA contribution, there are several reasons why it might make sense to send your money to a Roth anyway.  

Regardless of which IRA you contribute to, you have to pay income tax on your contribution. It’s just a question of whether you pay it now or when you start to withdraw money to live on in retirement. At that point, presumably the investments in your IRA account will have grown in value.

The big difference between a traditional IRA and a Roth is the way the earnings in your IRA are taxed. With a traditional IRA, you have to pay income tax on every cent you withdraw; in the case of a Roth, the earnings are never taxed. But that’s not the only reason I’m a big fan of these IRAs.

One question I get all the time is “What’s the likelihood the government will change the rules and start taxing Roth IRA withdrawals?”  Frankly, I have no idea.  Please don’t ask me to predict what Congress is going to do 15 or 20 years from now.

But there are a couple of things I do know: First, there are millions of baby boomers who have made contributions to Roth IRAs based on the understanding that if they forgo the tax-deduction of their contribution, any future appreciation will be tax-free. Millions more will be converting their traditional IRA assets to Roths when the income limit on this disappears in 2010. In general, when the tax laws are changed, Congress includes a “grandfather” clause which protects those with existing accounts.  

In addition, as everyone knows, baby boomers aren’t getting any younger. And the older someone gets, the more likely they are to vote.  Regardless of party affiliation, the one thing every politician seems to want is to be re-elected. I don’t think Congress would risk inciting the wrath of the baby boomers by changing the Roth “deal” mid-stream. It would be political suicide.

While I doubt the Roth rules will change, I’m not at all confident that income tax rates will stay the same. Which is why, just as it’s smart to diversify your portfolio in terms of the investments you own, you also want your portfolio to be diversified in terms of the tax consequences. This involves spreading your investments among taxable, tax-deferred, and tax-free (Roth) accounts. Then, no matter what tax rates are in effect during your retirement, you have the option of pulling income from whatever type of account makes the most sense from a tax standpoint.

I’m not the only one who appreciates the tax-free nature of Roth accounts. Although only about 10% of us who are eligible to contribute to an IRA actually do, most of those annual contributions go into Roth IRAs. The younger you are, the greater the impact of tax-free compounding.   

But even individuals closer to retirement can appreciate the fact that you are not required to take withdrawals from a Roth IRA- ever. That is, unlike a traditional IRA, there are no “required minimum distributions” starting at age 70½.  Plus, as long as you have earned income, you can contribute to a Roth IRA regardless of your age, provided your income doesn’t exceed the limit.

The ability to make an annual Roth IRA contribution starts to phase out once your “modified” Adjusted Gross Income reaches certain levels. (“MAGI” is explained in my previous column.) For the first time since Roths were introduced in 1998, these income limits have been adjusted for inflation. If you’re single, the amount you can contribute begins to decline when your MAGI exceeds $99,000; once it hits $114,000 or more, you are not eligible to send your annual IRA contribution to a Roth.  

Unlike a traditional IRA, whether one or both of you is covered by a retirement plan at work does not affect your ability to contribute to a Roth IRA.  It’s simply a matter of your income and filing status. If you are married and file “joint,” the phaseout for 2007 occurs from $156,000 to $166,000. Those who choose to file “married/separate” cannot make a Roth IRA contribution once their modified AGI (adjusted gross income) hits $10,000.

To answer your question, Ginger, I’m going to assume that you and your husband are under age 50, file “married/joint,” and that your AGI of $159,000 is a close approximation of your MAGI. Since you fall somewhere in the phaseout range, you can make a partial contribution to a Roth IRA for 2007. The only question is, “How much?”

To calculate this, head to the IRS website, www.irs.gov. Next, click on “Forms and Publications.”  Under “Publications” search for #590, “Individual Retirement Arrangements.” You’ll find Worksheet 2-2 in the Roth IRA section.

 

1. Enter your MAGI:                   $159,000
2. Subtract $156,000:                 -156,000

                                                          $3,000

3. Dividing this by $10,000 gives you: 30%

4. Multiply this by the maximum IRA
   contribution you could potentially
   make for 2007:                           $4,000
                                     
5. This gives you the amount by which your
     Roth contribution is reduced:   $1,200

 
As a result, you and your husband can each contribute $2,800 ($4,000-1,200) to a Roth IRA for 2007.

Although your Roth contribution is reduced, you can still make the full $4,000 IRA contribution for 2007. Your only option is to put the $1,200 into a traditional IRA on an after-tax basis. You won’t have to pay income tax on this amount again when you start withdrawals, however the earnings on this contribution will be subject to ordinary income tax.

Hope this helps!

Gail

If you have a question for Gail Buckner and the Your $ Matters column, send them to: yourmoneymatters@gmail.com, along with your name and phone number.